In a new study by Harvard Business School scholars looks into the performance of LPs invested with private equity over four decades.
In the paper, Investing Outside the Box, the scholars found that it is generally better to invest inside the box. Specifically, they found that the performance of alternative investment vehicles offered by successful GPs to their limited partners predictably lags behind the performance of the main funds.
There is a tiering of performance based on bargaining between GPs and LPs, and the LPs’ outside options. The GPs want some LPs to invest more than they want others. They want LPs with solid connections and/or with deep pockets, and (closely related to the later of course) with a willingness to wait out bad times. They want LPs that will serve as liquidity performance.
Thus, within the vehicles offered by a given GP, one would expect as a hypothesis that there would be a tiering, with the most desirable LPs getting the most desirable products. Some high-prestige GPs (“the best groups”) consider the main funds to be for their best clients. On a related point, the HBS scholars observe that there is relatively little competition across private capital managers other than the pricing of their main funds.
The Bottom Line
The bottom line after an analysis of the data is that the hypothesis is right, the best groups offer other arrangements to those they consider less valuable LPs, with lower tier assets or higher fees. Some of these LPs might understand what is going on, but be happy to receive medium-tier results, because they could not otherwise obtain access to the top-tier managerial talent at all.
Others of the LPs who get this treatment might be in the dark about what is going on, and those who have aggressively pursued discounts may find that they are ending up with lower returns.
The key metric for measuring the difference between the main fund and the lower-tier products is the ratio of total value to paid-in capital (TVPI). The authors of the Harvard paper find that, in accord with the above described hypothesis, the main fund does substantially better than the alternative vehicles in TVPI.
Such alternative vehicles are much more likely to be offered by buyout funds than by debt or VC funds. The alternative vehicles account for 38% of all vehicles and 18% of all capital raised by the buy-out grounds.
A Note on the Data
Their data set comes from State Street, whose custodial division has a “rich array” of information on its clients. The authors looked at 108 asset holders with private capital exposure as shown in that data, who have invested in over 70,000 private investment vehicles; 22,000 of which are PE-related. After applying various filters, the HBS group was left with 5,322 vehicles that were best for their purposes.
Of those 5,322, roughly two-thirds—3,620—were main funds in the sense in which the term is used above. Most of those are traditional eight- to 10-year partnerships, though a few of them have “less common structures, such as the long-duration funds that a number of private equity groups have raised in recent years.”
They are not saying that the LPs with less clout and thus occupying the lower tiers are losing money, or even that they are getting less than the market return. Rather, the authors of the working paper conclude that “better performing GPs offer alternative vehicles which perform worse than their main funds, but still offer investors a return that is commensurate with the rest of the market.” [Italics added.]
The authors of the HBS study are: Josh Lerner, Antoinette Schoar, Jason Mao, and Nan R. Zhang. Lerner is the Harvard Business School’s Jacob H. Schiff Professor of Investment Banking, Schoar with the Massachusetts Institute of Technology Sloan School of Management’s Michael M. Koerner Distinguished Professor of Finance. Mao and Zhang are with the State Street Global Exchange. Mao has designed and implemented various quantitative models at State Street, such as PE performance attribution analysis; Zhang is State Street’s head of product implementation and alternative investment research.