All winning streaks come to an end eventually, from UCLA’s basketball Bruins to UConn’s basketball Huskies. They are exhilarating while they last and can stretch from season to season. Nor does a single loss betoken a dramatic fall off in performance, provided the core of the team remains and plays to its strengths. Still, a contrarian might be prepared to stake money on a loss. It’s bound to happen, sooner or later.
Here at All About Alpha we love sports analogies. But sports diverge significantly from investing because true investment skill and superior management can be hard to discern. Was it first time lucky? Is there evidence of a of a streak forming? Can a streak be sustained? Those are questions every alternative investor asks. The optimists hope that past success, coupled with a repeatable investment process, will reap continued rewards into the future. Contrarians, however, are more likely to pull in their horns when they see large quantities of capital flowing into an investment space.
It seems the contrarians may be right, at least when it comes to private equity: Streaks end sooner rather than later. A recent paper, “Performance Persistence in Private Equity Funds,” by Ji-Woong Chung of the Chinese University of Hong Kong suggests that if the first fund from a private equity firm outperforms, the second one will too. But not the third and later funds. Market conditions are one reason, success at capital raising being another.
That stands in marked contrast to earlier studies, which suggested a strong persistence in performance among top-quartile managers. The touchstone is a seminal 2003 paper by Steven Kaplan at the University of Chicago’s Booth School of Business and Antoinette Schoar at the MIT Sloan School of Management. In the interim, private equity returns have been subjected to the same analysis applied to hedge funds: namely, how robust is the data and is performance overstated. Still, many have asserted that such studies affirm that top-quartile funds at least earn their fees and provide alpha to investors.
But for how long? According to Chung’s research,
“The difference in median values between first quartile portfolio (best performing funds) and fourth quartile portfolio (worst performing funds) formed based on initial performance is 35.8%. But the difference shrinks to 11.5% and 3.8% for the first and second follow-on funds, respectively. For venture capital funds, the corresponding differences are 34.8%, 12%, and 2.4%, respectively.”
You can see this in the chart below from Chung’s paper, where lines show subsequent returns of quartile winners in the first time period:
Thus, despite a firm’s initial success and subsequent follow-on record, outperformance seems to disappear after the second fund has been raised. Do manager skills atrophy over the space of four funds (or, chronologically, 12 to 20 years)? What accounts, then, for the first successful follow-on fund? Much depends, as Chung argues, on the investment environment: like conditions will conduce to like results. “Since a private equity fund’s life is about ten years, and a follow-on fund is usually raised three to five years after a preceding fund raising, successive funds share several years of an overlapping investment period during which the common economic condition or shocks can influence the performance of preceding and following funds simultaneously. Therefore, the similarity of market conditions and the length of the overlapping investment period of successive funds can affect persistence.”
As evidence, he points out that “the longer the time gap (the number of years elapsed) between two consecutive fund raising cycles, the weaker the performance persistence. In other words, as the duration of overlapping investment periods becomes shorter, there is less of a performance correlation between current and follow-on funds. On average, a one standard deviation increase in the number of years between two successive funds leads to a 0.144 (or 41%) decrease in performance persistence. However, I find this evidence only for buyout funds.”
The market factors he incorporates are IPO and stock market conditions, macro economy and credit market conditions. A divergence can produce dramatically different results. “For example, a one standard deviation increase in the measure of IPO market dissimilarity between two investment periods of two consecutive funds completely explains away performance persistence between two neighboring buyout funds.”
But that leaves out venture capital! A second factor he canvasses is that success attracts money – too much, perhaps – for general partners to deal with. Successful managers do raise more money for new funds than less successful ones, he notes:
“However, funds that have grown more subsequently underperform. The return-chasing-capital phenomenon is slightly more pronounced for buyout funds, and the diminishing returns to capital inflows are found only among venture capital funds. These results suggest that the resources and skills necessary for managing venture capital funds are not readily scalable compared to buyout funds.” As evidence, he reports that a “[o]ne standard deviation increase in fund growth reduces performance persistence by about 0.19 (or 52%) among venture capital funds. A two standard deviation increase in fund growth could completely eliminate persistence.”
All of this, Chung adds, says little about the persistence of manager skill. But it does point to the terrain over which skill is deployed.
Maybe, in private equity, success goes not to the champions but to the contrarian underdog – or at least the contrarian market timer. Repeats? Sure. “Three-peats”? Not likely. But “Four-peats?” Those are only for John Wooden.