In private equity, “the big get bigger”
One firm's analysis of fund raising in the private equity industry
Prior research on performance persistence in private equity indicates that it is rational for investors to assign more capital to general partners whose prior funds have performed well. But do limited partners follow this capital allocation rule? We find that investors in general do not respond strongly to past fund performance. Instead, firms that have raised large funds in the past are overwhelmingly more likely to attract significant capital from limited partners.
Suppose partnership A raised twice as much capital as partnership B for its current fund. Our results indicate that for its next fund, partnership A is likely to raise 1.69 times as much capital as partnership B. The results apply across different fund investment types, regions, and vintages. The findings extend to situations where there is a six to ten year difference between the vintage of the prior fund and that of the subsequent fund.
We show further that the tendency to earmark more capital for partnerships that have managed larger funds is detrimental to performance. As a consequence of capital constraints at the fund level, a dollar invested in partnerships with large prior funds delivers 48 cents less than a dollar invested in partnerships with small prior funds. These findings indicate that slow moving capital in private equity is costly for limited partners.
The literature on performance persistence in private equity suggests that it is rational for investors to allocate capital to partnerships that performed well in the past (Leong, Tan, and Teo, 2014; Harris, Jenkinson, Kaplan, and Stucke, 2014; and Phalippou, 2010). For example, in Leong, Tan, and Teo (2014), we show that a dollar invested in partnerships at the top past performance quintile yields $1.21 more than a dollar invested in partnerships at the bottom past performance quintile.
Yet at the same time there are several reasons to believe that institutional investors may simply forgo stellar performance and gravitate towards the larger partnerships. Institutional investors may have formed deep relationships with these large partnerships in the past and it may be costly from a due diligence standpoint for these limited partners to allocate capital to emerging partnerships.
Moreover, limited partners motivated by career concerns may find it less risky to herd into the larger partnerships. In addition, large institutional investors who write big cheques may be reluctant to invest in funds raised by small partnerships due to worries that such small partnerships may not have the necessary resources and infrastructure to manage and deploy the capital.
Still such behavior may be suboptimal from a performance standpoint since (i) investors do not capture the performance persistence premium, and (ii) investors run into capacity constraints (Berk and Green, 2004; Teo, 2013a) when they herd into the latest fund launched by large partnerships. In this issue of the private equity insight, we explore how limited partners allocate capital in the private equity industry. In particular, we test whether limited partners respond rationally to the performance of the prior fund launched by the partnership or whether they gravitate towards partnerships than have managed larger funds in the past. Our findings will help us understand the pace at which capital moves across private equity partnerships and whether capital is allocatively efficient in private equity.
Do limited partners respond to past performance?
To understand whether limited partners base their capital allocation decisions on past performance, we sort partnerships into quintiles based on the performance of the previous fund launched and evaluate the size of their subsequent funds. When we sort firms based on prior fund IRR, we find that partnerships that delivered top quintile performance do not raise funds that are larger than partnerships that generated bottom quintile performance.
Indeed the results indicate that the funds raised by top performance quintile partnerships are smaller on average than those conceived by bottom performance quintile partnerships. We observe the same phenomenon when we sort based on fund multiple. Partnerships with top quintile investment multiples raise funds that are on average US$50m dollars smaller in AUM than partnerships with bottom quintile investment multiples.
Only when we sort on PME do we find that prior fund performance matters for future capital raised. One view is that fund performance may matter more within the set of larger partnerships, which are more likely to provide the cash flow data needed for the PME calculation. Still in general for the bulk of our fund sample, it is clear that past performance does not exert a first order impact on future launch sizes.
Slow moving capital
If stellar prior fund performance does not engender larger subsequent fund capital, what influences the size of the subsequent fund raised?
One hypothesis is limited partners simply allocate more capital to larger partnerships. First, limited partners may have developed strong relationships with the same general partner if they have invested in the prior funds launched by the partnership. Second, limited partners may gravitate towards the larger partnerships because of herding and career concerns. Third, large institutional investors write big cheques and feel more comfortable if the capital they allocate to the fund is not a significant portion of total fund AUM. Therefore, these institutional investors may limit their search to the larger partnerships in the private equity universe.
To test, we sort funds into quintiles based on the AUM of the previous fund launched by the same partnership and report the fund sizes. The results indicate that partnerships that have raised larger funds in the past are more likely to raise larger funds subsequently. The subsequent fund performance numbers reported also indicate that such capital allocation behavior tends to be detrimental to investor returns. The larger funds raised by larger partnerships subsequently underperform the smaller funds raised by smaller partnerships by 5.83 percent when we examine IRR and by 48 cents when we compare investment multiples.
Next, to understand the interaction between prior fund performance, prior fund size, and subsequent fund size, we first sort funds into quintiles based on previous fund size. Within each size quintile, we further sort funds into quintiles based on previous fund investment multiple. The average fund sizes reported reveal that past performance only influences future fund launch size for the larger partnerships in the sample. Past fund size on the other hand impacts future fund launch size across the entire past fund performance spectrum.
Challenges for fund raising
Our findings suggest that smaller partnerships face significant difficulties moving up the food chain in the private equity industry. To understand the challenges that they face, we compute the transition probabilities for firms sorted by prior fund size and subsequent fund size. The probabilities reported indicate that there is significance persistence in the sizes of the funds raised by partnerships over time. This is especially true for firms in the largest prior fund size quintile and the smallest prior fund size quintile.
Firms in the former group have a 62.7 percent chance of raising a subsequent fund that belongs to the top size quintile. Similarly, firms in the latter group have a 62.3 percent chance of conceiving a fund that belongs to the bottom size quintile. We note that on average, funds in the top prior fund size quintile manage US$2.01bn in capital while funds in the bottom prior fund size quintile manage US$41.6m. Also funds in the top subsequent find size quintile manage US$2.61bn while funds in the bottom subsequent fund size quintile manage US$55.7m. Firms in the other three prior fund size quintiles display less size persistence than firms in the extreme size quintiles. Although, when they do migrate they typically migrate to adjacent size quintiles.
The results from this analysis paint a fairly bleak picture for the smaller partnerships in the private equity industry. We show that the adage that “the big gets bigger” applies to private equity. Not only does performance persist in private equity but size persists as well. Investors are in general reluctant to move their capital away from the larger shops and towards better performing but smaller firms.
The slow moving capital that we uncover in private equity may be induced by prior investor/investee relationships, career concerns, or the institutionalization of the industry. Regardless of the underlying driver, it is clear that such capital allocation behavior is not optimal for investment performance.
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