The Performance of Private Equity Funds

ThePerformanceofPrivateEquityFundsLudovicPhalippouandMaurizioZolloSeptember2005Usingauniqueandcomprehensivedataset,wereportthatinvestingintheoverallprivateequityportfoliohasbeenahighlynegativenetpresentvalueprojectunderconservativeassumptions.Weproposeanestimateofperformancethat,incontrasttotheexistingliterature,takesintoaccountthetimevalueofmoneywhenaggregatingperformanceand,iscorrectedforbothsampleselectionbiasand“livingdead”investments.Thereturnofprivateequityfundsraisedbetween1980and1996lagsbyasmuchas3.3%(perannum)ontheS&P500return.JEL:G23,G24Keywords:Privateequityfunds,performancePleaseaddressallcorrespondenceto:LudovicPhalippou,UniversityofAmsterdam,FacultyofEconomicsandEconometrics,Financegroup,11Roerterstraat,1018Amsterdam,TheNetherlands.Tel:[phone],Email:l.phalippou“at”uva.nlMaurizioZolloisaffiliatedtoINSEAD.FinancialsupportfromtheR&DDepartmentatINSEADandtheWharton-INSEADAlliancearegratefullyacknowledged.TheauthorswouldliketothankJesseReyesandThomsonVentureEconomicsformakingthisprojectpossiblethroughgenerousaccesstotheirdatabases.WealsothankBernardDumas,OliverGottschalg,AlexanderGroh,RonKaniel,RobertKosowski,JoshLerner,VinayNair,EricNowak,AndrewMetrick,DimaLeshchinskii,AnnaScherbina,AntoinetteSchoar,ClemensSialm,andseminarparticipantsatINSEAD,Toulousebusinessschool,theEFMAmeetinginBasle,theCEPRmeetinginGerzensee,andtheEFAmeetinginMoscowfortheirconstructivecomments.1ThePerformanceofPrivateEquityFundsUsingauniqueandcomprehensivedataset,wereportthatinvestingintheoverallprivateequityportfoliohasbeenahighlynegativenetpresentvalueprojectunderconservativeassumptions.Weproposeanestimateofperformancethat,incontrasttotheexistingliterature,takesintoaccountthetimevalueofmoneywhenaggregatingperformanceand,iscorrectedforbothsampleselectionbiasand“livingdead”investments.Thereturnofprivateequityfundsraisedbetween1980and1996lagsbyasmuchas3.3%(perannum)ontheS&P500return.2WhenTheEconomistdubbedprivateequityfundsas“Capitalism’snewkings”,1itwasinpartcommentingontheastonishinggrowthintheamountofmoneymanagedbythesefunds.2Indeed,thecapitalcommittedtoUSprivateequity(PE)fundsincreasedfrom$5billionin1980to$300billionin2004,andinthecourseofthepast25years,over$1trillionhaspassedthroughthehandsofprivateequityfunds(Lerneretal.,2004).Moreover,asmostinvestmentsarehighlylevered,theeconomicimpactisevengreaterthantheamountsinvestedsuggest.3Despitebeingamajorclassoffinancialassets,estimatesofthenetperformanceofprivateequityfundsarescarceandarethesubjectofthispaper.Tworecentexceptions—studiesbyLjungqvistandRichardson(2003)andKaplanandSchoar(2005)—bothreportthatprivateequityfundsoutperformtheS&P500.Importantly,thefocusofthesetwostudiesisnotonmeasuringperformancebutratheroncertainaspectsofinvestinginprivateequityfunds(e.g.theflow-performancerelationship,performancepersistence,ordeterminantsofthespeedatwhichcapitalisinvested).Onereasonwhythesestudiesdonotcenterontheexpectedperformanceofprivateequityinvestorsisthelackofacomprehensivedataset.Indeed,inauniverseofatleast3400funds,LjungqvistandRichardson(2003)basetheiranalysison73fundswhileKaplanandSchoar(KS,2005)examine746funds.OurstudydrawsonanupdatedversionofKS’sdataset,comprising983funds.Inaddition,thisdatasetisenrichedbyinformationontheperformance-relatedcharacteristicsof1391additionalfunds,whichenablesustocorrectforsampleselectionbiaswhenestimatingperformance.Furthermore,asourfocusisonperformance,wemaketwomethodologicalcontributionsthatconsistofamoreeconomicallyappealingfundaggregationdeviceandtreatmentofresidualvalues(deletionofso-called‘living-deads’).4Wefindthatthesethreecorrectionsdramaticallydecreaseperformanceestimates.ThefirstcorrectionadjuststheoriginalKSdatasetforapotentialsample-selectionbias(thatwasacknowledgedbyKS).UsingthetraditionalHeckitmethodology,andinformationaboutboththeinvestmentsuccessandcharacteristicsoftheadditionalfundsinoursample,wefindthattheexpectedperformanceoftheseadditionalfundsisabout2%lowerthantheexpected127November2004,TheEconomist.2Notethatrealestateandentrepreneurialinvestmentsinnon-publiccompaniesaresometimescalledprivateequity.Inthispaper,weconsiderso-calledprivateequityfunds.Suchfundsprimarilyinvestinbuyoutandventurecapital.3Forexample,thelargesthistoricalbuyout,ofNRJNabisco,usedonly$1billionofequityforanacquisitionworth$25billion.Morerecentleveragedbuyouts(LBOs),however,uselessextremeleverage.4Residualvalueisthevalueofnon-exitedinvestmentsreportedbyfundsonaquarterlybasis.3performanceofselectedfundsintermsofInternalRateofReturn(IRR)and9%lowerintermsofProfitabilityIndex(PI).5Aftercorrectingforthissampleselectionbias,thevalue-weightedaverageperformanceofprivateequityfundsisfoundtobebelowthatoftheS&P500(PIisreducedfrom1.05to0.95).Thesecondcorrectionconsistsincomputingperformancebasedontheaggregatedcashflowsacrossallfunds,therebygivinganestimateofthereturnoftheoverallprivateequityportfolio.Inoursample,thisestimateofoverallperformancedifferssignificantlyfromthevalue-weightedaverageperformance(withcapitalcommittedasweights)usedintheliterature.Thischan