Private Equity in the 21st Century

The following post comes to us from David Robinson, Professor of Finance at Duke University, and Berk Sensoy of the Department of Finance at Ohio State University.

In the paper, Private Equity in the 21st Century: Cash Flows, Performance, and Contract Terms from 1984-2010, which was recently made publicly available on SSRN, we use a large, proprietary database of private equity cash flows and management contract terms over the period 1984-2010, comprising close to 40% of the U.S. Venture Economics universe, to provide new evidence on the determinants of private equity performance, cash flow behavior, and contract terms. The data are the first available for academic research to include cash flow information for a large sample of private equity funds extending beyond 2003, to include information on general partner capital commitments, and to combine cash flow information with the terms of the management contracts.

Our analysis is centered around two interrelated themes. First, we investigate the impact of broader market conditions on private equity markets. While it is well known that public and private equity markets are correlated through time, with shared periods of boom and bust, the implications of this correlation for private equity investors and managers are not well understood.

Because we have complete cash flow data, we can explore the link between public and private markets by constructing Public Market Equivalents (PMEs), following Kaplan and Schoar (2005), rather than rely simply on IRRs for our performance assessments. PMEs explicitly account for the timing of cash flows in and out of funds by discounting cash flows using the return of public equities, whereas IRRs simply compute the implied return earned on the capital put into the fund. Put differently, IRRs make no attempt to account for the opportunity cost of capital at the time it is called or distributed. Although the two measures have a high cross-sectional correlation, the distinction between absolute performance and performance relative to an investable index is critical for understanding the relative performance of private equity as an asset class, both on average and over time.

As an asset class, our sample of private equity funds has performed well. Using PMEs, we find that on average, private equity has outperformed the S&P 500 by about 15% over the life of the fund during our sample period. Performance based on IRRs looks worse, but this reflects the fact that overall market conditions were poor during portions of our sample period. For example, buyout funds with vintage year 1999 earned a negative 3% IRR, but this is largely due to overall market conditions during their investment horizon: this vintage outperformed the S&P 500 by 22% over the funds’ lives. More generally, we find that hot fundraising markets are followed by low IRRs, consistent with conventional wisdom. However, hot fundraising markets are not followed by low PMEs. That is, hot markets are not generally followed by underperformance of private equity relative to public equities.

The difference between absolute and relative performance over time is clearly driven by a correlation between private equity cash flows and public market returns. Investigating this correlation in more detail, we find that capital calls and distributions are both more likely and larger when public equity valuations rise, but distributions are more sensitive to public markets than calls are, implying a positive correlation between public and private equity returns. These results also imply that net cash flows are procyclical and private equity funds are liquidity providers (sinks) when valuations are high (low).

Controlling for public market valuations, there is little evidence that private equity is a liquidity sink, except during the financial crisis and ensuing recession of 2007-2009. During the crisis, the tendency for calls to occur independent of measurable macroeconomic variables spiked, even though overall call activity dropped slightly. At the same time, distributions plummeted, and the sensitivity of calls and distributions to changes in underlying measurable macroeconomic variables changed considerably. These results suggest a greater abnormal liquidity demand by private equity funds, perhaps reflecting an increase in attractive investment opportunities, as well as a lack of exit opportunities during the crisis. Overall, our evidence on the timing of cash flows and distributions suggests that the time-series liquidity properties of private equity are largely driven by the presence and nature of underlying investment and exit opportunities.

The second main theme of our analysis is the view that the terms of the management contracts, and the relation between these terms and eventual fund performance, reflect both changes in GP bargaining power relative to LPs over time, and also the agency relationship that arises when LPs hire a GP of (partially) unknown ability to conduct private equity investments on their behalf. We find that GP compensation rises and shifts to fixed components during fundraising booms, when GP bargaining power is likely to be at its highest. We also find that both GP capital commitments and carried interest are higher in larger funds, while management fees are lower. But there is no relation between compensation terms and net-of-fee performance. This contrasts with the mutual funds literature, which generally finds that higher mutual fund fees translate into lower returns for investors. Our results on private equity contractual terms are consistent with an optimal contracting equilibrium in which higher ability GPs raise larger funds, receive greater incentive pay and fractional ownership, and earn back their total compensation by generating higher gross performance.

The full paper is available for download here.

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  1. […] Private Equity in the 21st Century: Cash Flows, Performance, and Contract Terms from 1984-2010 – Via SSRN – we use a large, proprietary database of private equity cash flows and management contract terms over the period 1984-2010, comprising close to 40% of the U.S. Venture Economics universe, to provide new evidence on the determinants of private equity performance, cash flow behavior, and contract terms. The data are the first available for academic research to include cash flow information for a large sample of private equity funds extending beyond 2003, to include information on general partner capital commitments, and to combine cash flow information with the terms of the management contracts. Our analysis is centered around two interrelated themes. First, we investigate the impact of broader market conditions on private equity markets. While it is well known that public and private equity markets are correlated through time, with shared periods of boom and bust, the implications of this correlation for private equity investors and managers are not well understood. […]