Limited Partner Performance and Maturing of the Private Equity Industry

Since the modification of the “Prudent Man” rule in 1978 that allowed institutional investors to allocate part of their portfolios to alternative assets, the private equity industry has changed substantially. In 1980, the largest fund raised was the Golder-Thoma $60 million dollar fund that invested in many different kinds of deals, including both venture capital and buyouts. At the time, institutional investors were somewhat skeptical of the industry, GPs, LPs and portfolio firms were experimenting with different contractual structures, and indeed “private equity” itself was not an accepted term. By the time of the 2008 Financial Crisis, individual funds of over $20 billion were being raised, funds became specialized in particular types of investments so that “renewable energy” or “infrastructure” funds were commonplace, contracts have become standardized, and private equity has become an accepted part of the financial world in which most major business schools teach courses, and is even a topic for debate in presidential campaigns.

It is natural that such maturing of an industry can lead to changes in the fundamental relationships between participants. In the private equity industry, the major participants are the limited partners (LPs), the general partners (GPs), and the portfolio companies. In the paper, Limited Partner Performance and the Maturing of the Private Equity Industry, which was recently made publicly available on SSRN, my co-authors (Berk Sensoy and Yingdi Wang) and I explore the relationship between limited partners and general partners by focusing on access to funds, and the way in which it has changed over recent years. An overarching hypothesis is that the fundamental changes brought on by the maturing of the private equity industry have changed the nature of relationship between limited partners and general partners in private equity.

We examine this hypothesis empirically with special attention to the unusually good performance earned by endowments documented by Lerner et al. (2007). To do so, we gather a sample of 1,852 LPs’ stakes in 1,250 buyout and venture funds between 1991 and 2006, which is substantially larger than any previous sample of LP stakes. We start by showing changes in returns brought on by the maturing of the industry. Consistent with prior work, we find an industry-wide decline in returns and a decline in the relationship between GP experience and return. These results are driven by changes in venture funds.

We also confirm the Lerner et al. (2007) finding that endowments outperform other investor classes during the 1991-1998 period. We argue that this unusually good performance was likely due to endowments’ access to the best funds during this period, rather than superior skill at picking funds, for three reasons.

First, the superior performance demonstrated during 1991-1998 did not continue subsequently; during the 1999-2006 period endowments’ performance in their private equity investments was very similar to that of other investor classes. The unusual performance was limited to venture funds that benefited from the technology boom of the 1990s, the performance of endowments’ investments in buyout funds was similar to that of other asset classes. Presumably, superior skill would have manifested itself in other kinds of funds as well.

Second, endowments’ reinvestment decisions are not consistently better than that of other investors, especially over time. In the venture sector during the 1991-1998 bull market, even if endowments had made random reinvestment decisions, or had only reinvested in the fund families for which they chose not to invest, they still would have earned close to a 60% IRR on those investments and outperformed other classes of investors.

Third, even in the 1991-1998 period, endowments did not outperform other investor classes in their investments of first-time funds, for which access is unlikely to be limited and so represent a pure test of selection skill. Moreover, direct tests of access using abnormal growth of fund assets to measure limited access reveal that endowments were more likely to invest in venture funds with limited access during the 1991-1998 period, and also that these funds (venture funds with limited access during the 1991-1998 period) had unusually good performance.

It is clear that there have been major changes in private equity industry in recent years. We argue that this maturing has had implications for the relationship between GPs and LPs. Presumably the huge inflows of capital and commoditization of the industry has lowered the rents to GPs. If limited access reflected the sharing of these rents, then as these rents decreased over time, we should expect that the importance of limited access would decrease as well.

The full paper is available for download here.