As GPs gain more experience, returns go down . . . but so does risk!

For many years, investors in private equity have been laser-focused on returns. As the asset class has matured, the discussion around returns has been leavened with an understanding of risk. Research suggests that as a GP matures, returns tend to go down – which may, on its face, sound bad, but the risk associated with these returns diminishes, as well. In other words, as the chance of a really great deal decreases, the chance of a really bad deal does as well, a trade-off that works for quite a few LPs.

What explains this dynamic? Dr. Oliver Gottschalg of HEC Paris, Dr. Josh Lerner of Harvard Business School, Dr. Timothy Jenkinson of Said Business School at Oxford University and Henny Sender of the Financial Times discuss the topic of private equity risk and returns at SuperInvestor Berlin.

It takes a long time to for firms to learn how to invest in private equity successfully, especially if early successes were based on more risky deals. “There is actually a big delay between doing the deal and knowing whether this was a good idea or bad,” says Dr. Gottschalg. “It is very difficult for private equity firms to get the right learning going on.”

Dr. Gottschalg has conducted numerous studies in the dynamics of risk in the private equity asset class. In a study conducted in conjunction with Dr. Bernd Kreuter, Managing Partner at Palladio Partners, Dr. Gottschalg found a substantially lower-than-expected level of value-at-risk in private equity.

Additionally, Dr. Gottschalg has also identified a link between returns and risk in PE. While returns and risk may go down together, there is an inverse correlation between risk and alpha. By analyzing 152 PE GPs and their 263 PE Funds (always at least with 9 realized investments), Dr. Gottschalg found that the most capable GPs delivered greater Alpha at lower return volatility, while less capable GPs create less value and made more mistakes.

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