Understanding the “How” of Private Equity Returns

Private equity performance measurement is moving away from determining “how much” firms have generated and towards “how” and by what methods those returns are achieved. Behind this evolution from quantity to quality is the need to know whether a private equity fund’s performance is likely to be replicated or not. Eschewing the traditional, backward-looking performance measurements thus far employed by the industry, Dr. Oliver Gottschalg of PERACS has developed a set of metrics and analyses designed to peer into the future and, by understand “how” returns are generated, understanding whether those returns are likely to persistence or not.

In a recent paper published by Dr. Gottschalg, Understanding the “How” of Private Equity Value Creation to Spot Likely Future Outperformers, found that one category of deal characteristics above all else was predictive of future performance. This category, referred to as the “implementation” components of the returns, were comprised of the “Who and How” decisions were made, i.e. the performance of the specific investment approaches into specific target companies and who was responsible for them – as opposed to investment fund vintage year, timing of investments and or the type of company bought.

At its core, the paper is based on a novel methodology that measures four distinct components of a PE fund’s performance, three of which are proxy indicators for underlying capabilities of the fund manager. The approach compares data on tens of thousands of underlying investments made by thousands of PE funds, grouping them according the three different aspects of similarity: (a) timing of the funds’ raising, (b) timing of the deals themselves, and (c) the type of target company. This classification of the universe of funds based on similarity, shown in the below Venn Diagram, facilitated further analysis of outperformance controlling for these variables.

Figure 1: Comparing of fund to sets of competitors with different levels of similarity

By controlling for the year a fund was raised, the time of the investment was made, and the type of company, the methodology is able to isolate the portion of the fund’s overall performance that can be attributed to the specific investment approaches into specific target companies, above the returns of other funds who made similar decisions in terms of timing and strategy. A representative illustration of the impact of these separate, isolated components is below.

Figure 2: Illustrative example of performance components

The aforementioned findings have important implications for PE investors, as they suggest that without a deeper understanding of the nature of a GPs value creation, the ability of investors to reliably identify likely future outperformers is substantially limited. Based on an assessment of the deeper value driver components in a GP’s past funds, however, investors are likely to be able to select funds that are significantly more likely than the average to outperform.

Beyond the Quartiles_White Paper on Scribd

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