What Private Equity Capital Flows Tell Us About Future Performance

The private equity industry is facing a capital overhang of nearly $750 billion dollars, according to an article by ValueWalk. Most of this is due to capital raised in 2015. It appears that the average private equity GP is flush with the requisites capital to conduct investments far into the future.

picture1But are their downsides to this kind of overabundance? The common concern has been that the availability of dry capital drives up asset prices and places an undue pressure on private equity firms to put this money to work in a less than perfect environment for doing so.

A recent study conducted by Dr. Oliver Gottschalg (with the support of the HEC PE Observatory and Fondation HEC and data provided by ILPA and Cambridge Associates) entitled The Risk Return Characteristics of Institution Buyout Fund Investments measured capital flows into the buyout industry and found that buyout fund performance is significantly and negatively related to the extent of commitments. In other words, periods with large amounts of dry powder are characterized by less-profitable buyout exits.

In addition, the study interestingly shows a negative relation between capital commitments and investment duration. It appears that during periods of high levels of dry powder, GPs put money to work in investments that end up having shorter holding periods. This could be for a number of reasons. Generally favorable economic environments tend to coincide with high levels of private equity fundraising, as well as a favorable exit environment. This higher speed driven by capital inflows could indicate that in times of stronger competition, transactions are being liquidated prematurely, possibly contributing to the observed performance effects.

Finally, the study indicates that private equity allocations have no link to the performance of the public markets. Both a regression of the market returns on commitments and its coefficient parameter indicate that institutional investors do not systematically allocate more or less capital to buyout funds when stock markets are entering pronounced periods of increase or decline. In other words, LPs are not swapping capital commitments between public and private equities depending on the performance of public equities.

In summary, Dr. Gottschalg’s study on the effect of capital flows on performance produced a number of interesting findings:

  1. The amount of dry powder and performance are negatively correlated;
  2. Periods of large amounts of dry powder result in investments with shorter hold periods; and
  3. There is no link between public market performance and capital inflows to private equity

Methodology: To measure capital flows into the buyouts industry, the study calculated the institutional capital commitments to buyout funds by vintage year and geography using fund size information from an internal data set. The cumulative size of all funds raised in the given vintage year and geography provides an (albeit imperfect) estimate of the amount of capital available to fund deals. Following previous research (e.g. Kaplan and Schoar, 2005), we divide the annual capital commitments by the total value of the U.S. stock market at the beginning of the vintage year. This “deflation” makes capital commitments comparable over a long period of time without the distorting effect of an overall expansion of economic activity. In line with Harris et al. (2014), we then regress aggregate capital flows, separately for North American funds and for the entire global sample, on pooled vintage year performance – as measured by IRR, TVPI, KS-PME, PERACS Alpha, PERACS Rate of Return, as well as on Duration and Market Returns. Table VII shows the results of these calculations for North America (Panel A) and for the complete sample (Panel B).

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The Risk and Return Characteristics of Institutional Buyout Fund Investments on Scribd

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