PDF Ebook What Drives Private Equity Fund Performance?
The activities of private equity funds have recently received considerable attention due, primarily, to two factors. First, the amount of capital committed to US private equity funds has grown from $5 billion in 1980 to $300 billion in 2004, totaling over $1 trillion over the last 25 years (Lerner et al., 2004). Second, it has been extensively argued that fund managers play an important strategic role in the companies they finance (e.g. Lerner, 1995, Hellmann, 1998, and Hellmann and Puri, 2002).
Given the importance of private equity both as an investment vehicle and as a catalyst for economic growth, the need for a comprehensive assessment of the risk profile of this industry is apparent. In a review paper, Gompers and Lerner (2001) classify the understanding of risk and return as “what we don’t know about venture capital,” a statement that is also true for buyout investments.
Getting insight into the risk profile of private equity funds as well as the other drivers of their performance is the objective of this paper. We believe that this endeavor is not only interesting per se (e.g. for portfolio allocation) but also interesting in light of recent research that reports that private equity funds have a relatively low performance. For example, Kaplan and Schoar (2005) show that, in their sample, private equity funds have a performance that is close to the performance of the S&P 500. This is puzzling as the bulk of the money of private equity funds is invested in leveraged buyouts, which are typically significantly more levered than the S&P 500. This should result in a sizeable premium for buyout investments. The rest of the money is invested mainly in venture capital, which might also command a premium over the S&P 500 due to betas likely higher than one. Furthermore, Phalippou and Zollo (2005) show that the sample selected by Kaplan and Schoar (2005) includes superior funds and that the realized aggregated performance of private equity funds is actually significantly below that of the S&P 500. Such results prompt the following questions: what are the characteristics of the funds that under-perform? Do funds exhibit risk and hedging characteristics that would make the above performance estimate fair?
Using a unique and comprehensive dataset containing information on cash flows to/from investors and the investments made by about 700 private equity funds, this paper addresses these two related questions by investigating what are the drivers of private equity fund performance.
To evaluate the influence of business cycles and stock-market cycles on performance, we first construct a proxy for the CAPM-beta of funds. We use the information on the industry in which funds invest and the type of investment they make (venture capital versus buyout) to compute a beta for each investment based on the matching industry betas and making appropriate leverage assumptions. The investment betas are then aggregated at the fund level to obtain a beta for each fund. These fund betas are found to be about 1.6 and we do not find a statistically significant relation between fund beta and fund performance.
Second, we assess how macroeconomic conditions at the time of investments, during the life of investments, and at the exit of investments relate to fund performance. Irrespective of the proxies we use, we find that private equity fund performance is significantly procyclical. Performance significantly increases with the average GDP growth rate and decreases with the average level of interest rates – in particular corporate bond yields – that prevailed during the life of the investments. Moreover, macroeconomic conditions are found particularly important at the time investments are made. When either credit spreads or corporate bond yields are low at the time investments are made, fund performance is higher.
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PDF Ebook What Drives Private Equity Fund Performance?
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