How to predict your PE manager’s performance

There are an estimated 1,600 private equity firms around the world in capital-raising mode at the moment, offering fiduciary investors a smorgasbord of alternatives, split on regions, style, size, stage and sector categorisations. Some recent good news for investors is that, for private equity at least, there is now evidence of performance persistence.

Research from global alternatives advisor Preqin shows that the early returns from private equity funds, before they reach maturity, are actually fairly good predictors of final returns, contrary to popular opinion.

Fund managers typically launch a new offering as they come to the investment period for their previous PE fund, which will average about four years after the previous fund closed. With the previous fund being less than half-way through its life cycle, the question has been whether its early returns are much of a guide to manager skill.

After analysing 5,300 PE funds, including about 2,500 buyout and venture funds with sufficient maturity to be part of the research, Preqin compared the funds’ performance during their fourth year with their performance at maturity. They also performed the same analysis for funds in their sixth year and looked at the proportion of funds which change quartile form year to year. The results are interesting. The main points are:

•      early quartile rankings for both buyout and venture capital funds are an excellent predictor for future relative performance,

•      half of the buyout funds ranked in top quartile in year four go on to be top quartile at maturity, with 75 per cent beating the median, while 60 per cent of venture funds in top quartile at year four maintain top quartile position at maturity with 76 per cent beating the median,

•      poor relative performance early on in a fund’s life proves to be extremely difficult to turn around. Just over half (51 per cent) of buyout funds in the bottom quartile in year four remain there at maturity, while 60 per cent of venture funds in the bottom quartile at year four maintain this position at maturity.

•        By year six, quartile rankings are even more important. A total of 67 per cent of top quartile buyout funds in year six maintain this position at maturity, with only 11 per cent failing to beat the median. A total of 73 per cent of venture capital funds maintain their position in the top quartile, with only 5 per cent failing to beat the median. Conversely, only 11 per cent of bottom ranked buyout and 7 per cent of bottom ranked venture funds in year six are able to turn things around and beat the median at maturity.

Tim Friedman, Preqin senior manager and author of the report, says that the results of this work indicate that investors should pay attention to a fund manager’s quartile ranking for recently launched funds and those considering purchases on the secondaries market should be extremely wary of bottom-quartile funds.

However, not all funds perform to type. A significant minority – 12 per cent – of bottom-quartile buyout funds at year four are able to achieve top-quartile status at maturity.