Asset Classes

Alternative PE vehicles underperform

Co-investment, and other alternative private equity vehicles, underperform a manager’s associated main fund, a new paper by leading private equity academics Josh Lerner and Antoinette Schoar shows.

The paper, co-authored by Harvard’s Lerner, Schoar from MIT, and Nan Zhang and Jason Mao from State Street Global Exchange, examines the performance of alternative vehicles, such as direct investing and co-investments, for the first time.

The research found that, on average, co-investment private equity vehicles underperform a general partner’s (GP) main fund; however, there is a twist. The paper also found that limited partners (LP) with better past performance invest in alternative vehicles that have above-average market performance. In fact, the performance of co-investment vehicles for those investors outperforms even the GP’s main fund.

In other words, if you’re an investor with access to high-performing GPs, it’s worthwhile to invest in a co-investment vehicle. For everyone else, it’s not worth it.

“When comparing the performance of alternative vehicles to those of the main funds raised by the same private capital group in the same year (or in the five years prior), we see that on average the alternative vehicles underperform their associated main funds,” the paper, Investing Outside The Box, states.

In an interview with, Lerner, who is the Jacob H. Schiff Professor of Investment Banking at Harvard Business School, said the same funds that were good at choosing private equity funds (and managers) were also good at choosing alternative vehicles, and outperforming the associated main fund.

“Those that do it well show it’s worth doing,” Lerner says. “This supports early work that Antoinette and I did that highlighted that not all LPs are created equal.

“If you take the conclusions of this paper seriously, then doubling down on choosing the right funds to invest in is the winning strategy for investing in private equity, rather than investing in alternative vehicles”, with the exception of LPs that are proven to be very good fund-pickers.

The good news is Lerner’s observation that LPs often learn from their investments in private equity, resulting in improved performance.

“There is evidence that LPs have a general pattern of increasing performance over time,” he says. “Trial and error really matters. One thing that has impressed me about the leading LPs is their experience really comes to bear. A lot of it is pattern recognition and inference from stuff they have seen before and where the warning signs are.

“A lot of the LPs that are good often have people who have been in the industry for a while and worked together for a while so are good at the softer things. This is definitely an area where LPs can get better.”

The allocation to alternative vehicles has grown from 7 per cent of private equity capital commitments in the 1980s to 24 per cent in the 2010s.

Of the 108 investors in the research sample that allocated to private equity, only four did not use any alternative vehicles.

The paper also shows that investment in alternative vehicles could be the result of a bargaining process between a set of very different GPs and LPs.

Why it happens

Lerner says there are potentially several different stories as to why there is disparity in performance.

“When do GPs need help filling out their dance card? It’s usually in situations where they are putting a lot of money to work, so in big deals or at market peaks. I’ve said before, if an investor wants to be successful in private equity, avoiding the times where money is being put to work is a good strategy,” he says.

Lerner says it is also possible that investors are choosing alternative vehicles at the wrong time.

“Alternative vehicles might be the only thing an LP can get access to at a quantity they want,” he explains.

He also says perhaps the LPs view the GP as sufficiently good that the alternative vehicles are “good enough”, compared with other funds in which the LP could invest.

Another reason might be that the decision to employ co-investment is a portfolio management decision and discretionary deals are a way of getting a particular exposure.

Or maybe LPs just view doing direct deals as more interesting and intellectually challenging.

“We can say that most literature suggests private equity is not a cheap asset class so the desire of LPs to get a better deal is understandable,” Lerner says.

But there is a huge disparity of returns in private equity, so while an investor might be getting a discount, it could be on an investment that underperforms.


To access the paper click here: Investing Outside The Box

Other stories related to this research include:

Private equity persistence slips

Asset owners rethink private equity





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