Thoughts on Persistence
Luck, Skill and Out-performance in Private Markets (Part 1)
Persistence is more elusive in private markets than most investors appreciate. As the private markets matured and firms increased their level of skill it has become more difficult for a manager to consistently outperform. This is because as absolute skill increases, the relative skill between managers gets narrower which is the source of persistent out-performance. It has important implications for investors including the increasing impact of luck on outcomes.
“WE ONLY INVEST IN TOP QUARTILE MANAGERS”
We all apply some variation of this theme in our manager selection. I’ve talked to hundreds of LPs over the years and I’ve never heard “we look for average.” Many manager selection processes are built around finding high performing firms based largely on historical results, develop access and recommit to the winners because winning is persistent in private markets. Early studies supported this thesis. A 2005 paper from Kaplan and Schoar noted, “we document substantial persistence in fund performance…General Partners (GPs) whose funds outperform the industry in one fund are likely to outperform the industry in the next; GPs who under perform are likely to repeat this performance as well.”[1]
But what if the cornerstone assumption of persistence in this asset class is wrong? Without persistence, selecting a top performing manager ex-ante requires a different mindset, different diligence and introduces much more uncertainty into the equation.
PERSISTENCE IN RETREAT
As the industry has matured, Kaplan, Schoar and others have revisited their research with more recent data which shows performance is in fact less persistent today.
In 2014, a paper by Harris and co-authored by Kaplan found “little evidence of persistence for buyout funds.”[2] Figure 1 shows follow on fund performance for all funds, with a highlight on performance of previously top quartile funds. If persistence existed, we would expect a significantly higher frequency of top quartile funds from the funds that were previously top quartile. But according to this data, follow on performance is more random with 81% of previously top quartile funds NOT achieving top quartile with their follow-on fund.
Figure 1: Has Persistence Persisted in Private Equity? Harris [2]
McKinsey recently released a report that found a similar trend although not as quite as damaging to the argument as the Harris data, stating that “follow-on performance is converging towards the 25 percent mark — that is, random distribution — but hasn’t reached that point yet.”[3]
Antoinette Schoar, one of the original authors of the persistence theory, commented in 2017 that the probability of a top quartile fund repeating as a top quartile fund was only 12%[4]. “This persistence we saw in the 1990s has gone down over time… The question now is, why is this happening and what implications does this have for investors in private equity?”[5]
WHY HAS PERSISTENCE DECLINED?
Investment outcomes are a result of two random variables, the variance in skill and the variance in luck.
Variance(skill) + Variance (luck) = Variance(outcome)
As absolute skill increases the difference between the best and the worst becomes narrower, increasing the relative impact of luck on outcomes. This was coined the Paradox of Skill and has been written about extensively by Mike Mauboussin, Stephen J. Gould, Peter Bernstein and others across fields as unrelated as baseball and mutual funds.
The Paradox of Skill in Private Equity
Starting in the 1980sthe mutual fund industry experienced an explosion in fund formation, but as more funds were formed the standard deviation of excess return declined dramatically. A study in 2014 titled “Scale and Skill in Active Management” concluded that [mutual] fund managers had become more skillful over time and that ‘new funds entering the industry are more skilled, on average, than the existing funds.’ Like the mutual fund industry, the private equity industry has experienced a surge in the number of funds and there is no evidence that growth is slowing. A recent Preqin report shows 3,754 funds in market, up from 1,385 just 5 years ago[6]… a 19% compound growth rate.
Figure 2: Private Equity Funds closed by Vintage Year from Preqin database
The dispersion between the top quartile and the bottom quartile in private equity continues to be robust, increasing every year since 2012 according to Preqin. But the level of persistence has declined dramatically with a seemingly random outcome in follow on funds for previously top quartile managers.
Figure 3: Dispersion of Return. Median Net IRRs and Quartile Boundaries by Vintage Year
Judging the skill of new entrants in private equity is highly subjective, but the lack of persistence suggests the variance in skill between managers has narrowed. There are strong economic incentives for talented investment managers trained at leading private equity firms to start their own firm, which spreads that expertise and training more broadly. Increasing specialization across sectors, geographies or sub-strategies or the addition of operating professionals suggests a higher level of domain expertise across the industry. And Limited Partners have played a role by utilizing improved market data to discover and continuously reallocate capital to the fittest firms. But as absolute skill increases across firms, the variance in skill declines, leaving luck a more important determinant in outcomes.
IMPLICATIONS FOR INVESTORS?
To minimize the role of luck, Limited Partners can improve their own skill relative to peers or compete in different ways. Mauboussin called this “finding the weaker game” In his words, “being a consistent winner among the best gamblers or in the most intensely competitive markets can be very difficult. Instead, your energy might be better spent looking for less-efficient niches.” Private Equity is not a ubiquitous asset class and with so many diverse strategies, it offers a degree of freedom for investors that other asset classes may not.
As for improving relative skill, if you’ve done this long enough, you know the feedback loop is long and outsmarting other smart people is hard. Improving relative skill in that environment is challenging. In my experience, great investors demonstrate the intellectual humility and confidence to acknowledge this. (see Bessemer Ventures Anti-Portfolio or Howard Mark’s Memo on Uncertainty) I’ve had many intellectually humble moments in this business but probably none more painful than passing on a fund that generated >9x net to LPs. Ugh.
What about competing in different ways, or “finding weaker games”? One obvious trend of the last 10 years was the increasing disintermediation of the industry as LPs move closer to the underlying assets, become more transactional and minimize the economics to managers or other service providers to save on fees. In light of declining persistence this makes even more sense. An investor should be willing to pay for persistent & high returns. But if those returns are no longer persistent and therefore includes more uncertainty (randomness), why pay the high fees? Think about a gambling analogy, if the payout and odds are constant, would you rather pay $1 to play the game or something less than $1 to play the game?
Now imagine another game, a horse race, where one breed of horse wins MORE OFTEN and when it wins it has HIGHER payouts. Yet for some reason the market misunderstands these horses and you don’t have to pay more to bet on that breed of horse. Would you pay $1 to bet on that horse just like everyone betting $1 on the other horses? You should. You might be wrong occasionally, but systematically you win. (if you haven’t read Fortune’s Formula by William Poundstone, I highly recommend it)
Emerging managers within the private equity market offer a similar risk/reward proposition as these mispriced horses.
· Systematically, they beat the field more often than they lose
· The payouts are often higher when they win
· The cost to investors is no higher (and sometimes lower due to negotiating leverage of the LP, allowing the LP to win 2 ways)
Stay tuned for my next post which will review the case for emerging managers.
[1] Steven Kaplan, Antoinette Schoar, 2005. Private Equity Performance: Returns, Persistence and Capital Flows.” Journal of Finance 60
[2] Robert Harris, Tim Jenkinson, Steven Kaplan, Ruediger Stucke, 2014, Has Persistence Persisted in Private Equity? Evidence from Buyout and Venture Capital Funds. Working Paper from Darden Business School.
[3] McKinsey Global Private Markets Review, 2018, The Rise and Rise of Private Markets
[4] Dan Primack, Private Equity has a Persistence Problem, November 21, 2017
[5] Amanda White, Top1000Funds, Private Equity Persistence Slips, coverage of Schoar presentation November 9, 2017
[6] Preqin Quarterly Update: Private Equity & Venture Capital Q2 2020
