Private Persistence That Just Ain’t So?
This essay was originally published by CFA Institute on the Enterprising Investor.
“It ain’t what you don’t know that gets you into trouble, it is what you know for sure that just ain’t so.”
The famous Mark Twain line, correct?
Actually, no.
As Forbes and others have reported, the phrase originated with Josh Billings in his 1874 book Everybody’s Friend.
In saying this, we are not pointing fingers at anyone and we’re certainly not knocking Mr. Twain. The phrase has just been attributed to Twain so many times that it has become as if it were so.
Humans are hardwired to anchor on repetition and Nobel Prizes have been won for studies of what are called availability and frequency biases. We tend to be swayed by what we are told over and over again.
Related to this, most everyone in or around the investment business has heard the following warning:
“Past performance is not indicative of future results.”
Who consistently says, however, that the past will be like the future?
Some who promote private equity funds.
The examples below are quotes we have experienced in private equity presentations:
“Achieving top-quartile performance is not random.”
“Past and future fund performance tend to be highly correlated in private equity.”
“The factors that drive returns in private equity are different and top funds have performance persistence.”
Our view, which is supported by others who helped with this article, is this:
Private equity is a form of active equity management. It just tends to be a more illiquid one for which it’s hard to find good information on what true cash-on-cash, net of all fees performance has really been.
We do appreciate that some factors that drive private investment performance may be different, but consider the following:
“No large-cap, mid-cap, or small-cap funds managed to remain in the top quartile at the end of the five-year measurement period.”
This is a quote from one of many studies that show that fully transparent and daily-valued public equity managers haven’t exhibited performance persistence.
If this is the case with most every other type of active equity management, how is it that the more opaque and often higher fee private version can consistently replicate performance?
Recent studies suggest the following answer:
It just ain’t so.
The following chart is from a detailed report on private equity by McKinsey & Company.
We expect this to come in for some criticism, so to be complete, below are precise quotes from a section they titled Inconsistent Results.
“Our own analysis shows that about 33 percent of buyout funds raised between 1995 and 2004 performed in the same quartile as their immediate predecessor — that is, the fund raised by the same manager with the same strategic and geographic mandate.”
“[Performance persistence] fell to only 25 percent for successor funds raised between 2005 and 2009 — the same level that random chance would predict.”
“In 2010 to 2013, the last four years for which meaningful data are available, the persistency of funds was only 22 percent.”
“The story is worse for top-quartile funds.”
“From 1995 to 1999, an average of 31 percent of top-quartile funds were followed by similar successors, but by 2010–13, this average had fallen to only 12 percent.”
Yes, according to this paper . . .
Top-quartile funds haven’t persisted more, they’ve consistently persisted less.
Some may counter this by saying that this is why you need institutional-quality consultants and advisers who can cut through the noise and help investors find only the best of the best that can persist.
Investors do need help navigating return and risk metrics, which as McKinsey & Co. warned investors back in 2004, can “make good funds look great and bad ones look good.”
We hate to break it to our professional colleagues, however, but it seems that we often aren’t very good or consistent at picking managers.
According to a peer reviewed study in The Journal of Finance, researchers found “no evidence” that recommendations from institutional investment consultants “add value, suggesting that the search for winners, encouraged and guided by consultants, is fruitless.”
The Journal of Finance quotes may be a little strong, but we do agree with McKinsey that it’s “quite difficult for even the most astute LPs to predict how [private] fund managers will perform.”
As we’ve mentioned in some form in every piece that we’ve written about private equity, we are not trying to knock down the many good private equity managers that exist. We believe that some private equity funds and private investment opportunities are worthwhile and we should keep a lookout for them.
What we are saying — again — is this:
When investing, it’s always wise to question bold presentations, especially when they suggest that the future will be like the past.
If you hear something that sounds too good, step back and ask probing questions.
Keep in mind that, even though presentations can be legally compliant according to accredited investor rules, they might not be fully transparent and can obscure a lot with complex disclosures.
Bottom line . . .
Claims that sound like they are for sure are often the ones that get you into trouble.
Special Thanks:
Special thanks to Dan Rasmussen of Verdad Capital, Philippe Maupas, CFA, CIPM,past president of the CFA Society France, and Ludovic Phalippou of the Said Business School at the University of Oxford for their editing help and contributions.
Related Reading:
Are Selectors Good at Selecting? – Elisabetta Basilico, PhD, CFA – Research Roundtable
Bad Ingredients? – Tommi Johnsen, PhD – Research Roundtable
Bungled Benchmarking – Preston McSwain
Internal Rate of Return: A Cautionary Tale – McKinsey & Company
The Truth about Private Equity Performance – Harvard Business Review
Private Equity Laid Bare – Chapter 11, – Ludovic Phalippou – University of Oxford, Said Business School
Stop It – Provoking Posts – Preston McSwain
Is Top Manager Performance A Random Walk? 
Smaller Is Better 
The Simple Alternative – Keeps On Winning