How Do You Find the Best Private Equity Funds?

A growing number of people are considering investing in private equity funds. Given the low returns available elsewhere, they may be interested in putting money into funds that invest in startups or undertake acquisitions. In fact, even the smallest investors may start seeing private equity funds as an option in their 401(k) plans.

At first glance, it seems as if that could be a winning bet, or even easy money with the potential to outperform other asset classes, especially in the hands of a skilled firm. The average annual return for PE funds — including venture capital and buyout funds — started between 1969 and 2001 was between 17% and 18%, net of fees, according to research we recently completed.

But we found that much of the average return was attributable to the great results of the most skilled firms. Firms in the top quartile of skill added 7%-8% to returns annually, compared with firms in the bottom quartile of skill. That means that investors who wish to invest in private equity should spend a lot of time and resources trying to figure out the skill level of the different firms before investing.

In addition to providing some insight to people who wish to invest in private equity, our research is significant for another reason: although people have typically attributed success in private equity solely to luck, we have found evidence there is also skill involved.

Luck versus skill is a perpetual question in investing research in general. Some 40 years’ worth of quarterly data on managed stock mutual funds has made it clear that there is much more luck than skill in stock market investing. Except for a few anomalies — people such as Peter Lynch or Warren Buffet — investing to beat the market is a loser’s game. No matter how skilled a manager, over time the forces of competition and the number of variables in the stock market overwhelm the skill. In fact, from an investor’s perspective, a mutual fund manager who outperforms the market one year is no more likely to outperform it the following year.

But, by its nature, private equity is more opaque than stock investing, which has made private equity more difficult to study. A firm raises money for a particular fund from investors, which can be large institutions, companies, or individuals. Managers then use a variety of strategies to earn a return by the end of the fund’s lifetime. The lifetime of the funds varies and can be extended if the funds have not earned a high enough return — a crucial characteristic that helped us in our analysis.

Funds known as venture capital funds invest in startups. Buyout funds invest in existing companies. Still others invest in everything from distressed debt to oil to real estate. There are few rules, either about what strategies can be undertaken or how the results should be reported, making private equity a little like the Wild West of investing.

To get a window into this world, we used data gathered by Preqin, a commercial data provider that collected much of its information using Freedom of Information Act requests for government agency data regarding investors. We looked at a sample of 1,924 funds raised between 1969 and 2001. Our sample of funds was managed by 891 firms. There are 842 venture capital funds and 562 buyout funds. The remaining 518 funds were classified as “other.”

The key difficulty in studying the skill of private equity firms has been the extent to which the timing of their funds affected their returns. Though it was clear that some private equity firms consistently outperform the market — unlike in mutual funds — there are reasons why this pattern is partly an illusion. Funds last for 10 years or longer, but private equity firms raise a new fund every 3 or 4 years. The overlap between funds of the same firm results in correlated performance even if the manager has no skill: Market movements in the period of overlap will affect the performance of both funds. Managers make similar bets in multiple funds, and this doubling down on a single idea will show up in both funds’ performance.

To separate skill from luck, our research used patterns between the firms and the returns, fund lifetimes, and the degree of overlap between funds of the same firm. These patterns inform how the overlap affects the returns across funds. We found enough of those patterns over time to conclude that there is skill involved in private equity investing.

But there are limits to our research. It is like looking at ocean currents: While we see that there are two separate currents, luck and skill, we can’t identify yet which firms are more apt in the future to be able to use the skill. Further research that includes the performances of individual managers within the firms, or individual investments within the funds, could provide more conclusive evidence.

In the meantime, we suggest investors in private equity undertake a lot of due diligence before investing in this asset class with high fees and high risks.

To make a reasonable determination based solely on a firm’s past performance, you need to look at the performance of 25-30 venture capital funds, and 10-15 leveraged buyout funds. Very few, if any, of these private equity firms — either those who invest in startups as venture capitalists or those who buy out or merge existing firms — have raised this many funds. Neither have the kinds of funds that fall into the “other” category. Most firms thus lack the length of track record required to make this determination.

Investors can consider factors other than performance, such as the record of an individual partner, deal flow, and the investment strategy. The fact that some firms show skill over time suggests that they have captured something in their culture — a certain process or particular knowledge — that is passed from manager to manager.

Whether investors will have the information, resources or insight to evaluate the managers, let alone the firms, is another question. Small investors who are increasingly being given opportunities to invest in private equity may not have the time, experience, or even access to the information they need to make good choices.

Arthur G. Korteweg is Associate Professor of Finance at Stanford Graduate School of Business, and Morten Sørensen is Daniel W. Stanton Associate Professor of Business at Columbia Business School.

This piece originally appeared in Stanford Business Insights from Stanford Graduate School of Business. To receive business ideas and insights from Stanford GSB click here: (To sign up : https://www.gsb.stanford.edu/insights/about/emails ) ]