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Private Equity Secret Sauce

Private Equity Secret Sauce


Why understanding the HOW of private equity
returns is more important than the HOW MUCH
- Prof. Oliver Gottschalg, Head of Research, PERACS
Private
equity
performance
measurement is by design initially
about the how much of value creation
of a given fund manager. It is implicitly
retrospective as todays investors
cannot buy a funds past returns but
only commit to a managers future fund
with the hope of obtaining high returns
from this investment. For traditional
performance measures (IRR and MOIC)
however, a number of studies have
shown that the past is not a particularly
useful indicator for future returns1.
There are more advanced measures
that provide a meaningful level of
guidance to likely future outperformers2,
but for most funds the granular level of
cash flow data these require is simply
unavailable.
The good news is that it is now possible
to derive insight into a persistent
value-creating ability for over 1,200
private equity funds through a novel
benchmarking approach. This approach
compares Preqin data on tens of
thousands of underlying investments
made by thousands of private equity
funds to identify funds that are similar
according to three different aspects:

Fig. 1: Insights into the Nature of Value Creation

-0.2x
Impact of
1.67 Timing Decision

MOIC

Average of All
Funds
in 5 VY Window

-0.3x
Impact of
Strategy Decision

1.42

1.94
1.17

Benchmark
Based on
Timing Similarity

Benchmark
Based on
Timing and
Strategy
Similarity

Fund to Be
Benchmarked

Source: PERACS

Fig. 2: Picking Winners using Secret Sauce vs. TVPI

(a) similar in the time period in which the


fund was raised;
(b) similar in terms of when investments
were made (based on acquisition years
of the underlying deals); and

+.77x
Impact of
Implementation

TVPI

1.73

0x
Impact of
Picking Past
Performers on TVPI*

1.73

+.28x
Impact of
Picking Past
Performers on
Secret Sauce**

2.01

(c) similar in terms of which types of


target companies were chosen.
By identifying the differences in average
performance between these three
groups we can isolate the contributors
to relative fund performance into three
distinctive decisions a GP makes: the
Timing or the When, i.e. the decision
of how investments were timed over
the investment period of the fund; the
Strategy or the What, i.e. the decision
of which types of target companies
were chosen (industry sector, size
category, geography) to acquire at

Average TVPI

Return Using "Secret


Return Using TVPI Top 25
Performers
Sauce" Top 25 Performers
Source: PERACS

* No material difference
** Significant at the 99% confidence level

Harris, Robert S. and Jenkinson, Tim and Kaplan, Steven N. and Stucke, Rdiger, Has Persistence Persisted in Private Equity? Evidence from
Buyout and Venture Capital Funds (February 28, 2014). Darden Business School Working Paper No. 2304808; Fama-Miller Working Paper.
Available at SSRN: http://ssrn.com/abstract=2304808 or http://dx.doi.org/10.2139/ssrn.2304808
2
Please see page 31 of the 2016 Preqin Global Private Equity & Venture Capital Report: www.preqin.com/gper

Private Equity Spotlight / May 2016

2016 Preqin Ltd. / www.preqin.com

Contribution

Private Equity Secret Sauce

those times; and finally the Who and


How decisions, which are really the
secret sauce of implementation of
the fund, i.e. the performance of the
specific investment approaches within
specific target companies, above
the returns of other funds that made
similar decisions in terms of timing and
strategy. This typically encapsulates the
best practice and operational insight
applied by the GP within its portfolio and
is the key differentiator when comparing
private equity to other forms of asset
management. An example of the results
of this decomposition is illustrated in
Fig. 1.
So what do investors gain from this new
benchmarking approach? Well, it not
only offers at least partial insights into
the underlying skillset of fund managers,
but also enables one to explore whether
and how the different performance
components of the same fund manager
persist or perish over time. To this end,
we analyzed performance and deal
activity data from Preqin on 1,253 funds,
for which we observed a statistically
3
4

significant3 level of positive performance


persistence in the secret sauce
component across the 257 fund pairs
within the dataset4. Importantly, this
component is also a significant driver of
the overall multiple of the subsequent
funds, whereas the simple TVPI of the
prior fund (in line with prior academic
work) fails to predict subsequent returns.
Now that we know secret sauce
persists, the remaining question is
then the so what for investors. In
other words, how much better would
a portfolio perform had the investor
systematically committed to GPs
whose prior funds indicated high levels
of secret sauce-based returns. The
results give investors a strong reason
to consider the implementation skill
measure for future fund commitments.
Had an investor picked 25 of the 257
funds, using only those with the highest
previous
implementation-based
returns, the portfolio would have yielded
2.03x, which is significantly higher than
if they had picked top performing funds
by TVPI which returned only 1.73x.

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Even if the sample was extended to


include the best 50 of the 257 funds
by implementation returns, there would
still be a meaningful performance
improvement of 1.86x.
In summary, it is clear that traditional
performance metrics are failing as an
indicator of future outperformance.
Working within the information limitations
of private equity, the secret sauce
component of fund returns, however,
provides an effective way of identifying
top performers in addition to providing
valuable insight into the components of
GP value add.
For
more
information
on
the
methodology, detailed results and to see
how this applies to your portfolio, please
visit the PERACS website:
www.peracs.com

At 99% confidence level


Vintages of last fund range from 1997 to 2007

Private Equity Spotlight / May 2016

2016 Preqin Ltd. / www.preqin.com