Performance matters… to a point

Successful capital raising relies on a number of different elements, but one – performance – tends to trump the rest.

Next week we will publish the latest PEI 300, our proprietary ranking of the largest private equity firms in the world by capital raised. Spoiler alert: this year’s list will show a seismic shift in the upper echelons of the industry.

Beyond the spectacular rises and falls of individual names, some granular track record analysis of our 300 firms by private equity technology group Bison reveals some interesting points about the link between investment performance and fundraising capability.

First is that the market seems to be functioning broadly as you would hope: investors are gravitating towards firms with superior performance.

Our top 50 firms have generated, on average, an IRR of 14.9 percent since inception (net of fees), according to Bison’s data. For the wider PEI 300, the figure is a slightly more modest 13.3 percent. For the industry as a whole, meanwhile, the average net return is just 11.3 percent.

However, the flow of capital at the large end of the industry is more nuanced than that.

One might expect our top 10 firms to have the best collective returns of all, but this is not the case. The average since inception net IRR for a top 10 firm is 14.1 percent, marginally lower than the wider top 50.

Let’s be clear: it is not dramatically worse, but it is worse. Clearly the difference between a successful firm and a true industry giant is not investment performance, but something else.

There are, in fact, a number of differentiating factors, say investors. The largest firms tend to be the best equipped in terms of investor relations, compliance and have the widest variety of strategies and structures. For a large investor this can be difficult to resist. Or, as a US-based fund investor puts it: “Big investors like state pension funds need big, safe hands to deploy the large amounts of capital they must put out each year. They would be the first to tell you that they can't possibly deploy all of it in the smaller, often better performing funds.”

One European LP points to the fact that the ability to not lose money – as some firms demonstrated during the financial crisis – is also highly appealing to large investors.

Bison data on distributions versus capital calls may provide a final clue as to what really counts when it comes to raising private equity capital in vast quantities.

In the third quarter of last year – the most recent data available – the top 10 firms handed back around three times more money to LPs than they drew down. The ratio was even more distribution-heavy the quarter before.

At the same time, the rest of the PEI 300 were also handing back more money than they were drawing down, but not quite on the same scale: they were paying out twice as much as they were drawing down.

When it comes to raising money, long-term performance is a must. However, firms should never underestimate the additional persuasive power of a giant wave of cash distributions. 

The PEI 300, the only apples-to-apples ranking of the largest managers of private equity capital, will be published next week in print and on privateequityinternational.com.