That is one of the upshots of an April academic paper, “Skill and Luck in Private Equity Performance,” posted earlier this month on the Social Science Research Network. Using a “variance-decompositional model” to measure returns, the paper attempts to address what the authors see as a flaw with prior mathematical models used to measure the persistence of performance over time in private equity—that they do not distinguish between outperformance due to skill versus luck.
“Our model explicitly captures skill and luck, so an unskilled PE firm with a lucky fund is not immediately considered a skilled firm,” write the authors, Arthur Korteweg, associate professor at the Stanford Graduate School of Business, and Morten Sorensen, associate professor at the Columbia Business School. Below are other main findings of the study, based on a Preqin data set of 1,924 funds raised between 1969 and 2001.
• Performance in venture capital can be attributed mainly to luck, making it particularly difficult for investors to identify highly skilled venture firms. The authors believe investors would have to study the performance of 25 to 50 past funds to “identify a VC firm as having top-quartile skills with reasonable certainty.”
• Sponsors of smaller funds tend to repeat their relative performance, whether good or bad, more consistently than larger funds.
• Over time many sponsors have been less able to repeat their performance, a finding consistent with that of a separate academic study published about a year ago, ”Has Persistence Persisted in Private Equity?” However, that earlier study found the decline in persistence concentrated in buyout firms. This study, by contrast, finds the decline in persistence most pronounced in venture funds. Write the authors: “…we find that (buyout) and other funds still show substantial long-term persistence, even post 2000.”