Dr. Josh Lerner is the Jacob H. Schiff Professor of Investment Banking at Harvard Business School, with a joint appointment in the Finance and the Entrepreneurial Management units. He has authored several studies on private equity, many of which are considered “must reads” by industry pros.
Dr. Lerner, your report “Smart Institutions, Foolish Choices?” (co-authored by Antoinette Schoar and Wan Wong), indicates that endowments have found a lot more success in private equity than nearly every other class of limited partner. Why is that?
This is an issue we spent a lot of time thinking about while writing the paper. We have a number of ideas, but cannot definitively answer the question… It appears that endowments make better investment decisions than their peers. In part, this may reflect their ability to leverage the insights of alumni, who serve as investment advisors. In part, it may reflect the greater stability of the staff at these funds. Determining the “secret sauce” that explains the out-performance of endowments is still an open question.
Access to the best funds is always important, but at the same time that is a primary selling point of most fund-of-funds. But the FoFs, according to your paper, lagged most other limited partner groups.
One of the big surprises from our analysis was how poorly funds-of-funds performed as a category. Of course, as in all categories, there were some effective investors, but there were considerably more ineffective ones among the funds-of-funds.
It is worth highlighting that the performance of funds-of-funds was among the lowest of any class of investor. In fact, their performance is, in some senses, even worse than the paper suggests. In the analysis, we compute the performance of the venture funds the funds-of-funds selected, rather than the net returns to their limited partners (who pay management fees and frequently carried interest to the funds-of-funds, and thus garner even lower returns).
Why do you think that is?
We have two possible explanations for this pattern. First, this may reflect the immaturity of the funds-of-funds market. The late 1990s saw a considerable amount of entry by funds, many of which proved to be unqualified. The poor performance of these funds has undoubtedly dragged down the return of this category as a whole. Alternatively, this result may reflect inappropriate incentive schemes in the funds-of-funds industry more generally. Far too often, groups generated huge financial rewards from additional management fees as a result of attracting new investors and capital. The funds-of-funds managers benefited from growth, even if they could not deploy their capital as wisely in the past. This created an incentive among these funds to raise too much money.
To find success, is it as simple as just avoiding the bottom quartile GPs?
I would argue that the design of an effective private equity investment program entails far more than avoiding unsuccessful funds.
What can institutions do to improve their performance in private equity?
To be successful, groups must undertake several approaches: They must develop a deep understanding of the private equity market and the dynamics of recent trends; thoughtfully examine one’s previous investment decisions, both good and bad, and seek to refine decision criteria accordingly; and develop formal and informal incentive schemes that allow groups to retain investment professionals for a considerable period of time.