Letting Your Winners Run

Doubling down on your winners can be an effective strategy in the stock market and horse racing—so why not in private equity? An analysis of several high rollers in the buyout business finds that they take something of a double-down-on-winners strategy to investing. And the approach tends to produce remarkably consistent results.

Buyouts recently compiled performance data publicly disclosed by nine institutional investors for pre-vintage-2003 U.S. and international buyout/corporate finance funds (see November 19 edition, page 28, for a complete list of investors, information on how we put the database together, and caveats). A close look at the portfolios assembled by seven of these individual investors (excluding CPP Investment Board and Indiana State Teachers’ Retirement Fund because of their relatively small sizes) confirms that most follow a similar investment principle: Once they find a manager they like, investors tend to reward that manager with larger and larger slugs of capital.

Oregon Public Employees’ Retirement Fund is a case in point. According to our count, Oregon backed 68 pre-vintage-2003 U.S. and international buyout and corporate finance funds. Fifty-one of those funds are part of fund families in Oregon’s portfolio that have at least two members managed by the same GP; often the younger funds secured successively larger commitments. Consider Oregon’s relationship with media investor Providence Equity Partners LLC. Oregon backed a 1996 partnership to the tune of a $75 million commitment, followed with a $100 million commitment to a 1998 partnership, and a $150 million commitment to a 2000 partnership.

Just how much this double-down-on-winners strategy accounts for the returns that investors achieve is a question for greater mathematical minds than mine. But the investors in our sample did post remarkably similar returns in some respects. Median internal rates of returns generated by funds in the seven portfolios ranged from 10.5 percent to 17.4 percent; however, throwing out the bottom figure as an outlier produces a far narrower range of 13.9 percent to 17.4 percent.

We were also able to calculate total investment multiples—total distributions plus estimated values of remaining holdings, divided by total capital drawn by funds—for five of the investors in our sample, California Public Employees’ Retirement System, Oregon, New York State Common Retirement Fund, Washington State Investment Board and University of Texas Investment Management Company. Their investment multiples occupy the narrow range of 1.6x to 1.8x, with Oregon, New York State and Washington all posting 1.8x multiples. The median investment multiples achieved by the individual funds in their portfolios show even more consistency. They range from 1.6 to 1.7.

It’s tempting to conclude that these five investors must have all backed the same funds. And, sure enough, the names of some fund managers—The Blackstone Group, Hellman & Friedman, Kohlberg Kravis Roberts & Co. among them—do pop up with regularity across several of the portfolios. But, in general, the portfolios are remarkably diverse, not just in fund managers backed, but in the size of individual commitments, and the size of the portfolios analyzed, from 63 funds for UTIMCO to 119 funds for CalPERS.

So what is the key to out-performance for investors? Of the seven portfolios examined, Oregon, with $10.2 billion drawn down by a 68-fund portfolio, achieved the highest investment multiple, at 1.8x, as well as the highest median IRR for funds in its portfolio, at 17.4 percent. One fact that leaps out upon lining up the funds in Oregon’s portfolio by investment multiple is just how much the state owes to KKR for its strong performance. The state’s early, frequent backing of KKR funds in the 1980s delivered tremendous returns—an investment multiple of 2.4x on $1.9 billion invested. The returns of KKR funds of a more recent vintage have been solid, but less spectacular; they have to date produced an investment multiple of 1.7x on $3.3 billion invested for Oregon.

Hindsight being 20-20, it’s easy to sit back and suggest Oregon might have been better off flattening its support of KKR after the 1980s in favor of finding the next Secretariat. But faced with an industry where median returns are unspectacular, and bottom returns pitiable, you can’t blame investors for sticking with their top horses.