Sponsors excel at picking sectors: MIT Sloan study

A working paper published by the MIT Sloan School of Management suggests the outperformance divides into two components—an “asset class alpha” generated by sponsors’ ability to pick the best sectors to invest in, and an illiquidity premium rooted in sponsors’ ability to invest and exit at optimal times without having to worry about redemption requests. Both components contribute about equally to the outperformance, which the authors put at 520 basis points per year over the 17-year period ending in the third quarter of 2013.

How do sponsors anticipate which sectors will outperform? The authors speculate that venture capital funds by their very nature focus on areas of the economy where innovation is proceeding at a rapid clip—a precursor to economic growth. Buyout firms, meantime, often seek out underperforming segments of the economy that are oversold and therefore due for a rebound.

That said, the authors turn this into something of a back-handed compliment by pointing out that investors can generate the asset class alpha themselves by using vehicles like exchange traded funds to mirror the sector weightings of sponsors. ”This means that investors who are not skilled at identifying superior private equity funds should invest in this asset class only to extract an illiquidity premium.” Moreover, by pointing out that the illiquidity premium may not be as big as investors thought (half of outperformance comes from sector selection), the authors posit that “private equity becomes less attractive relative to all liquid asset classes.”

The working paper, dated Feb. 28, is called “The Components of Private Equity Performance: Implications for Portfolio Choice.” The three authors are William Kinlaw of State Street Associates; Jason Mao of State Street Corporation and Mark Kritzman, a founding partner at State Street Associates, as well as a founding partner and CEO of Windham Capital Management and a teacher at MIT Sloan School of Management. 

For their research the authors relied on the State Street Corp private equity index, updated quarterly and based on the performance of some 2,273 private equity partnerships covering a variety of investment strategies (including venture capital and buyout), vintage years and regions of the world. Funds in the index represent about $2 trillion in capital commitments, or roughly half the known private equity market. State Street Corp measures cash flows from these funds based on its role as a custodian for institutional investor clients.