Who Needs General Partners?

That was the question asked recently by a trio of academic researchers—Lily Fang, associate professor of finance at INSEAD; Victoria Ivashina, associate professor of business administration at Harvard Business School; and Josh Lerner, professor of investment banking at Harvard Business School and one of the most influential academics producing research on private equity today.

Their co-authored paper, which notes a widespread move toward direct investments, finds that institutional investors get mixed results on co-investments made alongside buyout and venture capital sponsors. Unweighted for how much is invested in any given year, co-investments outperform commonly used private equity benchmarks, the paper found; but when weighted they underperform. (Like traditional sponsors, limited partners tend to invest directly most heavily during market peaks, to the detriment of returns.)

On the other hand, the paper finds that solo deals, done by investors without benefit of a sponsor, “significantly outperform” co-investments and also beat private equity benchmarks. This finding holds true even after the authors take into account the costs of direct investing.

Investors do particularly well, the paper finds, investing in later-stage solo deals and in solo deals located closer to home.

Dated October 2012, the paper is titled, “The Disintermediation of Financial Markets: Direct Investing in Private Equity.” It is available from the Web site of the Social Science Research Network, a popular forum for soliciting comments on pre-publication academic papers.

All told, the authors gathered data on 392 direct transactions, totaling just under $23 billion in value, undertaken from 1991 to 2011 by seven institutional investors around the world. The investors are large, averaging $94 billion in assets under management as of mid-2012, and $21 billion in alternative assets under management. About a quarter of these were solo deals, and the rest co-investments made alongside sponsors, which typically involve reduced fees and carry or none at all. The authors took into account the timing, location and performance of the deals, both exited and still-to-be-realized. The names of the investors are not revealed in the study.

To be sure, the authors recognize that investing through funds has its advantages. They note that by pooling capital into funds institutional investors can, in effect, share the costs of identifying, making, monitoring and exiting investments. They can leverage the considerable expertise that general partners have in each of these areas. Other benefits are less tangible but no less significant, such as the ability to sell fund interests on the secondary market.

But, citing prior academic studies, the authors also roll out some negatives associates with limited partnerships. GPs, they write, can be tempted to increase assets under management even at the expense of returns; to invest heavily during market peaks, when valuations are at their highest; and to exit investments with more of an eye toward raising their next fund than with maximizing returns. GPs, many of which are quite small, also can get distracted from new deals by portfolio problems and other issues that arise.

Through direct investing investors can avoid these negatives although they face others of their own. Among them are the high cost of due diligence and ongoing monitoring of direct deals. Then there’s the risk that they get offered co-investment opportunities only on less promising deals. Many pension funds also are notorious for not paying investment officers as much as they could earn at private equity firms; as a result investors may not be able to hold on to the talent necessary to effectively execute a direct investment program.

Then again, direct investing has advantages. Most important are the reduction or elimination of fees and carried interest; the paper estimates that the “2 and 20” compensation structure commonly charged by GPs “implies a cumulative investment cost of 5 to 7 percentage points per year under a wide range of performance assumptions. …”  In addition, direct investors can cherry-pick their favorite transactions, backing companies they think will be particularly successful or where they can bring special skills or connections to bear. Lacking pressure to put money to work, or other distractions, they also can take control of the timing of their investments. For example, they can take contrarian bets, such as by investing during a recession on the chance that things will soon bounce back.

At least when it comes to solo investing, the seven investors studied in this paper have enjoyed benchmark-beating returns. “These results are robust to the use of various benchmarks and lag structures,” the authors write, “and provide an economic rationale for the disintermediation trend in private equity investing.”