The Troubling Evidence Against Private Equity and Venture Capital

Investors who believe in active management rely on the past performance of the managers they select. Unfortunately, when it comes to stocks, bonds and hedge funds, there’s no evidence of persistence of outperformance beyond the randomly expected. However, there has been some evidence of persistence of outperformance in the investment/asset class of private equity/venture capital (VC).

But new research challenges those findings and makes a compelling case that advisors and their clients should proceed with caution in those assets classes, investing only when they are confident they have identified a compelling strategic advantage.

My September 12, 2019, article for Advisor Perspectives provided a summary of the research on the performance of private equity. Unfortunately, it was not encouraging – in general, private equity has underperformed similarly risky public equities, without even considering their use of leverage and adjusting for their lack of liquidity. However, the authors of the 2005 study, “Private Equity Performance: Returns, Persistence, and Capital Flows,” offered some hope. They concluded that the evidence suggests that private equity partnerships are learning – older, more experienced funds tend to have better performance – and there’s some persistence in performance. Thus, they recommended that investors choose a firm with a long track record of superior performance.

The most common interpretation of this persistence has been either skill in distinguishing better investments or in the ability to add value post-investment (e.g., providing strategic advice to their portfolio companies or by helping recruit talented executives). The research does offer another plausible explanation for persistence: Successful firms are able to charge a premium for their capital.

Reputation and the cost of capital

David Hsu, author of the 2004 study, “What Do Entrepreneurs Pay for Venture Capital Affiliation?” analyzed the financing offers made by competing VCs at the first professional round of startup funding. He found that offers made by VCs with a high reputation are three times more likely to be accepted, and high-reputation VCs acquire startup equity at a 10-14% discount.