Edhec research reveals negative correlation between private equity deal performance and duration

Research shows a strong negative association between performance and duration for private equity deals. Quick flips account for 12% of all PE investments with a median internal rate of return of 85%.

Private equity (PE) became a global phenomenon in the past decade as it injected liquidity and fuelled the mergers and acquisitions (M&A) wave in the US and Europe. Strömberg (2007) estimates that by 2007 PE companies worldwide had acquired almost 14,000 companies worth nearly $3.6 trillion.

Although recent papers have begun to analyse investor returns in PE (Kaplan and Schoar (2005); Ljungqvist, Richardson and Wolfenzon (2007)), there is still little evidence on the cross-section of the performance of individual PE investments and, more importantly, on the drivers of this performance.

In recent research with co-authors Ludovic Phalippou of the University of Amsterdam Business School and Tinbergen Institute and Oliver Gottschalg of HEC Paris, we have put together the largest and most up-to-date dataset of PE investment performance and characteristics.

Our data comes from fundraising private placement memoranda (PPMs) collected over the past eight years from investors on all continents. After applying a number of filters, our final sample contains 7,453 investments made in 81 countries by 254 PE companies between 1971 and 2005. This data allows us to derive statistics that contribute to several debates in private equity and to document the main drivers of the cross-section of returns.

Prompted by the large increase in the size of PE funds, we pay special attention to the impact of scale on returns and provide evidence of the potential mechanisms of this relationship.

The first contribution of our research is to provide new descriptive statistics and stylised facts on the distribution of performance, duration and size of PE investments around the world. We find a dramatic dispersion of returns: investments at the75th percentile have an internal rate of return (IRR) of 50% whereas those in the 10th percentile earn nothing.

Most investments in our dataset, as in the samples of Kaplan (1991) and Strömberg (2007), are relatively long-lived. The median duration of the investments is nearly four years. However, these long-lived investments are not those that deliver high returns.

We document a strong negative association between performance and duration. Quick flips (investments held less than two years) accounting for 12% of all PE investments have median IRR (PME) of 85% (1.94), whereas investments held more than six years, which account for nearly 18% of all PE investments, have a median IRR (PME) of only 8% (0.79).

Our statistics uncover additional stylised facts for investments across countries. We are the first to document substantial under­performance of investments in emerging countries which may be of interest given their recent spectacular growth.

The data also allows us to show for the first time that most PE investments around the world are small. The median equity investment is a mere $10 million. The large deals trumpeted in the press are the exception.

A second contribution of our research is to identify empirically the drivers behind the great variation in the performance of PE investments. Because data availability is limited, the literature has focused on analysing aggregate performance over time (for example, Kaplan and Strömberg (2009)) or across funds (such as Kaplan and Schoar (2005)). Our investment level data allows us to document the performance impact of several investment and PE firm characteristics.

We find that small investments outperform large ones. In addition, and contrary to some arguments by fund managers, our results show a close connection between public and private equity: the average stock-market return over the life of an investment has a significant impact on IRR.

Our most important finding, however, is that PE company scale is a significant and consistent driver of returns. Casual evidence suggests that the scale of PE firms is an important concern of investors. Lerner et al (2003, p.44) argue “the unprecedented growth of the private equity industry appeared to have changed the industry in some permanent ways. First was the scale at which private equity groups operated. These concerns were particularly acute on the buyout side, where multi-billion-dollar funds have become the norm.”

Along similar lines, Swensen et al (1999, p.5) report “many leveraged buy-out (LBO) companies appear to have explicitly lowered their return hurdles… pricing deals to yield returns in the mid-to-high teens.”

The current scale of several PE companies contrasts sharply with that of PE companies 20 years ago. When comparing the 16 professionals at KERR and the 470 at RJR Nabisco’s headquarters, Jensen (1989) implied that PE companies were positioned to generate superior performance partly because they were lean and focused organisations. Today the industry has concentrated (Cornelius et al (2007)) and PE companies sometimes have hundreds of professionals of varied backgrounds doing a large number of deals around the world.

Blackstone, a prominent PE company, describes itself as “a firm of 1,300 professionals in 15 offices worldwide. But we are more than that. Our portfolio companies employ nearly 1 million people around the world, making us a major factor in economies around the world. If our portfolio holdings and transactions were combined into a single company, [we] would rank as the equivalent of number 13 in the ­Fortune 500.”

A similar calculation would place KKR fifth in the Fortune 500 ranking, just ahead of General Electric. This change in the industry raises the question: can large PE companies deliver sufficient returns?

There is a large body of theoretical literature on the connection between company size and performance. Williamson (1975) was among the first to point to “organisational diseconomies” as a potential mechanism of diseconomies of scale. Holmström and Roberts (1998) argued that, among other things, problems transferring knowledge may influence scale diseconomies.

Models such as those of Bolton and Dewatripont (1994), Garicano (2000), Stein (2002) and Vayanos (2003) have provided additional insight into the importance of knowledge transfer and communication costs to diseconomies of scale. According to Garicano (2000, abstract) “the key trade-off an organisation confronts occurs between communication and knowledge costs.”

He argues that as a company scales up it benefits from an increased uptake of knowledge but is penalised by greater communication needs. Stein (2002) adds that the organisational diseconomies arising from coordination and communication costs in large firms may be more acute when the information that circulates is of a softer nature (trustworthiness of a borrower, company strategy, and so on).

Although diseconomies of scale may be important for industrial comapnies, they may not lead to differences in returns across financial intermediaries if agents are rational and the market for capital is competitive and without significant frictions. Berk and Green (2004) suggest there should be no differences in the performance of large mutual funds and that of small mutual funds because their market for capital is highly competitive.

The provision of capital for PE companies involves more frictions than the provision of capital for mutual funds. Investors can add capital to a PE company only every two to four years, when it raises new funds, and arbitrage is significantly more limited (no short selling, capital is locked in).

In addition the kind of investment information that is transferred in a PE company is of a softer nature than the stock-trading strategies in mutual funds, making communication costs greater in PE. All of these arguments suggest that diseconomies of scale could be great and highly visible in PE.

In view of these theoretical arguments, communication costs should be a key determinant of performance. Since we have data for individual investments, we can create a proxy for the amount of communication of soft information in the firm over the life of each investment.

Specifically, we measure firm scale for each investment as the average number of simultaneously held investments managed by the firm over the investment’s life. We believe this is a good measure because it captures two key features connecting scale and returns in PE.

First, PE companies are supposed to provide significant and continuous attention to each of the companies in their portfolio. In addition each investment regardless of its size probably requires a similar amount of time and communication (Quindlen (2000)). So the number of investments under management is a good proxy for firm scale.

Second, the monitoring phase of the investment is the period during which the information that circulates is softer. The amount of communication of soft information may best be captured by looking at the average scale of the company over the life of the investment rather than at a specific point such as the time of entering or exiting the investment.

Our empirical estimates show company scale is a robust and consistent driver of the cross-section of returns of PE investments. Investments held at times of a high number of “simultaneous investments” (SI) underperform substantially.

The economic magnitude of the scale effect is large: a one standard deviation increase in SI decreases IRR by 9%. Investments in the lowest SI decile earn a median IRR (PME) of 36% (1.65), whereas those in the highest SI decile earn a median IRR (PME) of 16% (1.08). These results hold in a regression setting controlling for other factors that could be associated with performance, including several investment characteristics, PE company characteristics and fixed effects (country, industry and time).

A series of tests corroborates the robustness of the negative scale effect. Diseconomies of scale are present across sub-samples, they survive the use of alternative econometric methods and they are not the result of a simple mechanical effect resulting from firms exiting best-performing investments faster.

We also show that survivorship bias, differences in risk, and reverse causality are unlikely to explain our findings. Finally, the scale effect is robust to the inclusion of fund and firm fixed effects and it is still present when we aggregate investments by fund and by firm.

The third and final contribution of the research is to test additional predictions of diseconomies of scale models and to provide evidence of the potential mechanisms explaining the negative scale effect. Although we believe our measure of scale comes closest to key theoretical concepts connecting scale and returns, our data also allows us to create alternative proxies for both the activities of the PE company and the type of investment information that travels within the PE company.

We find the number of simultaneous investments over the life of the deal is a better predictor of negative returns than are other proxies. Finally, in the last section of the paper we collect additional data from PE directories, PE company websites, managers’ biographies and the PPM to develop proxies for the organisational structure of PE companies.

These measures provide empirical support for Stein’s (2002) idea that hierarchical companies and organisations in which information flow is more difficult face higher marginal communication costs and so display greater diseconomies of scale. Our data shows independent PE companies, those with flatter decision structures and those with professionals of similar backgrounds exhibit less pronounced scale diseconomies.

Our paper is also connected to two strands of the finance literature. First, it builds on the recent work exploring the relationship between performance and size in mutual funds (Chen et al (2004); Pollet and Wilson (2008)) and in hedge funds (Fung et al (2008); Teo (2009)).

Second, it complements the results of papers looking into venture capital, an asset class similar to PE. We provide empirical evidence consistent with that of the papers analysing the trade-off between larger/smaller portfolios and diversified/concentrated portfolios (Kanniainen and Keuschnigg (2003); Bernile et al (2007); Cumming (2006); Fulghieri and Sevilir (2008); Cumming and Dai (2010); Gompers et al (2008); Hochberg and Westerfield (2009)) and we find results consistent with those in Bottazzi, Da Rin and Hellmann (2008), who show that greater management involvement is associated with greater success in venture capital.

Florencio Lopez de Silanes, professor of finance at Edhec Business School and a member of Edhec-Risk Institute wrote this article.

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