By LARRY SWEDROE
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 is some evidence of persistence of outperformance in venture capital and other types of private equity.
My September 12, 2019, article for Advisor Perspectives provides a summary of the research on the performance of private equity. Unfortunately, it is not encouraging, as the findings show that, in general, private equity has underperformed similarly risky but public small value stocks, without even considering adjusting for the 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 there’s 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).
Ramana Nanda, Sampsa Samila and Olav Sorenson contribute to the private equity literature with their study The Persistent Effect of Initial Success: Evidence From Venture Capital, which was published in the July 2020 issue of the Journal of Financial Economics. Their data sample was from the VentureXpert database maintained by Thomson Reuters and included round-level information on venture capital investments of U.S. private equity firms. It covered the period 1961 to 2008.
The authors noted: “To gain greater insight into the sources of persistence, we shift the unit of analysis to the individual investment.”
Their analysis focused on the venture capital segment of private equity because of the previously documented persistence of performance. Here is a summary of their interesting, and perhaps surprising, findings:
— Consistent with prior studies of returns at the fund level, there is a high level of performance persistence at the investment level across VC firms. However, the strength of this persistence in success rates attenuates over time. In other words, venture capital performance exhibits mean reversion. Firms with the highest initial performance decline the most over time, while those with the lowest initial performance improve the most.
— Despite mean reversion, performance differences still persist for long periods of time, usually a decade or more. VC firms that enjoyed higher initial success continued to see higher subsequent success until they invested in more than 60 companies. Since the average fund in the sample invested in about 18 portfolio companies (median = 12), their results imply that the advantages of success in the first fund persisted well into the third or fourth fund.
— For any given VC firm, greater success in its prior 10 investments predicts a lower likelihood of success in its next investment. In other words, while there is persistence in performance across VC firms, there is mean reversion in performance within VC firms.
— The average IPO and exit rates for all investments made by other VC firms in the same year-state-industry-stage segments, as the focal VC firm’s initial investments strongly predict the observed success rates for the focal VC firm’s initial investments. Initial success, therefore, stems not so much from choosing the right companies or from nurturing them but from investing in “the right places at the right times”.
— Initial success, rather than some underlying characteristic of the VC firms, appears to account even for the apparent within-segment persistence — differences across venture capitalists in their ability to select and nurture specific companies appears to play little if any role in accounting for performance persistence.
— There is no evidence that venture capitalists persist in their selection of attractive segments. VC firms that had invested initially in attractive industries and regions continued to invest in them, and those segments often continued to experience above-average exit rates. But when choosing industries and regions in which they had not previously invested, VC firms that had enjoyed initial success displayed no better ability than those that had not in selecting promising segments — the persistence in selecting outperforming segments is close to zero.
— Differences in the selection or nurturing of specific portfolio companies contributes little to explaining persistence.
— Initial success leads to changes in how venture capitalists invest. VC firms that enjoyed early success began to invest more and in larger syndicates, allowing them access to a larger selection of deals. VC firms with higher levels of initial success also shifted their investments away from the first round of financing, where assessing the potential of a startup proves most difficult. Firms without access to syndicated rounds may need to focus more on early stages to “get into” promising startups, while those with access have the luxury of investing later, after some of the uncertainty surrounding the startup’s prospects has been resolved. Adjusting for these differences eliminates most of the remaining performance persistence within a particular region, industry, investment stage and year.
— There is little correlation between experience and success, as many VC firms with investing experience do better while many others do worse.
— Access to deal flow explains most of the residual persistence in performance.
Their findings led Nanda, Samila and Sorenson to conclude the following:
“Our investment-level analyses suggest that initial success matters for the long-run success of VC firms, but that these differences attenuate over time and converge to a long-run average across all VC firms. Although these early differences in performance appear to depend on being in the right place at the right time, they become self-reinforcing as entrepreneurs and others interpret early success as evidence of differences in quality, giving successful VC firms preferential access to and terms in investments.
“This fact may help to explain why persistence has been documented in private equity but not among mutual funds or hedge funds, as firms investing in public debt and equities need not compete for access to deals. It may also explain why persistence among buyout funds has declined as that niche has become more crowded.”
They added: “The picture that emerges then is one where initial success gives the firms enjoying it preferential access to deals. Both entrepreneurs and other VC firms want to partner with them. Successful VC firms therefore get to see more deals, particularly in later stages, when it becomes easier to predict which companies might have successful outcomes.” It is the access advantage that perpetuates differences in initial success over extended periods of time.
The research does offer another plausible explanation for persistence. Successful firms, such as Kleiner Perkins, are able to charge a premium for their capital.
Reputation and the cost of capital
David Hsu, author of the study What Do Entrepreneurs Pay for Venture Capital Affiliation?, analysed 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 percent discount. This evidence suggests that VCs’ “extra-financial” value may be more distinctive than their functionally equivalent financial capital.
Hsu explained that if a company borrows from a bank and the terms are similar, it doesn’t matter what bank it gets the money from. However, the situation is different when the firm is seeking venture capital investment. The firm is likely seeking not just cash but also the venture firm’s “reputation and access to a network of relationships — with customers, suppliers, investments bankers and other important constituents in the universe that the entrepreneur cares about.”
A VC firm can also add value through its human capital, providing guidance on strategic planning as well as helping attract top caliber employees and lining up the best IPO underwriters. Thus, a startup may not always choose the best “pre-money” offer when it raises private equity.
Hsu’s study covered 51 small companies that received at least two offers. The total number of offers was 148. The companies were among about 300 that had participated in the Entrepreneurship Lab at MIT. He found that “a lot of money is left on the table” by the companies, both in absolute terms and as a percentage of the pre-money valuation accepted by them:
— Less than half of the firms surveyed accepted their best financial offer.
— For the group of multiple-offer firms declining their best financial offer, the foregone pre-money value as a fraction of the accepted offer ranged from a low of 3.6 percent to a high of 217 percent, with an average of 33.2 percent.
Hsu explained what makes the VC’s reputation valuable:
“As a venture capitalist gains more investment experience in a particular industrial sector, he or she is more likely to gain the expertise needed to help startups in their portfolio acquire resources for successful development, which is a powerful contributor to VC reputation. Each additional investment extends the VC’s information network, either acquiring important social contacts and/or gaining experience in effectively structuring deals or monitoring entrepreneurs in the industrial sector.”
He went on to note: “Outsiders may say, ‘I don’t know the entrepreneur, but I know the venture capital firm through its prior deals and make inferences about the quality of the company they are looking at.’”
The author also noted that a “research stream suggested that when the quality of a start-up cannot be directly observed, external actors rely on the quality of the start-up’s affiliates as a signal of the start-up’s own quality.”
The bottom line is that entrepreneurs raising equity capital know that it is far more important whose money you get than how much you get or how much you pay for it. This knowledge allows successful VCs to charge a higher cost for their capital. And that in turn helps explain the persistence in outperformance.
If you are considering investing in venture capital or in private equity more generally, The Quest for Alpha includes a chapter on the asset class, presenting the historical evidence and the risks involved. The chapter contains the following warning from David Swensen, legendary CIO of the Yale Endowment Fund:
“Understanding the difficulty of identifying superior hedge fund, venture capital and leveraged buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high. Even many well-equipped investors fail to clear the hurdles necessary to achieve consistent success in producing market-beating, active management results. When operating in arenas that depend fundamentally on active management for success, ill-informed manager selection poses grave risks to portfolio assets.”
Those who choose to ignore Swensen’s warning still need to understand that, due to the extreme volatility and skewness of returns, it is important to diversify the risks. This is best achieved by investing indirectly through a private equity fund rather than through direct investments in individual companies. Because most such funds typically limit their investments to a relatively small number, it is also prudent to diversify by investing in more than one fund.
And finally, you should remember that the top-notch funds are likely closed individual investors. They get all the capital they need from the Yales of this world.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
Want to read more of Larry’s insights? Here are his most recent articles published on TEBI:
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