A CIO’s skill in fund selection is one of the most important
factors in determining private equity returns, research has claimed.
An analysis of more than 12,000 investments by 630 limited partners (LPs) found
that skill was more likely to be a factor in high returns than luck or
preferential access to managers.
Daniel Cavagnaro and Yingdi Wang of California State
University, and Berk Sensoy and Michael Weisbach of Ohio State University
studied venture capital and buyout fund investments made between 1991 and 2006.
“Our results imply that an increase of one standard
deviation in skill leads to about a 3% increase in internal rate of return
[IRR],” the quartet wrote. “The magnitude of this effect suggests that
variation in skill is an important driver of institutional investors’ returns.”
The effect was even greater—5%—with venture capital
investments, the researchers said. LPs performed
consistently well or consistently poorly in private equity fund selection,
implying “differential skill” rather than pure luck.
The researchers also singled out first-time funds in an
effort to analyze the effect to which some general partners only allow their “favorite”
LPs to invest. This analysis showed that skill in fund selection was still an
important factor in achieving desired returns.
“Systematic differences in returns across LPs do not appear
to occur only because those LPs have better access to the best private equity
funds,” the researchers reported.
“Better access does appear to help explain some of the
superior performance, such as that of endowments’ investments in venture
capital during the 1990s,” the authors concluded. “However, the evidence of some
LPs’ systematic outperformance goes well beyond established venture capital
partnerships during this period, and appears to exist in first-time funds, in
buyout funds, and in other time periods as well.”
Read the research paper, “Measuring
Institutional Investors’ Skill from Their Investments in Private Equity.”
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