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.”