Limited Partner Performance and the Maturing of the Private Equity Industry
Endowments outperformed other investors early on because they had access to the most successful funds while other investors did not.
During the 1990s, returns among endowments investing in private equity funds soared and endowments outperformed other private equity investors. This was not the case between 1999 and 2006. In Limited Partner Performance and the Maturing of the Private Equity Industry (NBER Working Paper No. 18793), Berk Sensoy, Yingdi Wang, and Michael Weisbach conclude that: "The disappearance of abnormal performance by endowments is consistent with changes in the economics underlying the private equity industry." In fact, the private equity industry had matured. In 1990, private equity was a little-known niche, with $6.7 billion in investments. By 2008, just prior to the financial crisis, the industry had ballooned into a $261.9 billion mainstay of institutional portfolios.
Based on a sample of 14,380 investments by 1,852 limited partners in 1,250 buyout and venture funds between 1991 and 2006, the authors confirm that endowments outperformed other investors early on because they had access to the most successful funds while other investors did not. Rather than expand or charge higher fees, the best private equity partnerships rationed access to their funds, accepting investments from favored investors, such as prestigious educational and other nonprofit endowments, to the exclusion of others. Also, endowments were better able to evaluate alternative investments, such as private equity, that were unfamiliar at the time.
Between 1991 and 1998, endowments enjoyed an average 13.38 percent internal rate of return on private equity investments, the highest of any limited partnership groups. "The performance gap is driven entirely by endowments' investments in the venture industry, which benefited most from the 1990s technology boom," the authors write. "Compared with other types of institutions, endowments were more likely to invest in older partnerships, which not only were more likely to restrict access but also earned higher returns."
In the aftermath of the technology bust of the 2000s, which put an end to booming returns from venture capital, that outperformance had evaporated. The authors find that endowment investors' skill in picking venture funds declined significantly after the tech bust. The marginal outperformance that could be attributed to the funds they invested in, relative to those that they did not invest in, fell to levels similar of other institutional investors during 1999-2006. And, endowment investors didn't show particular skill in picking first-time funds, which were unlikely to restrict access, either before the tech crash or afterward.
The authors explain this pattern as the result of maturation of the private equity industry. In the early years, high returns were earned in part by purchasing mismanaged companies and improving their operations. Investments in high-tech companies were also an important driver of venture capital returns in the 1990s. Over time, though, the "low-hanging fruit" was picked, and the dispersion of returns across different private equity groups shrunk dramatically.