In a paper released Monday, researchers at EDHEC-Risk Institute in France examined the determinants of private equity returns using a newly constructed worldwide database of 7,500 investments made over 40 years.
The paper, “Giants at the Gate: On the Cross-Section of Private Equity Investment Returns,” is timely. Private equity in the past decade has injected liquidity and fueled the M&A wave in the U.S. and Europe. By 2007, according to one estimate, private equity firms worldwide had acquired nearly 14,000 companies worth some $3.6 trillion. Researchers have begun to study investor returns in private equity, but according to EDHEC, until now there has been little evidence on the cross-section of the performance of individual private equity investments and on the drivers of this performance.
In their study, Florencio Lopez-de-Silanes (left) of EDHEC Business School and his co-authors Ludovic Phalippou and Oliver Gottschalg made these key findings, some of which, they said, were previously undocumented:
- The scale of private equity firms is a significant and consistent driver of returns. Diseconomies of scale are linked to firm structure: independent firms, less hierarchical ones and those with managers of similar professional backgrounds exhibit smaller diseconomies of scale. More globally, small investments outperform large ones.
- The evidence is consistent with the view that private equity performance suffers from a firm’s structural features that curtail information flows and reduce the value-added capacity of management in more hierarchical operations and those in which communication is more difficult. In other words, as the private equity firm scales up, its larger communication costs outweigh the benefits of its higher knowledge utilization rate.
- Investments held at times of a high number of simultaneous investments underperform substantially.The number of simultaneous investments over the life of the deal is a better predictor of negative returns than are other proxies. The median internal rate of return (IRR) is 36% in the lowest simultaneous investment decile and 16% in the highest one.
- The authors document substantial underperformance of investments in emerging countries. Investments in developing countries exhibit poorer performance across all measures, with the exception of bankruptcy rate.
- The data also show for the first time that most private equity investments around the world are small equity-wise. The median equity investment is $10 million; only 10% of the investments in the sample involve more than $100 million of equity.
- The median investment IRR is 21%, gross of fees. One in 10 investments goes bankrupt, whereas one in four has an IRR above 50%.
- A strong negative association exists between performance and duration. A large proportion of high-return deals are quick flips (investments held less than two years) and quick flips are cyclical. Accounting for 12% of all private equity investments, quick flips have median IRR of 85%, whereas investments held more than six years, nearly 18% of all private equity investments, have a median IRR of only 8%.
- IPO-exited investments have higher returns than the rest. Yet investments exited through a sale (a trade sale or secondary buyout) or recapitalization, refinancing or other methods also perform well.
- The notion that private equity focuses heavily on cash-rich industries is not borne out by the data.
EDHEC-Risk Institute, established in 2001, is part of EDHEC Business School. The institute is a center for financial research and its applications to the industry.