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Kellogg Insight: Focus on Research

The Promise, perils and performance of private equity

Returns that institutional investors realize from private equity can differ dramatically

Based on the research of Senior Lecturer Wan Wongsunwai

By Peter Gwynne

  Wan Wongsunwai
  Wan Wongsunwai   Photo © Evanston Photographic

Insight insights: selections from the Kellogg online faculty research digest

To find more articles, including faculty biographies and suggestions for further reading, or to join the conversation by leaving your own comments, visit Kellogg Insight.


Private equity — the class of investments that includes venture capital investments and buyouts — accounts for a relatively small and, to date, little analyzed percentage of overall investments. Studies have shown that institutional investors, such as university endowment funds, corporate and public pension funds, private advisers, banks and insurance companies generally outperform individual investors. However, researchers have unearthed very little information on the success rates of different types of institutional investors.

Research conducted by Wan Wongsunwai, senior lecturer in accounting information and management at the Kellogg School, with co-authors Josh Lerner (Harvard Business School) and Antoinette Schoar (Massachusetts Institute of Technology), has changed that. The team studied previously unexplored records of portfolio composition and fund performance and found large disparities in private equity investment performance among different institutions.

Between 1991 and 1998, the best performers by far were endowment funds run by universities and foundations. Funds in which endowments invested showed, on average, a 44 percent internal rate of return (IRR). In contrast, investments by private advisers showed a 23 percent IRR, and those by public pension funds 20 percent IRR. Corporate pension funds and banks performed even more poorly, reaching IRRs of 13 percent and just 4 percent, respectively. An extension of the analysis through 2001 — covering a period when returns from many funds were at best mediocre — reveals even greater differences. No noticeable changes in those results were caused by correcting for factors such as the time in which the investments were made and the choice between venture capital investments and buyouts.

The team expected to find some variation among different types of investors in private equity, based on anecdotal evidence. For example, they knew that several academic endowment fund managers had spent years earning high returns. However, the sharp contrast between endowment funds and the others was a surprise.

What causes the marked performance differences? Wongsunwai and his colleagues examined the possibilities. First, different types of investors might prefer different risk profiles for the funds in which they invest. Certain investors, such as banks, might use their investment as kinds of "loss leaders." Wongsunwai explains: "Banks don't invest in private equity only to generate returns, but [also] to get more business." Second, certain successful private equity funds might limit access by not accepting new investors, thus allowing only existing investors to participate, a factor that could favor long-established endowment funds at the expense of newer investors.

Analysis showed that those issues have some influence on variations in performance by different types of institutional investors, but nowhere near enough to account for the wide gap. However, the team broke new ground by identifying another factor that does have a significant impact. "Funds in which endowments decide to reinvest show much higher performance going forward than those in which endowments decide not to reinvest," the team reported in The Journal of Finance. "This suggests that endowments proactively use the private information they gain from being an inside investor, while other [institutional investors] seem less willing or able to use information they obtain as an existing fund investor."

Why should endowments make better reinvestment decisions than other institutional investors? "This might be an access story of a different kind," Wongsunwai speculates. "It's a matter of relationships that involve private equity players who might, for example, be alumni on the boards of university endowment funds. It's an old boy network."

The team quickly found a good reason for the lack of research on the issue: unlike public companies, private equity organizations reveal very little detail about their financial situations. "The disclosure of performance in the private equity business is tricky; the information is not exactly publicly available," Wongsunwai points out. "Some investors and even private equity firms themselves occasionally provide the information, but so far this is not a widespread trend."

What advice does Wongsunwai have for private equity investors? Don't just chase returns, and beware of funds required to invest locally. "Successful investors seem to know when to terminate relationships with fund managers based not only on how well they have done in the past but also — and more importantly — how well they are expected to do in future," he says.

Peter Gwynne is a freelance writer based in Sandwich, Mass.

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