Beyond the Quartiles …

Understanding the “How” of Private Equity Value Creation to Spot Likely
Future Outperformers

Draft – Comments and Feedback Welcome

Oliver Gottschalg
HEC Paris

July 2016

This Paper was prepared for a Practitioner Audience

Please address all correspondence to:
Oliver GOTTSCHALG,
HEC School of Management, Paris; 78351 Jouy-en-Josas, France;
gottschalg@hec.fr

Introduction
Private equity performance measurement is by design initially about the “how much” of value
creation of a given fund manager. It is implicitly backward looking as today’s investors cannot “buy” a
fund’s past returns but only commit to a manager’s future fund with the hope of obtaining high
returns from this investment. For measures based on traditional performance measures (IRR and
Multiple of Invested Capital), a growing number of studies show that historic performance is not a
particularly useful indicator for future returns1. Whenever detailed cash flows are available, there are
more advanced measures of past performance that provide a meaningful level of guidance to likely
future outperformers, but for many funds, such data is unavailable to many investors.
The present paper proposes a novel methodology to measure four distinct components of a PE
fund’s performance, three of which are proxy indictors for underlying capabilities of the fund
manager. This approach compares data on tens of thousands of underlying investments made by
thousands of PE funds to identify fund that are similar according to three different aspects of
similarity: (a) similar in the time period in which the funds was raised (three year vintage cycle), (b)
similar in terms of when investments were made (based on acquisition years of the underlying deals)
and (c) similar in terms of which type of target companies were chosen (i.e. similarity in terms of
their industry sector, size category and geographic location) to be acquired at those times. Starting
from the funds raised in the same three year vintage year cycle, the corresponding other two peer
groups correspond to sequentially filtering for peer funds that are similar to a given fund in terms of
two key investment decisions of a PE Firm: The Timing or The When, i.e. the decision of how
investments were timed over the investment period of the fund; and the Strategy or The What, i.e.
the decision of which type of target companies were chosen (industry sector, size category,
geography) to acquire at those times. We can hence assess the performance impact of each of these
decisions by comparing the average performance of the different peer groups. Finally, the
comparison between a fund’s performance and the performance of those funds that are similar in
terms of what they acquired and when they acquired it, reflects the portion of a fund’s overall
performance that is attributable to The Who and How decisions, which is really the "key ingredients"
of implementation of the fund, i.e. the performance of the specific investment approaches into
specific target companies, above the returns of other funds who made similar decisions in terms of
timing and strategy. Figure 1 shows Venn Diagrams comparing the vintage year approach with the
nested samples of similar competitor funds. Figure 2 illustrates these different performance
components based on hypothetical data.

1

See, for example Harris, Robert S. and Jenkinson, Tim and Kaplan, Steven N. and Stucke, Rüdiger, Has
Persistence Persisted in Private Equity? Evidence from Buyout and Venture Capital Funds (February 28, 2014).
Darden Business School Working Paper No. 2304808; Fama-Miller Working Paper. Available at SSRN:
http://ssrn.com/abstract=2304808 or http://dx.doi.org/10.2139/ssrn.2304808

Figure 1: Comparing a fund to sets of competitors with different levels of similarity

Vintage Year
Peers

Fund to be
benchmarked

Funds with
similar timing
and similar
strategy

Funds
with
similar
timing

All funds raised
in same period
(Vintage Year
+/- 2 years)

Figure 2: Illustrative example of performance components

2.1
1.9
1.7

0.70
0.25

1.5

0.10

1.3
1.1

2.00

1.65

0.9
0.7
Avg performance of Impact of Timing
all funds raised in
the same VY period

Impact of Strategy

Impact of
Implementation

TVPI

Based on the breakdown of overall performance into these components, we can not only quantify
the magnitude of the performance impact of these choices, but we can also provide benchmark
statistics with annual quartile cut-offs for each of these components, making it possible for investors
to determine to what extent a given fund manager has been a “top quartile” value generator within
each of these categories. Finally, we conduct a series of analyses to assess the degree to which a
fund manager’s performance persists in aggregate, and within each of the value creation
components. Importantly, this provides the basis for the identification of factors that historically

would have enabled investors to identify subsequent outperformers with a reliability that would
have led to a statistically significant and economically relevant level of performance improvement in
the portfolio.
Summary of Key Findings
We assessed performance and the deal activity data from Preqin on 1,119 Funds for which
performance data and data on investment year, size category, industry sector and geography for at
least 5 underlying investments was available. From this data, we then identified 257 pairs of buyout
funds raised by the same GP and with the same strategy and regional focus, immediately following
each other in the sequence of fundraises2. Comparing always the first fund to the corresponding
subsequent fund in these 257 pairs, we found that statistically significant positive persistence occurs
only in the “implementation” component of returns. While past TVPI does not provide insights into
subsequent IRR, other components of performance have no significant (timing, When) or a significant
negative (strategic choice, What) level of persistence. This finding is not only statistically relevant but
also meaningful in terms of its magnitude: Had an investor picked 25 of the 257 funds using only
those with the highest previous “implementation-based” returns, the portfolio would have yielded
2.03x, which is significantly higher than if they had picked top performing funds by TVPI which
returned only 1.73x. Even if the sample was extended to include the best 50 of the 257 funds by
implementation returns, there would still be a meaningful performance improvement of 1.86x.
Data and Analysis
We obtain data from Preqin on the performance (TVPI) of 7,524 funds from vintages 1977 to 2014 in
addition to data on 41,065 underlying investments of buyout funds. Linking the deal-level activity to
the fund-level performance, we obtain a sample of 1,119 buyout funds for which performance data
and data on at least five underlying investments is available. Descriptive statistics for this sample can
be found in table 1.

Table 1: Descriptive Statistics
N
Peers
Timing
Strat
Implementation
Focal
Valid N (listwise)

1119

Minimum
0.94

Maximum
5.39

1119

(0.76)

1119

Mean
1.63

Std. Deviation
0.35

0.42

0.01

0.04

(3.82)

1.17

(0.01)

0.18

1119

(2.50)

5.17

(0.00)

0.63

1119

0

8.29

1.62

0.70

1119

We note that the average performance contribution of each of the three value components is close
to zero across the sample, which makes intuitive sense. However we can see that the greatest
2

Vintages of last fund range from 1997 to 2007

standard deviation and coefficient of variation is on the Implementation component. This suggests
PE fund managers differ most in their ability to add value relative to the performance that other fund
managers generate based on investments in similar assets at similar points in time. We document
the differential ability of PE fund managers to add value based on the different value components
based on benchmark statistics with annual quartile cut-offs for each of these components (Table 2).
This makes it possible for investors to determine to what extent a given fund manager has been a
“top quartile” value generator within each of these categories.
Table 2: Quartile Cut Offs by Performance Component

Vintage
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007

Bottom Q
Bottom Q
Bottom Q CutCut-Off Median Top Q Cut- Cut-Off Median Top Q CutOff
Median
Top Q Cut-Off
Timing
Timing Off Timing
Strat
Strat
Off Strat Implementation Implementation Implementation
-0.02
-0.01
0.01
-0.14
0.01
0.09
-0.48
-0.20
0.34
-0.06
-0.03
0.00
-0.09
-0.04
0.01
-0.41
-0.18
0.22
-0.02
0.01
0.03
-0.13
-0.09
-0.01
-0.53
-0.15
0.15
0.01
0.02
0.03
-0.13
-0.07
0.02
-0.35
0.06
0.44
0.02
0.02
0.03
-0.15
-0.05
0.01
-0.34
0.28
0.69
-0.01
0.00
0.01
-0.10
-0.03
0.02
-0.60
-0.20
0.15
0.00
0.04
0.06
-0.05
0.03
0.07
-0.43
-0.09
0.41
0.03
0.04
0.06
-0.05
0.01
0.06
-0.11
0.08
0.48
-0.01
0.01
0.04
-0.03
0.02
0.08
-0.46
-0.16
0.14
-0.01
0.00
0.01
-0.05
0.00
0.07
-0.41
-0.07
0.21
-0.01
0.00
0.01
-0.08
0.02
0.08
-0.26
-0.02
0.18

We proceed to explore to what extent we observe performance persistence in this data, in other
words whether any or all of the performance components of one fund by a given fund manager
indicate above- or below average performance (overall or in any of the components) for the
subsequent fund managed by the same fund manager with the same strategic focus. To this end, we
looked for such pairs of funds in the sample, i.e. pairs of buyout funds raised by the same GP and
with the same strategy and regional focus, immediately following each other in the sequence of
fundraises and with the successor fund raised between 1997 and 2007. This window of vintages was
chosen to exclude recent and immature funds for which performance cannot be assessed with
accuracy due to the J-Curve effect, as well as fund-pairs from the early and mid-1990s, which
operated in a substantially different competitive environment. We identified 257 such fund pairs.
As a first step, we performed a simple bivariate correlation analysis between the overall performance
and the performance components of the predecessor funds and the overall performance and the
performance components of the successor fund in each pair. Table 3 shows the results of this
analysis, which point to a number of important implications.

Table 3: Bivariate Pearson Correlation between performance of predecessor and successor fund

We first see that in line with recent research, there is no significant persistence of performance with
respect to the overall performance, as the TVPI of the predecessor fund is not significantly related to
the TVPI of the successor fund. Importantly, however, we observe significant persistence-type
relationships with respect to individual performance components. Notably the implementationrelated performance component (the “How”) seems to persist, as the implementation-related
performance component of the predecessor fund is positively and significantly related to the
implementation-related performance component of the successor fund (p<0.01). Interestingly, the
strategic choice related performance component (the “What”) has the opposite effect, as the
strategic choice -related performance component of the predecessor fund is negatively and
significantly related to the strategic choice -related performance component of the successor fund
(p<0.01). The timing related performance component (the “When”) of the successor funds is not
significantly related to the timing related performance component of the successor funds.
Arguably, the most relevant question for practitioners is which performance component of the
predecessor funds is more indicative of the overall performance of the successor funds, as this
information would be valuable for fund selection processes. Our analysis suggests that predecessor
funds with high level of implementation-related performance are followed by fund with greater
overall performance (p<0.05) and that predecessor funds with high level of strategic choice-related
performance are followed by fund with lower overall performance (p<0.05). Given the strong
interdependencies between the explanatory variables in Table 3, we proceed with a multivariate
assessment of performance persistence.
Based on a stepwise entry function for an OLS regression with the overall performance of the
successor funds as dependent variable and the different performance components of the

predecessor funds as independent variables, we confirm that the implementation-related
performance component is the only variable with a statistically significant link to overall subsequent
performance. The relationship is positive and significant at the p<0.05 level. The explanatory power
of this model does not improve by adding any other of the predecessor fund performance
components. This points to the dominant role of the implementation-related performance
component as indicator of likely future outperformance. In other words, investors should give
preference to GPs with a proven ability to add value based on the “How” of value creation in earlier
funds to build outperforming portfolios.
This raises the question of the economic magnitude of the performance improvements one could
have obtained historically by systematically investing in funds preceded by funds with high levels of
the implementation-related performance component. We can also address this question based on
our sample of 257 fund pairs. The reference performance for this assessment is the average
performance of all 257 successor funds, which is highest previous “implementation-based” returns,
the portfolio would have yielded 2.03x. A t-test confirms that the difference in mean performance
between the 25 and the total sample is statistically significant at p<0.001. Even if the sample was
extended to include the best 50 of the 257 funds by implementation-based returns, there would still
be a meaningful performance improvement to 1.86x.
Summary and Conclusion
The present paper has demonstrated that while traditional measures of the “how much” of value
creation are limited in their ability to provide investors with reliable insights into a GP’s ability to
outperform in the future, a deeper understanding of the How of value creation can be a meaningful
starting point for the identification of likely future outperformers. We utilized a novel methodology
to measure distinct components of a PE fund’s performance, leveraging data on tens of thousands of
underlying investments made by thousands of PE funds. This enables us to assess the performance
impact of The When, i.e. the decision of how investments were timed over the investment period of
the fund and the Strategy, The What, i.e. the decision of which type of target companies were chosen
(industry sector, size category, geography) to acquire at those times and to compare this to the The
Who and How decisions, i.e. the performance of the specific investment approaches into specific
target companies, above the returns of other funds who made similar decisions in terms of timing
and strategy.
Analyzing data on 1,119 PE funds we show that funds differ most in the implementation-related
“How” component. We then explore the persistence of overall return or return components, based
on 257 pairs of buyout funds raised by the same GP and with the same strategy and regional focus,
immediately following each other in the sequence of fundraises. Comparing always the first fund to
the corresponding subsequent fund in these 257 pairs, we find that statistically significant positive
persistence occurs only in the “implementation” component of returns. While past TVPI does not
provide insights into subsequent IRR, other components of performance have no significant (timing,
When) or a significant negative (strategic choice, What) level of persistence. This finding is not only
statistically relevant but also meaningful in terms of its magnitude: Had an investor picked 25 of the
257 funds using only those with the highest previous “implementation-based” returns, the portfolio
would have yielded 2.03x, which is significantly higher than the sample average TVPI of 1.73x.
While the analyses presented in this paper constitute a major step ahead towards the goal of better
understanding the relevant and persistent drivers of PE value creation, there are inevitably remaining

limitations. While this methodology has been designed to provide directionally correct insights
despite possible isolated imperfections in the underlying data on fund performance and investment
activity, the method only considers deals that actually happened. As such it cannot capture that
funds may have been in regular competition for similar deals, but eventually ended up making
investments that were not very similar as per our definition of similarity. Data limitations further
prohibit us from considering other deal attributes than size, industry and geography, so that we do
not capture which fund are similar with respect to their choice of buy-and-build versus standalone
buyout strategies.
The aforementioned findings have important implications for PE investors, as they suggest that
without a deeper understanding of the nature of a GPs value creation, the ability of investors to
reliably identify likely future outperformers is substantially limited. Based on an assessment of the
deeper value driver components in a GP’s past funds, however, investors are likely to be able to
select funds that are significantly more likely than the average to outperform.

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