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 advisors, banks, and insurance companies—generally outperform individual investors. However, researchers have unearthed virtually no information on the success rates of different types of institutional investors.

A research project conducted by Wan Wongsunwai, senior lecturer in accounting information and management at the Kellogg School of Management, along with coauthors 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.

During the period between 1991 and 1998, the best performers (see figure 1) 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 advisors 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 such factors as the time in which the investments were made and the choice between venture capital investments and buyouts.

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Figure 1: Average annual returns by type of institutional investors in private equity between 1991 and 1998

The team had 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 several years earning high returns. However, the sharp contrast between endowment funds and the others was a surprise.

What causes the marked differences in performance? Wongsunwai and his colleagues examined several possibilities. First, different types of investor 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: “Banks don’t invest in private equity only to generate returns,” Wongsunwai explains, “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 identified for the first time 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 reports 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.”

Wongsunwai became interested in studying venture capital and private equity after dealing with emerging technology companies in his previous career as an equity analyst. “The idea tied in with my previous work in investment banking, looking at new technology companies,” Wongsunwai recalls. “I was always fascinated by what makes these new companies come about—by the role of venture capital.”

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.”

Plainly, the team faced a difficult job to tease out the needed data. However, it benefited from a trend toward more openness. “Some prominent institutions, such as public pension funds, are pressing for greater transparency so that their members can know more about their investments,” Wongsunwai says. “And the Freedom of Information Act allows any member of the public, including data providers, to ask for disclosures.” He and his colleagues used data from compilations that had previously been unavailable to researchers: (1) Asset Alternatives’ Directory of Alternative Investment Sources, (2) the funds database in Asset Alternatives’ Galante Venture Capital and Private Equity Directory, and (3) Private Equity Intelligence’s Private Equity Performance Monitor. Those sources provided sufficient data for the team to reach its unexpected conclusions.

What advice does Wongsunwai have for investors in private equity? “The message,” he says, “is not to just copy the successful ones and chase past returns. 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 adds a cautionary word about the geography of investment in private equity. “Performance overall seems to deteriorate when funds invest in-state or locally,” he says. “For example, if there’s a state pension fund forced to invest locally, that may not be a good idea. Political factors can get in the way of financial performance.”