The amount of capital invested into Private Equity saw an unprecedented increase between the early 2000s and 2007. Funds raised in Private Equity as percent of stock market capitalization increased threefold in the US from 2000 to 2007. This is attributed to the strong growth in the fundraising for buy-out funds. The history for venture capital funds is different. VC fundraising peaked during the IT bubble in 1999-2000, and has since not been able to attain those high levels again. After the credit turmoil started in 2008, the fundraising activity has been very slow for both classes of private equity funds.
The private equity industry is a very cyclical industry. According to research done by Steve Kaplan (Chicago) private equity returns are negatively correlated with the inflow into the industry. For a given vintage year, if the fundraising for private equity has recently been strong – the returns would most likely be weak, and vice versa.
It is well known that most of the excessive fundraising in the boom years could be attributed to the so called “Mega Funds”, i.e. the largest buy-out funds which raised $5-20bn each particularly during the years 2005 – 2007. Those funds were able to make very large transactions based on the almost unlimited access to cheap credit during the previous credit regime. Today, the history is very different, and most of the Mega Funds are having a hard time completing transactions under the new credit regime.
There are certain difficulties related to classifying private equity as one single asset class. The two main subgroups in private equity; venture capital and buy-out, have little in common except sharing the private equity model of active ownership and fund structure. VC investments tend to be in industries which are technology driven and growth oriented and where the companies normally are not cash positive at the time when the VC funds invests. These investments are typically funded with 100% equity, so while the technology risk is high the financial risk is very low. Also, the VC funds are normally minority shareholders in the companies, although they may be able to achieve control of the companies together with other VC funds. Buy-out investments tend to be in industries where the technology component is less important; the industries are in general value oriented where the companies are cash positive and where the transaction is being financed by significant debt capital. The Buy-out funds normally own a majority stake in the acquired company.
What is common for the two sub asset classes is the big dispersion in returns among the different managers. Historically, the difference in performance between the upper and lower quartile managers has been in the range of 15-25%. This tells us that the manager risk is even more important than in any other asset class. Also, different from mutual funds and hedge funds, the consistency in performance is very strong among the different managers, i.e. managers with good historical performance tend to deliver above average return also in the next period. Similarly managers with poor historical returns tend to repeat their underperformance in subsequent funds.