We investigate whether buyout returns in a maturing market will diminish over time or whether the best performing managers can provide a learning curve that the rest of the market can copy and, thus, giving raising the entire market’s return. 

Many would argue (based on classic economic theory) that when the private equity industry within a given market grows ownership becomes more efficient, more liquid and there are fewer possibilities for arbitrage (buying cheap and selling expensive). In addition, there would be fewer “low-hanging” fruits on the stock exchange. These factors together could help explain why annual returns from US buy-outs have diminished over time.

A 2008 study by Klein and Chapman on “Value Creation in Middle-Market Buyouts:A Transaction-Level Analysis” finds contradicting results.

They advocate that the tendency they find for US Private Equity’s return on equity having a negative correlation with exit year and holding time, could suggest that the private equity “industry maturation” will imply elimination of excess returns over time. On the other hand, their conclusion that return is negatively correlated with holding periods implies that holding times will be reduced in favor of increased equity returns per annum as deal processes and executions become more efficient over time.  If this is the case, a learning curve will then lift average and specific annual returns*.

An Ernst & Young’s report** shows that more than 50 percent of value creation stems from operational improvements. This report also suggests that increased private equity activity in a particular market would improve companies and returns through active ownership more than it would diminish return through “competition for deals”.

A study done by Boston Consulting Group *** finds that increasing scale of the managers (consolidation) does not affect performance.  They question whether the lack of mean-reverting for top performing managers could either lead to a learning curve and lifting performance of the industry in general or increase the difference between the the rest of the market and the top performers resulting in a consolidation of the industry.

No conclusion has yet been reached and the question is yet to be answered. We will keep you posted on future research.

Sources:

*Klein and Chapman (2008) “Value Creation in Middle-Market Buyouts: A Transaction-Level Analysis”. Available from http://www.privateequitycouncil.org/wordpress/wp-content/uploads/value-creation-in-middle-market-buyouts.pdf [Accessed 24.11.2009]

**Ernest & Young (2007) “ How do Private Equity Investors Create Value? A Global Study of 2007 Exits”, Available from: http://www.ey.com/Publication/vwLUAssets/Private_Equity_Beyond_the_credit_crunch_global_study_of_2007_exits/$FILE/Private_Equity_Credit_Crunch.pdf [Accessed 24.11.2009]

***(Meerkat, Brigl, Prats,Lichtenstein, Herrera & Rose (2008) “The advantage of persistence – How the best private equity firms beat the fade”, online source) Boston Consulting Group. Available from: http://209.83.147.85/publications/files/Private_Equity_Feb_2008.pdf [Accessed 24.11.2009]