Reputation, Volatility, and Performance Persistence of Private Equity (Job Market Paper)
Abstract: This paper proposes a learning model with reputation concerns to shed new light on performance persistence for private equity funds. The model predicts: When the fund return is less noisy, performance persistence is more evident, the dependence of future payoffs on past performance is stronger, and high-ability managers are more likely to limit their fund sizes. Using a comprehensive dataset with private equity fund characteristics and performance measures, I document empirical evidence in favor of those predictions: (i) The volatility of venture capital (VC) fund returns is much higher than that for buyout funds; While buyout fund performance shows strong long-term persistence (more than ten years), I only find weak short-run persistence for VC funds. (ii) Buyout managersí» fund size is strongly related to their performance in previous funds, whereas VC managersí» fund size depends on the overall performance of VC industry in the past few years and total capital inflows to the industry. (iii) Top buyout managers expand their fund less than mediocre ones, suggesting voluntary size-limiting behavior, while no such evidence is detected for VC funds.
What Drives Persistence in Private Equity Fund Performance?
Abstract: Empirical evidence on private equity shows that returns persist strongly across different funds raised by the same group of fund managers (GPs), especially for funds that outperform the industry, and there is oversubscription in top performing GPs' follow-on funds. However, compensation scheme is relative homogenous across GPs. Why successful GPs persistently deliver substantially higher returns without expanding as much as they could have? I develop a model to address this puzzle, in which fund managers face a tradeoff between fund size (determining current income) and fund return (building a reputation and increasing expected future income). I prove that for a wide range of parameters, a seperate equilibrium is achieved, in which high-ability fund managers persistently choose to deliver high enough returns to prevent low-ability fund managers from imitating. Their losses in current funds are well compensated by the increasing probability of raising a follow-on fund. In addition to providing an explanation for the puzzle above, this model predicts that funds raised in boom year are likely to perform poorly and funds raised in bust year are likely to perform well. It also makes rich predictions on market timing and compensation schemes.
WORK IN PROGRESS
Returns from Private Equity Investments of Different Stages