The early performance of private equity funds can help predict future relative performance, according to new research from the alternative investment industry data provider Preqin.
Given that fund managers typically launch new offerings as they come to the end of the investment period for their previous vehicle (often around four years after closing their last fund), Preqin decided to determine the extent to which fund manager performance can be evaluated based on the relative performance of funds before they reach maturity.
To do so, the data provider compared the quartile positions of 2,500 buyout and venture capital funds in their fourth year of operation to the quartile positions of the same funds at maturity. Preqin also performed the same analysis for funds in their sixth year and then viewed the proportion of funds that change quartile from year to year.
The research, says Preqin, indicates that early quartile rankings are an “excellent” predictor of future relative performance for both buyout and venture capital funds.
Preqin says 50% of the buyout funds ranked in the top quartile in year four go on to be top quartile at maturity, with 75% beating the median, while 60% of VC funds in the top quartile at year four maintain top quartile position at maturity, with 76% beating the median.
On the flip side, funds returning a poor relative performance early on have trouble turning that around. According to Preqin, 51% of the buyout funds in the bottom quartile in year four remain there at maturity, while 60% of VC funds in the bottom quartile at year four maintain this position at maturity.
By year six, according to Preqin’s research, quartile rankings are even more important, with 67% of top quartile buyout funds maintaining that position at maturity, and only 11% failing to beat the median. In terms of venture capital funds, 73% maintain their position in the top quartile, with only 5% failing to beat the median. On the other hand, only 11% of bottom-ranked buyout and 7% of bottom-ranked venture funds in year six are able to turn things around and beat the median at maturity.
“Despite the fact that funds in their fourth year are still early on in their life-cycle, their performance relative to others provides an excellent indication of future quartile standings,” said report author Tim Friedman, a Preqin senior manager. “Institutional investors should pay careful attention to a fund manager’s quartile ranking for recently launched funds, and those considering purchases on the secondaries market should be extremely wary of bottom quartile funds. Of course, each fund must be assessed on its individual merits—there is a significant minority of funds that are able to overcome disappointing performance early on, with 12% of bottom quartile buyout funds in year four achieving top quartile status at maturity.”
Preqin says its interviews with investors also suggest increased scrutiny of existing relationships—re-ups are far from guaranteed as institutions carefully assess past performance and future prospects.