Size, returns and performance persistence: Do private equity firms allocate capital according to individual skill?

Abstract

Private equity firms have strong financial incentives to increase fund and deal sizes. As funds get larger it is harder to maintain relative performance, as the distribution of returns for larger deals becomes less skewed – with far fewer home-runs. On the other hand, larger funds have lower downside risk in terms of relative returns. Following the approach of Berk and van Binsbergen (2015), we contrast relative performance of a PE firm with their ability to generate increased absolute gross value added (GVA) as they increase fund size. One way to manage the size-performance trade-off is to allocate more capital to those individuals in the investment team with the most skill. We find evidence of such skill at the individual manager level, and that successful PE firms grow GVA in part by backing their winners with more capital to deploy. In this way, PE organizations can avoid sowing the seeds of their own decline: with initial strong performance leading to capital inflows and performance deterioration.

Authors

Reiner Braun, Technical University of Munich (TUM)
Nils Dorau, Technical University of Munich (TUM)
Tim Jenkinson, University of Oxford, Saïd Business School
Daniel Urban, Erasmus University Rotterdam