Performance patterns at a general level

Given the typical J-curve economic pattern observable at a fund level, we will now provide some considerations of what affects performance at a more general level, and its relation with other variables such as new capital influxes and the overall fund’s size. Moreover, we will see how performance movements closely drive market upturns and downturns that have occurred and will still occur over time. To begin with, we need to introduce the definition of what mainly drove the LBO market in the 1980s-90s decades, namely, the “persistence” phenomenon. Kaplan

and Schoar firstly issued such a locution in their seminal paper63_{, and it basically}

refers to the ability of a fund to maintain its performance in subsequent funds raised. Thus, in the case of LBOs, they argued that GPs whose funds outperformed were likely to outperform again in their subsequent fund64_{, and this was found to}

be primarily due to GPs’ skills and valuable expertise. Furthermore, the authors found a strong, positive relation between the fund’s performance and new influxes of capital in subsequent funds, meaning that investors were more prone to invest higher amounts of money in funds raised by GPs that previously performed well. Additionally, in times during which LBO firms showed above-average returns, more and more new players were willing to enter the market by raising early funds, even though they were found to perform poorly. This trend have led to what is generally called a “boom period”, that is, when the market gets “overheated” by

ever more numerous deals due to the increasing number of funds. Regardless, being early funds less skilled and hence less profitable, as well as a general tendency to undertake riskier and, at its limit, reckless transactions, this gradually reduces the overall rate of return average, ultimately leading to a market crash, or so-called “bust period”, in which higher default rates are registered, inefficient

funds disappear and the market gradually reorganizes.

63 _{Kaplan, S.N. and Schoar, A. (2005), “Private Equity Performance: Returns, Persistence and Capital} Flows”, The Journal of Finance, Vol. 60, No. 4

64 _{“Outperformance persistence” refers to the ability of top-quartile performance funds’ GPs to remain} top-quartile performers even in subsequent funds raised. As opposed to this, the authors found a negative “underperformance persistence” for mutual funds.

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As a proof of the robustness of the persistence phenomenon, other authoritative authors65 _{studied it and finally agreed on its validity. Furthermore, some recent}

studies developed one of the main implications of the original Kaplan and Schoar paper regarding scalability of LBO funds, namely the relationship between the fund’s size and its performance. In their work, the original authors found a concave relation between the two variables, suggesting a diseconomy of scale effect66 _for

buyout funds. In other words, funds that outperform and, hence, raise higher level of capital thereby growing their size, tend to impair performance, since they are not likely to be as high as they were before. As mentioned above, some recent studies67 argued the validity of the diseconomy of scale thesis, providing some new hints as well. In particular, the fund’s size may be enlarged by:

a. Raising greater amounts of committed capital b. Increasing the number of simultaneous investments c. A combination of both

Phalippou et al. (2015) found that the diseconomy of scale effect is more likely to occur when funds increase size by means of a soaring number of simultaneous investments (option b and c), because of superior growth of communicational and organizational costs that more than compensate increases in learning advantages and enhanced relationships with banks and other lenders. Hence, returns tend to decline in a concave relation with the overall size. Instead, genuine increases in the fund’s size along with a rather low number of simultaneous investments (option a) has a positive effect, allowing LBO firms to undertake bigger deals that, as shown in the paper, lead to strong performance. On the whole, then, the authors argued that scalability in LBO funds is possible, though it must be accomplished by keeping a somewhat low number of simultaneous investments at the same time

65 _{Phalippou, L. and Gottschalg, O. (2009), “The Performance of Private Equity Funds”, Review of} Financial Studies, Vol. 22, No. 4

Mozes, H.A. and Fiore, A. (2012), “Private Equity Performance: Better than Commonly Believed”, Journal of Private Equity, Vol. 15, No. 3

66_{Kaplan indeed states that “fund’s size is the enemy of persistence”, thereby implying the presence of} diseconomies of scale in buyout funds. A minority of research, though, supports the economy of scale thesis.

67 _{Lopez-de-Silanes, F., Phalippou, L. and Gottschalg, O. (2015), “Giants at the Gate: Investment Returns} and Diseconomies of Scale in Private Equity”, Journal of Financial & Quantitative Analysis, Vol. 50, No. 3

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to contrast the overwhelming increase in communicational and organizational costs.

Given the persistence and its economic implications, it remains to be seen whether such a phenomenon has varied over years, to evaluate if it is still applicable to more recent funds. As mentioned earlier, persistence in outperformance for buyout funds was argued to be valid and robust for funds raised in the 1980s-90s decades, but things may have changed today. Harris et al. (2014)68 recently published a renewed version of the original paper that introduced persistence in 2005, studying possible changes that may have led to some differences in this regard. They found that persistence in buyout funds has a far smaller magnitude than it had for the first two decades of activity: although it still exists for buyout funds, it has shifted to lower-end quartile performers. Notably, LBO funds shifted from an “outperformance persistence” in the 1980s-90s towards somewhat of an “underperformance persistence”, meaning that only funds in the performance lower-end quartile show a pattern that leads to poor performances even in subsequent funds. As for typical persistence in top-quartile funds, it is argued to be no longer applicable. Despite further research is going to be required, possible explanations may be due to the fact that either many GPs have appropriated expertise and skills of top performer GPs, thereby reducing the persistence rate, or sources of return have plausibly varied their importance over time and only a portion of GPs have adapted, disrupting the persistence pattern.

However, as far as diseconomies of scale are concerned, these results have an important implication: indeed, the outperformance persistence, which allowed GPs to raise more capital for next funds, has led to ever larger funds that have then underperformed, as persistence for top performers is, to date, no longer valid. This seems to validate the aforementioned diseconomy of scale thesis, which states that the relation between size and performance results in a concave function (mainly due to the increasing number of investments, as shown above).

68 _{Harris, R.S., Jenkinson, T., Kaplan, S.N. and Stucke, R. (2014), “Has Persistence Persisted in Private} Equity? Evidence from Buyout and Venture Capital Funds”, available at:

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