Investing Outside the Box: Evidence from Alternative Vehicles in Private Equity

The last two decades have seen a significant transformation of the structure of the private equity (PE) industry. Not only has the amount of capital under management by buyout, venture, and private debt funds grown dramatically, but it has become more concentrated in a smaller set of fund families. At the same time, general partners (GPs) have increasingly offered alternatives to their traditional monolithic large funds, such as co-investment vehicles, parallel funds, feeder funds, and more. This greater diversity of fund structures might allow for better customization of products to meet the preferences of each limited partner (LP), but also give GPs the opportunity for more differentiation of fees and access by investor types.

In this paper, we use a data set covering roughly 5500 investment vehicles of PE funds invested by 108 asset owners where State Street Corporation acts as a custodian, which includes over half a trillion dollars of commitments in twenty thousand investments by LPs between 1980 and mid-2017. We document for the first time several stylized facts about the growth of alternative vehicles over the last four decades, and revisit some of the enduring puzzles of private equity. Earlier research has shown that in the 1980s and 1990s, some funds persistently produced positive alphas for their investors, yet did not sharply increase their capital under management despite being highly oversubscribed (e.g., Kaplan and Schoar, 2005; Brown et al, 2015). Compensation has been shown to be bunched, with annual management fees falling between 1.5% and 2% of committed capital and carried interest (profit share) of around 20% (Gompers and Lerner, 1999; Metrick and Yasuda, 2010). This behavior seemingly runs counter to a neoclassical investment model, where managers with scarce human capital appropriate the residual rents from their funds either by charging higher fees or growing their assets under management, as depicted in Berk and Green (2004). We provide evidence to resolve this puzzle and suggest that the new vehicles allow private equity groups to differentiate between investors and vary the returns based on the quality and outside opportunities of the LPs.

We first show a set of new stylized facts concerning the evolution of alternative investment vehicles in private equity during our sample period:

  • Vehicle Types: PE investments can be broadly categorized into main funds, discretionary vehicles, and GP-directed vehicles—the latter two are what we term alternative vehicles. Discretionary vehicles include co-investment opportunities that are provided by a GP but in which the LP maintains discretion over which deals to invest. GP-directed vehicles typically are funds that invest in similar securities as the main funds while the GP retains key decision-making powers.
  • Capital allocation: The allocation of private equity outside of traditional funds has been growing over time. In the 1980s, less than 10% of capital commitments to private equity were to alternative vehicles. By 2017, this share increased to almost 40%. In addition, the use of alternative vehicles is widespread among investors. For instance, of the 108 investors in PE in our sample, 87 invested in GP-directed and 69 in discretionary vehicles.
  • Performance: In the cross section, the average performance of alternative vehicles is very similar to that of the average main fund in our sample. However, alternative vehicles underperform relative to the main funds raised by the same partnership in the same year (or in the years immediately prior). Based on weighted average Public Market Equivalent (PME) performance, discretionary vehicles underperform by 0.016 and GP-directed vehicles underperform by 0.101, with only the latter being statistically significant.

We then analyze what drives this underperformance of alternative vehicles relative to their main funds. We formulate two hypotheses that might shape our view of such “outside the box” investments: The first is heterogeneity in sophistication and information asymmetry by LPs. GPs may have superior information to LPs, and exploit their favorable position by offering inferior investment opportunities to LPs. Sophisticated LPs would turn them down, but some LPs may accept these opportunities as they do not understand they are being offered inferior vehicles. The second hypothesis relies on the idea that alternative vehicles can be seen as the result of a bargaining process between a set of heterogeneous GPs and LPs. In a Berk-Green world, we would anticipate that more established GPs would be more likely to capitalize on their reputation and raise larger funds and offer differentiated products to maximize their fee income. Groups with excess LP demand might set up alternative vehicles to allow less premier LPs to invest with them. Some asset owners are more attractive to GPs if they have abundant financial resources, which translate into larger capital commitments, greater connections and value added, or an ability to provide GPs with “liquidity insurance” in bad times (Lerner and Schoar, 2004). These LPs may have more bargaining power and may be offered attractive alternative vehicles. Key in this story is that top GPs offer lower return vehicles to LPs with below average past performance, but the performance of these vehicles still beats or matches the performance of the other funds these LPs could have invested in.

We provide evidence consistent with the second hypothesis. We find that partnerships with higher past PMEs are able to raise more capital in their main funds and also offer more side vehicles, which outperform the average fund in the market. However, when looking at the relative performance of alternative vehicles benchmarked against the main funds of these top-performing GPs, we see that GP-directed vehicles significantly underperform their main funds, while discretionary vehicles perform similarly to their main funds. The results are in line with the idea that GPs differentiate the returns to different types of investors, in the sense that discretionary vehicles are typically offered to LPs with better past performance. In further support of this interpretation, we find that LPs with above average past performance invest in alternative vehicles that even outperform the main funds of the GPs sponsoring them. The categories of LPs that have the highest performance in their alternative vehicle investments are those that are typically seen as high-prestige LPs, such as endowments and foundations, private pension funds, and insurance companies. The poorest performance in alternative vehicles is seen for fund-of-funds. We also find that larger LPs and North American LPs are less likely to resort to alternative vehicles, while European LPs are more likely to invest in these vehicles, even controlling for other LP characteristics. This again might suggest that LPs whose access to the top funds is more limited—i.e., those whose bargaining power is lower—are more likely to invest in alternative vehicles.

Finally, we classify GPs and LPs by past performance and test how the performance of the alternative vehicles varies with the match between LP and GP. The results show that alternative vehicles have the highest performance if LP and GP involved in the vehicle are both above-median performers. The magnitudes are larger for discretionary vehicles, which might suggest that human capital of LPs plays a role in their superior performance since discretionary vehicles require more active involvement of LPs. In contrast, vehicles where both LP and GP are below-median performers have the worst performance. Off-diagonal matches (above-median LP and below-median GP, and vice versa) perform at intermediate levels. These results support the idea that GPs tailor alternative vehicles based on the outside opportunities of LPs. We rule out that this heterogeneity is driven solely by the inability of some LPs to understand the investment opportunities: we confirm that the investments lower-performance LPs make in top GPs still outperform the rest of these LPs’ portfolios in PE. It appears LPs realistically assess the relative performance between different opportunities presented to them. In addition, we show that the match-specific differences in performance are not explained by some LPs and GPs having prior relationships that could reduce information asymmetries.

Download the complete
article PDF

Comments

There are no comments for this entry yet. Be the first to add your thoughts!

Add Your Comment