PE and fitness

Professor Oliver Gottschalg of HEC has developed a mathematical model to help assess the ‘fitness’ of private equity firms. The goal is to help predict how these firms will perform.

Although private equity is not the stuff of your average day-trader, its sometimes stellar returns attract interest from high net-worth individuals and institutional investors. How can this somewhat select audience find its way in the dark undergrowth of private equity offerings?

“One of the things that bothered us the most within the HEC strategy department was the opacity of the private equity performance,” explains professor Oliver Gottschalg. Indeed, private equity deserves its name, since the transactions that are its foundation are almost always cloaked in secrecy.

For professor Gottschalg to pry through this lack of transparency, he spent years developing close links to important actors in the private equity world.

Firstly, he approached the private equity funds that would provide data on the condition of strict anonymity, often going so far as to hide the ‘investee’ company names. Secondly, he approached the institutional investors who often provided the funds for the so-called GP (for General Partner, i.e. the private equity firm).

“Because of my years of work with institutional investors, and their trust in my maintaining confidentiality, we have used proprietary data on 15,000 company transactions. This database was used in combination with the publicly available data from Thomson Reuters via their VentureXpert dataset.”  In all, data for the past 20 years was used, making these unique datasets the solid foundation for original analysis.

Why collect this data?
What intrigued professor Gottschalg was not only the performance of the private equity funds, but the forward-looking ‘fitness’ of each GP. In other words, how likely was firm XYZ to be successful in the future also? On what variables and characteristics of the fund did XYZ’s future success rely? How well managed was each GP?

Which variables could explain the fitness of firm XYZ? After examining the data, professor Gottschalg and his team identified ten factors, some of which had positive impacts on performance, and some of which had the reverse.

“Although one cannot be certain that history repeats itself,” warns professor Gottschalg, “my analysis of historical data identified ten key explanatory variables.”

Among the most important positive factors were ‘recent variance in deal size’ (meaning an ability for firm XYZ to take advantage of different size deals), or the level of ‘industry focus’ (if firm XYZ is somewhat specialized that helps create value). Some of the negative factors include ‘average BAA yield’ (higher rating means cheaper debt raised, which in turn means better performance) or ‘active portfolio size’ (a smaller portfolio is easier to manage and therefore to render profitable).

“Starting from an intial analysis of 3,000 funds we focused on 276 PE firms managing over 1,200 funds, for which sufficiently detailed data was available,” explains professor Gottschalg. The table below provides the ranking of the top ten fittest funds:

For a firm to be included in the model for calibration, the most important criteria were that more than twenty transactions had been completed by the beginning of 2009; that more than $100 million of equity had been invested; and that the firm had more than five years of PE activity. For the full study, click here.
 
What purpose does this serve?
For professor Gottschalg, a prime benefit of the study is to help institutional and other larger investors in assessing the risks linked to specific private equity firms. “We are already providing advice to various investors, although we do not give out the exact coefficients of the mathematical algorithm.”

Another application is in assessing the expected performance of new PE funds being launched. “If a new fund performs well when its characteristics are plugged into our model, then we can hope for good returns down the road,” says professor Gottschalg.

By assisting investors, Gottschalg hopes to continue receiving the proprietary data that will enable him to adjust and refine his model, thus reinforcing the virtuous circle. Good news for investors, but perhaps more worrisome for those general partners whose lack of fitness will be exposed.

Published in May 2010