Academics at Harvard and Insead, the premier business school in France, have just produced new research suggesting that institutional investors who’ve been increasingly making direct investments are smart to do so.
Their research — based on “detailed cash flows for 392 direct investments” made between 1991 and
2001 2011 by seven large institutional investors — further concludes that solo investments outperform co-investments when the deals are local and/or later-stage.
Here’s how the researchers – Harvard Business School’s Josh Lerner and Victoria Ivashina and Insead’s Lily Fang – came up with the corollaries that they did. As they say in their paper:
We examine the investment patterns—e.g., timing and geography—as well as the performance of these direct investments. When studying the investment performance, we compare the performance of these investments against the major benchmarks for private equity. We use three metrics of investment performance:
1) returns net of the fees and carried interest paid to general partners;
2) returns net of fees, carry, and the added expenses borne by the limited partners (e.g., internal staff costs); and
3) the market-adjusted returns net of fees and carry.
What they found?
1.) Direct investments are cyclical. As with private equity funds (Kaplan and Schoar, 2005), the most direct funds are invested at times when ex post performance is relatively poor. As a result, aggregate performance is better when we undertake a simple average of annual performance than when years are weighted by the amount of capital invested in that year.
2.) Direct investments generally outperform fund investments. But the strongest finding is that within direct investments, solo transactions, i.e., investments initiated and executed by investors alone, significantly outperform co-investments, which are deals done alongside private equity funds. These results are robust to the use of various benchmarks and lag structures, and provide an economic rationale for the disintermediation trend in private equity investing.
3.) The impact of years with extensive private equity inflows is less deleterious to the returns of solo investments. While returns are lower, solo investments in peak years significantly outperform direct and partnership investments. Nonetheless, the volume of direct investments appears to fall after market peaks.
4.) The advantages of solo deals over co-investments are greater in setting where information problems are less intense, such as local and later-stage firms that perform less R&D.
The full, 42-page study — available for download here – will undoubtedly embolden groups like the Canadian Plan Pension Investment Board, which is already considered among the most sophisticated private equity operations in the world, including because of its direct investments and co-investments in equity, debt, infrastructure and real estate.
Of course, U.S. pensions, including CalPERS and CalSTERS, have also increasingly cut side deals with buyout funds to put more money to work directly into companies at lower costs.
Whether this or similar new research convinces more institutions to actively embrace direct investments — or even to have their assets managed solely by internal staff — remains another question. It’s worth remembering that in the 1970s, most pensions were run by internal investment pros and their returns weren’t anything to write home about. In fact, it was during the same period that institutions began actively seeking outside managers to oversee their assets, the hope being that paying for performance might make more sense.
Photo: Image courtesy of Shutterstock.