Calling all LPs! Thanks for joining me (John Bailey, Co-Founder at OneFund) for another edition of Capital Call. A bi-weekly private equity newsletter from LPs for LPs. 

The mission of Capital Call is to deliver concise, top-notch insights and updates from the private markets tailored to what matters for LPs. 

This week we will be looking at: 

• Refining the Manager Selection Process

• Fundraising updates and VC/PE reports

• GP Perspectives from Robert Smith & Bob Elliot

Join the upcoming OneFund webinar!

Join us for our upcoming OneFund x Guardia webinar, Navigating Private Equity. I'm thrilled to be teaming up with Miguel Osio Brillembourg, a good friend and the Founder of Guardia, a concierge platform helping individuals better navigate their financial lives. This exclusive webinar will be on Friday, September 22nd at 12 p.m.

In addition to answering your questions during the Q&A, we'll cover...

• How and why top institutional investors allocate to private equity and venture capital

• Recent trends shaping the private markets today

• Importance of manager selection and the risk premium in private equity investing

Industry Insights

Refining the Manager Selection Process: How much do past returns matter?

The global financial crisis catalyzed the start of an era of unprecedented growth in private capital, with, according to Pitchbook, the number of GPs more than tripling from 3,700 in 2007 to 13,000 in 2023 now managing over 20,000 strategies and nearly US$4 trillion in AUM. GPs have enjoyed a decade-plus-long period of ultra-low interest rates as well as banks shifting away from SME lending in the wake of the GFC, opening enormous opportunities in the middle market. 

Despite such exponential growth, manager selection processes have not evolved as rapidly and most LPs follow the “six Ps” of people, philosophy, process, portfolio construction, performance, and pricing. Performance tends to be the most controversial criteria as LPs assess the longstanding question of whether past performance is an indicator of future performance. And to be clear (and the SEC has a very clear stance on this) it is not. However, it can help prospective LPs build confidence in the ability of a fund to execute in the future if they have done it in the past.

In this week’s capital call, I’ll discuss this debated question by analyzing Pitchbook’s statistical review of GP performance using the latest available data points and dive into key insights LPs can use to improve their thinking around manager selection. 

Venture Capital Shows Strongest Correlation for Ex-Ante Data, but all Categories show a Correlation ex-Post

Analyzing ex-ante data points (i.e. predicted interim data points) from 2,854 funds across PE, VC, real estate and funds-of-funds (FoF) found that most categories did not see a statistically significant correlation between the performance of a manager’s family of predecessor funds and the performance of its successor funds.

In fact, PE and FoF show a slightly negative correlation where top quartile managers remain top quartile 17.2% and 15.4% of the time for successor funds, respectively. The opposite trend emerges for VC and real estate, where top managers remain top quartile 41.7% and 34.3% for future funds, respectively. 

This trend may be partially explained by the fact that top-quartile VCs have significantly greater access to deal flow through strong personal relationships, providing a significant informational edge. Having a strong VC backing tends to be more important for early-stage companies compared to other private capital strategies investing at later stages, and thus top companies are more likely to pick top VCs as their investors.

However, all categories show significant performance correlations ex-poste (using retroactive performance data, even if it was not accessible to LPs at the time of investment). Looking at the table below, top-quartile funds tend to produce top-quartile successors, and bottom-quartile funds remain in the bottom quartile at a rate higher than the baseline. This can be visualized by looking at the regression analysis below the table. 

I really recommend reading Pitchbook’s statistical review, which goes into a lot more detail than my summary.

How LPs should Think through the Data

The data ultimately shows there is performance persistence in private markets, but the interim performance of predecessor funds is not significantly helpful at the time of fundraising (besides a moderate correlation in VC) as most performance data relies on exits.

Even with retroactive data, the correlations for top-quartile funds and their successors remain moderate, meaning LPs should avoid relying too much on past performance when selecting GPs and remain focused on the broader investment thesis and whether the manager has sufficient processes and personnel to execute their thesis. Out of the six Ps of GP selection, performance is often considered the primary focus, but the data concludes it should be considered with lower weighting. Remember, past performance is not indicative of future results, and investing in even top funds can result in loss of capital.

Another interesting data point is that bottom-quartile funds show a relatively strong correlation with the remaining bottom quartile for successor funds. For LPs, this means those yellow flags raised during the diligence process may indeed be red flags. LPs must insist that GPs have clear explanations for any hiccups and ensure GPs are working on how to improve future returns. 

GPs that experience a poor vintage typically have trouble raising subsequent funds, and the data supports this rationale. Poor performance can often stem from an underlying issue within the fund structure that is difficult to correct, not just the investments being made. On the other hand, top quartile funds do show a correlation as well, but not as strong. LPs looking to create outperformance should consider conducting diligence on 2nd and 3rd-quartile funds with strong momentum and conviction of reaching the top quartile for subsequent funds. LPs pursuing this strategy can also unlock stronger negotiating power on management & performance fees and other fund terms compared to top quartile GPs.

Updates from Across the Ecosystem

Fundraising

📈 Princeton Equity Group wraps up sophomore fund at $575m

📈 Insight zeros in on Fund XIII’s $15bn cap as tech fundraising takes a dive

📈 Golden Gate spinout Lone View raises $466m for debut tech fund

Reports

🔬Blackstone 2023 Private markets outlook: A new era for investors

🔬Bain’s Global Recession Watch: The Latest Data

🔬Pitchbook’s Analysis of New SEC rules on GP-led Secondaries

GP Perspectives

Robert F. Smith (Founder and Chairmen, Vista Equity Partners)

Robert Smith, founder of Vista Equity Partners, believes tech investing has reverted to the basics, where selectivity, cost discipline, and a commitment to value creation are executed upon vigorously rather than hoping for multiple expansion. 

Smith believes the first critical component of success in tech investing is a sector-specific focus, such as enterprise software in the case of Vista Equity. With over 10,000+ enterprise software businesses at varying maturity stages across end markets, all are competing for talent, capital and market share. Investors’ ability to track, compare and evaluate performance across the market has never been more important than now, and in software this is much more feasible while focusing on a specific subsector. 

As for price, Smith notes that high valuations coupled with unprecedented dry powder led many to overpay for businesses based on assuming multiples would continue to expand back in 2021 and 2022. Now, disciplined GPs should not expect any easy multiple expansion going forward and must execute using strong operating experience. 

This typically requires successive investments in growth where the investment team is highly aligned with the management team through a shared commitment to organically improving businesses through measures such as enhancing customer success capabilities and scaling go-to-market engines. This typically proves difficult in practice and requires considerable investment in building an ecosystem with dedicated expertise.

Bob Elliott (CIO, Unlimited Funds)

The inverted yield curve has traditionally been a strong indicator of an upcoming recession, but Unlimited Funds CIO Bob Elliot believes a lack of borrowing demand is the cause this time. Elliot believes the most significant factor for why overall borrowing demand in the economy has slowed is because household borrowing is as low as any time since the financial crisis due to the cooling household market. However, household borrowing is picking up over the last few quarters as the housing market stabilizes. This should put upward pressure on long-term rates through 2023 and 2024 and ease investor concerns.

About OneFund

OneFund is democratizing access to Private Equity and Venture Capital for everyday investors. We partner with the world's top PE & VC funds to offer investment options without the million-dollar minimums. 

If you would like to follow what we are doing, get more regular updates directly from the team, or become a member, schedule a call!