Due Diligence Requires Deep Dives Into Data

The data and analysis provider eVestment has issued a new white paper on “enhancing private equity manager selection with deeper data.”

PE funds below the top quartile have not materially outperformed the public markets as a matter of history. So for an institutional investor, earning alpha is in large measure a matter of selecting the manager who is in and will stay in the top quartile. And to justify the fees involved, the PE allocation really must outperform the public markets.

Such simple observations account for the need for a more skillful due diligence process in the selection of managers. Neither luck nor preferential access to the best managers can be counted upon.

More to the point of this white paper, the “headline numbers” unearthed by not-so-deep data can’t be counted upon, either. Internal rate of return in particular can’t be looked at in isolation. Investors, as eVestment puts it, “need to look … into a variety of metrics and performance statistics across a manager’s track record” to understand how it creates value, what the skill set on offer is and how that skill set interacts with the strategy of the fund.

The authors of this study cite a recent paper by Daniel R. Cavagnaro, Bart Sensoy, Yingdi Wang, and Michael Weisbach.Cavagnaro et al found (in the eVestment paraphrase) that “an investor’s skill level in fund selection is a more important driver of their returns, than luck or access to managers,” and that indeed an increase in skill of one standard deviation accounts for a 3% increase in the annual IRR.

If Success were only Persistent….

Persistence is one name for one of the problems that a duly-diligent data dive must solve. Life would be easier for investors if those fund managers that had scored in the top quartile in the recent past could be counted on to do so for at least the near range future. But excellence does not persist. Investors “should consider putting as much scrutiny on a re-investment with this manager [one with a successful recent past] as when considering a GP in the second or third quartile with their latest fund.”