In global equities, managers in the top quartile generate an annualized return of around 12.5%, while bottom performers produce 10.7%. In other words, manager selection explains less than 2% of return dispersion. But in private equity, these numbers are grossly different. Some in the bottom quartile of VC funds lose money after inflation, while the top performers return over 30% yearly.
This means that fund selection is a significant driver of outcomes in private equity. To achieve top-quartile performance in private equity, then, it is essential to select the correct fund.
Finding Top-Quartile Funds and Managers
Despite the importance of fund selection, many investors do not have a systematic process for identifying top-quartile performers. This is particularly true for smaller investors who lack the resources to conduct in-depth due diligence on individual managers.
Compounding the challenge, the private equity market has become increasingly crowded and competitive, making it difficult for even experienced investors to identify the best opportunities. In this environment, many investors rely on gut instinct or heuristics when deciding which funds to commit to.
However, several research-based approaches can be used to identify top-quartile performers. One such approach is to seek out emerging managers with a track record of success in other asset classes.
These managers may not have lengthy private equity track records, but they will have deep domain expertise and a proven ability to generate alpha. They will also tend to be nimble and opportunistic, which is often key to success in private equity.
Fund returns decline with fund size, and smaller funds outperform larger funds by 3.65% per year on average. While almost 18% of first-time funds achieve a 25% IRR, later funds only reach that number 12% of the time.
Geographic diversification, too, is an essential factor. Emerging funds can offer exposure to new markets and industries that may be less competitive than traditional private equity markets. Preqin data shows that top-quartile net IRRs at emerging funds were above 20% for 2011-2015 vintages.
In India, small- and mid-cap funds have outperformed large-cap funds by a wide margin. Further, Africa’s VC space is hitting record growth, with exceptionally high funding in areas like crypto.
VC Outperforms Even at the Median
That said, private equity funds outperform even at the median because they have a key advantage: They can target specific companies and industries rather than being restrained by the need to purchase liquid securities. This allows them to put more money to work on their best ideas and reap the benefits of compounding returns.
Further, a long-term investment horizon enables private equity firms to support a company through thick and thin, which is critical to success in many businesses. In public markets, investors often punish companies for making the investments necessary for long-term growth. In private equity, patient capital provides the time required to make these crucial investments without worrying about short-termism.
For these reasons, private equity should be essential to any diversified investment portfolio. And Gridline makes it easy for individual investors to gain exposure to top-quartile performers in the private equity space. With Gridline, you can access a curated selection of professionally managed alternative investment funds with lower capital minimums, transparent fees, and greater liquidity. So if you’re looking to get the most out of your investments, Gridline is worth checking out.