Performance persistence in private equity, turned into an expected multiple for the successor fund and a budget for what to concede at re-up.
Much less than the track record itself. Weight each quartile's typical outcome by the probability that the next fund lands there: with illustrative persistence of 40 per cent in the top quartile and 15 per cent in the bottom, a top-quartile manager's next fund is worth an expected 1.80x against 1.64x for an unknown manager. The signal is worth 0.17x, about 2.2 points of IRR, not the 0.66x that assuming a repeat implies.
Worked in full in The Private Markets Limited Partner by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Re-up decisions are where a limited partner spends most of its manager selection effort, and "top quartile" is the phrase that ends most of those discussions. The arithmetic below does not say the phrase is meaningless. It says how much it is worth, which is the only form in which it can be weighed against a higher fee, a bigger fund or a team change.
| Quartile of the next fund | Net multiple | Net IRR | Unknown manager | Top-quartile predecessor |
|---|---|---|---|---|
| Top | 2.30x | 18.3% | 25% | 40% |
| Second | 1.75x | 11.9% | 25% | 25% |
| Third | 1.45x | 7.7% | 25% | 20% |
| Bottom | 1.05x | 1.0% | 25% | 15% |
The IRRs assume one standard profile for every fund: calls of 25, 25, 20, 15 and 15 per cent of commitment in years 1 to 5, distributions spread from year 4 to year 11. Published research on persistence disagrees on its strength and has generally found it weaker for buyout funds than for venture; the 40/25/20/15 row is a deliberately generous assumption, not a market statistic.
E[multiple] = Σ P(quartile) × multiple of that quartile
Unknown manager: 0.25 × (2.30 + 1.75 + 1.45 + 1.05) = 1.64x, an IRR of 10.4%.
Top-quartile predecessor: 0.40 × 2.30 + 0.25 × 1.75 + 0.20 × 1.45 + 0.15 × 1.05 = 1.80x, an IRR of 12.6%.
In Excel: =SUMPRODUCT(B2:B5, E2:E5) with the multiples in B and the probabilities in E.
The difference, 0.17x, is the value of the track record as information. On a commitment of 50 it is about 8.4 of expected value over the life of the fund, and about 2.2 points of IRR. That is a real edge. It is also a quarter of what the room usually assumes, because the usual assumption is that a top-quartile manager will be top quartile again: 2.30x against 1.64x, an uplift of 0.66x, or 33.1 on the same commitment. The naive view overstates the value of the signal by a factor of 4.0.
The other way to read the same row: the top-quartile manager's next fund still has a 35 per cent chance of finishing in the bottom half. Re-up with three such managers and the chance that at least one of them lands in the bottom quartile is 38.6 per cent. The chance that all three repeat in the top quartile is 6.4 per cent.
The weakness that matters most is timing. A successor fund raises when the predecessor is three or four years old and mostly unrealised. "Top quartile" at that point is a ranking on interim marks, and interim rankings move. With the weaker row in the table below, 32 per cent top and 20 per cent bottom, the expected multiple is 1.72x and the signal is worth 0.08x, about 1.1 points of IRR, or 4.1 on a commitment of 50.
| What you know about the predecessor | P(top) | P(bottom half) | Expected multiple | Expected IRR |
|---|---|---|---|---|
| Nothing (first-time or random) | 25% | 50% | 1.64x | 10.4% |
| Top quartile on interim marks | 32% | 42% | 1.72x | 11.5% |
| Top quartile on final returns | 40% | 35% | 1.80x | 12.6% |
| Strong persistence | 50% | 25% | 1.91x | 13.9% |
| Bottom quartile predecessor | 15% | 65% | 1.48x | 8.1% |
The bottom row is the more useful one. Between a top-quartile and a bottom-quartile predecessor the gap in expected outcome is 0.33x, twice the value of the top-quartile signal against no information. On these assumptions, a track record does more work in telling you whom to drop than in telling you whom to keep.
Using the number: if a top-quartile manager raises a fund twice the size of the last one, or moves its carry up, the question is whether that change costs more than the 0.17x the record is worth on final returns, or the 0.08x it is worth on interim marks. A change that costs 0.10x of net multiple wipes out the interim signal entirely.
The common mistake is to underwrite the successor fund at the predecessor's quartile: a 2.30x manager is modelled at 2.30x, and the commitment pacing, the expected return of the programme and the comparison with alternatives all inherit the error. Underwrite at the expected multiple instead, 1.80x on the generous row, and state the probability of a bottom-half result next to it. A committee that sees "35 per cent chance of the bottom half" asks better questions than one that sees "top quartile".
The second mistake is to read the quartile itself without checking how it was measured. A ranking depends on the peer set, the vintage, the measure and the date, as the worked example on how private equity quartile rankings are calculated shows.
Turn the track record into an expected multiple with an explicit probability table, put your own persistence assumption in it, and use the uplift over an unknown manager as the budget for what you will concede at re-up. The manager selection checklist and re-up checklist are among the free working documents for this book.
Some, but less than a repeat. On an illustrative and generous assumption, a top-quartile manager's next fund lands in the top quartile 40 per cent of the time and in the bottom half 35 per cent of the time, for an expected 1.80x against 1.64x for an unknown manager.
In the worked case, 40 per cent for one fund. Across three re-ups with three such managers, the chance that all three repeat in the top quartile is 6.4 per cent, and the chance that at least one lands in the bottom quartile is 38.6 per cent.
Because the successor fund raises when the predecessor is three or four years old and ranked on interim marks. With weaker illustrative persistence of 32 per cent top and 20 per cent bottom, the expected multiple is 1.72x and the signal is worth 0.08x, about 1.1 points of IRR.
This article is one calculation from The Private Markets Limited Partner. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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