Performance persistence of successful private equity fund managers leads to oversubscription in their follow-on funds. But the funds usually have size restrictions, in part because of most fund managers’ desire to create a positive perception in the minds of entrepreneurs about their ability to add value while limiting the effort required to search for quality firms to invest in.
Private equity fund performance is driven by two entangled factors: firm quality and manager value added. Successful private equity fund managers tend to have performance persistence, which leads to oversubscription in the follow-on funds of these managers. But these funds usually have size restrictions. One reason to keep fund sizes small, even at the cost of fee income, is to limit the unobserved cost of the effort required to select good firms and thus create a positive belief in the minds of entrepreneurs about the capability of the fund manager to add value. This process helps the funds subsequently selected by promising entrepreneurs.
How Is This Research Useful to Practitioners?
The authors look at private equity—in particular, venture capital—which is one of the less researched areas of the investment industry. Their model reinforces the empirically observed phenomenon of reduced performance and increased fees for a private equity manager and demonstrates that, over time, uncertainty about a manager’s ability decreases and thus the incentive to manipulate entrepreneurs’ beliefs decreases. In this way, managers increase fund sizes even at the cost of performance.
Variation in performance persistence across different types of private equity funds can be explained by variation in managers’ abilities to manipulate the beliefs of entrepreneurs. For example, there is little evidence of performance persistence in buyout funds, in which financial metrics play a bigger role than entrepreneurs’ beliefs regarding manager ability, in contrast to the situation in venture capital funds. Similarly, performance persistence has not been observed in mutual funds.
Despite diseconomies of scale, the managers who experience a larger (positive) shock to the investment opportunity set are expected to raise larger funds and provide higher returns to investors.
The authors’ model also finds higher performance persistence when managers’ incentives to manipulate entrepreneurs’ beliefs are larger. This situation occurs when the impact of a manager’s perceived ability on the matching process is higher, when the impact of effort on the quality of the firms in the fund’s portfolio is greater, and when there is greater uncertainty about a manager’s ability.
The elements and methodology of signal jamming can also be applied to the investor side and within hedge funds or investment banks.
The authors’ research is also a contribution to the ongoing work on the optimal size of a venture capital fund.
How Did the Authors Conduct This Research?
The authors extend the work of Berk and Green (Journal of Political Economy 2004) on mutual funds to the private equity setting, in which increasing size erodes returns. Specifically, they look at venture capital situations with two-way matching, in which successful entrepreneurs and fund managers choose each other.
In the absence of clear knowledge about their own ability, managers expend effort to choose companies to manipulate future entrepreneurs’ perception of their capability through the signaling mechanism of past fund performance—that is, signal jamming.
The authors consider manager activity in an infinite period model in which a new fund can be introduced in each period. Each period has three stages. In the first stage, the manager sets up a fund and determines fees and target size. In the second stage, the investors determine how much to invest and managers determine the final fund size. In the third stage, actual returns are realized. In the realistic case, all of the information is not available to outsiders, and the fund managers restrict the fund size to generate higher returns and manipulate entrepreneurs’ beliefs about their capabilities.
There are many factors at play when fund managers determine fund size. Some factors the authors do not identify are the following: the ability to manage a number of investments simultaneously, especially considering that it is not easy to scale up teams while maintaining a similar degree of quality or effective teamwork; the limited availability of investment opportunities for a particular strategy in a particular time period; the obligation to fulfill investor return expectations and commitments even when they are not legally binding; and the incentive fee. The manager works to maximize the incentive through performance, not just by increasing the fund size.
The signal jamming the authors discuss assumes that potential investee entrepreneurs rely on only portfolio performance to ascertain investor value added. In many cases, it is likely that the entrepreneurs would conduct a detailed reference check on the investors with their other investee companies and not rely on only the past portfolio performance.