Private equity firm performance a complex recipe

Private equity firms with the most recognizable brand names tend to raise huge funds and make mega deals, grabbing the headlines. But scale and size do not necessarily equate to top performance among peers, according to Oliver Gottschalg, a professor at HEC School of Management in Paris, who founded the HEC-Dow Jones Private Equity Performance Ranking.

The annual list ranks private equity firms according to a performance score, which is not an IRR-type annual return measure nor a money multiple. The score represents the merger of six performance indicators that "expresses how much better you are than the average private equity firm," he said.

"There's some sizable folks here on the top list, but the very, very biggest in the world are not on the top," Gottschalg said in an interview. "The best fly under the radar."

For the 2020 list, performance data was analyzed from 529 private equity firms and 977 funds they raised between 2007 and 2016 with an aggregate equity volume of $1.4 trillion.

Some larger firms had impressive performance, such as Thoma Bravo LLC, which was the sixth-best performer in 2020 and held the top slot the previous three years in a row. Clayton Dubilier & Rice LLC has appeared in the top 10 six times.

But in 2020, San Francisco-based Francisco Partners Management LP, a technology-focused buyout firm, was the top performer, appearing on the list for the first time. Another new entrant is Quadrant Pvt. Equity Pty. Ltd., a relatively unknown Australian firm.

"If I had just sampled a bunch of LPs around the world, asking who are the best-performing fund managers, I would have been surprised to see [Quadrant] somewhere up there in the top 10 list," Gottschalg said.

But the overlooked consistent best performer has been Netherlands-based Waterland Private Equity Investments BV, which has made the top 10 list of best-performing firms for 10 of the 11 years Gottschalg has been calculating the ranking.

Waterland is a buy-and-build specialist with AUM of €8 billion. It is not sector-focused but follows broad investment themes it believes hold "long-term growth potential or other economic fundamentals favorable to a consolidation strategy" and include an aging population, outsourcing and digitalization, leisure and luxury, and sustainability. In December 2020, the firm closed its eighth institutional fund oversubscribed on the €2.5 billion hard cap.

Disciplined growth

Gottschalg stressed that one key ingredient does not determine the recipe for performance, but nonetheless there are some general indicators of firms that have appeared at the very top and bottom of the list over the last decade.

Sector focus sometimes plays a role. In 2020, for example, some firms have been lifted to the top 10 because they specifically target buyouts of technology and software companies, which have had rising valuations. Those that fall to the bottom tend to be exclusively focused on industries that have been out of favor, such as energy, he said.

Another performance factor is fund discipline. "One theme of the firms at the top is that there is a good level of discipline on fund size evolution. It's more difficult to triple a $15 billion fund than a $1.5 billion fund, that's very intuitive."

"And if I look at the bottom end, likewise, you see some who have had a massive step-up in the fund size recently … kind of growing themselves to death because the excessive increase in fund size is usually a relatively sure recipe to destroy a good track record. Some can't absorb that much capital."

Gottschalg said the message to investors is don't spend too much time struggling about whether you want exposure to, for example, Europe mixed market or U.S. small caps, healthcare or industrial.

To build an outperforming private equity portfolio, strive for the best-in-class firms that have clearly — and likely quietly — built up expertise in a specific category.

"Apparently, there are some private equity firms, who, in their respective niche of the market, have really found a way to identify stellar returns."