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New fund structures in private equity benefit top-tier investors


It’s long been thought in private equity that anyone investing in the top funds would emerge a winner, no matter who you are.

But new research shows that endowments and other large elite institutions with top-quartile returns actually have far better returns than others when investing in offshoots of main funds — known in the private equity industry as alternative vehicles. Not only are these more elite investors getting better deals, but their returns are better as well.

“For the most experienced investors in these new investment vehicles, the returns are really good. But for less savvy investors, the returns look much worse,” said a professor of finance at MIT Sloan and one of the authors of “Investing Outside the Box: Evidence from Alternative Vehicles in Private Equity.”

The study — conducted by Schoar and co-authors Josh Lerner of Harvard University and Jason Mao and Nan R. Zhang, both of State Street Global Exchange — used previously unavailable data from State Street Corp. to examine 20,000 private investments for 112 asset owners between 1980 and mid-2017. The results provide valuable insight on a segment of the industry that has historically lacked available data and transparency.

“There’s a reason why it’s called ‘private’ equity — outsiders know very little about the returns of the majority of funds,” Schoar said.

New funds are popular, but performance is mixed

For years, the private equity industry has been expanding the set of vehicles it offers in order to attract more investors and meet increased demand for this asset class. The study showed that 40 percent of investors are pursuing alternative vehicles, a figure far higher than even industry insiders anticipated.

“Even many of our colleagues who work on private equity are surprised how big this number is because they hadn’t seen it before,” said Schoar.

Nearly 30 years ago, investors committed less than 10 percent of their capital to alternative vehicles in private equity, but by 2018, that share had jumped to 40 percent. Schoar attributes this to basic supply-and-demand dynamics. “The industry has become much more competitive over the last 10 years, with more and more investors wanting to come in,” she said.

Despite the popularity of these alternative vehicles, the study found they don’t perform as well as the main funds of the private equity firm that sponsors the vehicle. This is especially true for investments where the fund’s managers, known as general partners, control the investing decisions. By contrast, in alternative vehicles where investors are involved in the selection of the deals, the returns are much better — provided the investors have a record of top-quartile performance in the past, according to the study.

Elite institutions ink better deals, record better returns

Alternative vehicles are most often offered to large, high-profile investors, keeping with a historical trend of concentrating private equity capital among a small group of elite investors. Schoar says this has big implications for everyone else.


By 2017, 40% of capital commitments to private equity went to alternative vehicles, up from 10% in the 1980s.

“What you might be offered by a given partnership is not necessarily what other investors see,” Schoar said. “If you are a top limited partner, you’re offered much better opportunities than someone who doesn’t have great outside opportunities.”

This discrepancy in returns was also revealed when looking at different investor types. For investors in the top, such as endowments and private pensions, the returns in alternative vehicles “exceed the market benchmarks,” but lower-quartile investors reported mediocre returns. Schoar attributed the performance discrepancy to a combination of top investors having more experienced investing teams and getting better deals to begin with.

“There is a belief in this industry that as long as you manage to invest with the top-quartile funds, your returns would be great no matter what,” Schoar said. “But our results show that this is no longer true.  If you are not one of the top tier investors in PE, your returns are lower,  even if you were investing with a top fund. So funds tailor the investment vehicles they offer to different investors according to the investors outside options.”

Inexperienced? You may want to avoid the market entirely

Schoar said the study’s results have important implications for investors who are in the lower quartile of returns. If they’re interested in investing in PE, they should be aware that they might not be invited into the best deals. One way to find out if there is adverse selection is to keep asking the PE managers about all the funds they offer. Ask to see all deals on the table and operate with extreme discernment, Schoar suggested. If this isn’t possible, you might consider sitting out the sector entirely, she said.

“Either you build up your investment team to become an informed participant in this asset class, or make a decision to stay out,” Schoar said. “Without the knowledge and sophistication of an experienced investment team, you literally are better off just investing in the public market.”

For more info Tracy Mayor Senior Associate Director, Editorial (617) 253-0065