THE MATURING OF THE PRIVATE EQUITY INDUSTRY

During the 1990s, returns among endowments investing in private equity funds
soared and endowments outperformed other private equity investors. This was not
the case between 1999 and 2006. In Limited Partner Performance and the Maturing
of the Private Equity Industry (NBER Working Paper No. 18793), Berk Sensoy,
Yingdi Wang, and Michael Weisbach conclude that: "The disappearance of abnormal
performance by endowments is consistent with changes in the economics underlying
the private equity industry." In fact, the private equity industry had matured.

In 1990, private equity was a little-known niche, with $6.7 billion in
investments. By 2008, just prior to the financial crisis, the industry had
ballooned into a $261.9 billion mainstay of institutional portfolios.
Based on a sample of 14,380 investments by 1,852 limited partners in 1,250
buyout and venture funds between 1991 and 2006, the authors confirm that
endowments outperformed other investors early on because they had access to the
most successful funds while other investors did not. Rather than expand or
charge higher fees, the best private equity partnerships rationed access to
their funds, accepting investments from favored investors, such as prestigious
educational and other nonprofit endowments, to the exclusion of others. Also,
endowments were better able to evaluate alternative investments, such as private
equity, that were unfamiliar at the time.

Between 1991 and 1998, endowments enjoyed an average 13.38 percent internal rate
of return on private equity investments, the highest of any limited partnership
groups. "The performance gap is driven entirely by endowments' investments in
the venture industry, which benefited most from the 1990s technology boom," the
authors write. "Compared with other types of institutions, endowments were more
likely to invest in older partnerships, which not only were more likely to
restrict access but also earned higher returns."

In the aftermath of the technology bust of the 2000s, which put an end to
booming returns from venture capital, that outperformance had evaporated. The
authors find that endowment investors' skill in picking venture funds declined
significantly after the tech bust. The marginal outperformance that could be
attributed to the funds they invested in, relative to those that they did not
invest in, fell to levels similar of other institutional investors during
1999-2006. And, endowment investors didn't show particular skill in picking
first-time funds, which were unlikely to restrict access, either before the tech
crash or afterward.

The authors explain this pattern as the result of maturation of the private
equity industry. In the early years, high returns were earned in part by
purchasing mismanaged companies and improving their operations. Investments in
high-tech companies were also an important driver of venture capital returns in
the 1990s. Over time, though, the "low-hanging fruit" was picked, and the
dispersion of returns across different private equity groups shrunk
dramatically.