Understanding Private Equity Fund Returns: Access as the Determinant of Differences between Limited Partners’ Private Equity Returns

Top quartile of private equity funds produce superior returns compared to lower quartile funds or to most other asset classes (the difference in internal rate of return to first quartile funds compared to fourth quartile funds can be over 50 percentage units). Some limited partners continuously invest in the top quartile funds while others have very few investments to such funds. Given the nature of the private equity industry, and the information available to limited partners at the time of the investment decision, such results are puzzling. In this dissertation, utilizing a unique dataset I compiled for this dissertation, I show that large pension funds as limited partners are not statistically different in their ability to pick better private equity funds for their investments when prior returns to these funds' general partners are controlled for. Given that the access to invest in private equity funds is limited, and limited partners' prior investments are the main determinant of their access, the prior returns to limited partners are the main determinant of their future returns. Utilizing a simulation model I have developed based on the findings of the empirical analyses conducted in this dissertation and prior knowledge of private equity industry, I show that when general partners consider some of the limited partners to be better investors, there will be systematical differences between returns realized by different types of limited partners. Altogether the results of this dissertation help to explain several empirical findings in the prior private equity research: why systematic differences exist between limited partners? Why access is more important determinant of returns than selection skills? And how transparency of the private equity industry affects the return dynamics? Furthermore, the results of the empirical analysis show the importance – and one example method – of controlling for prior returns when analyzing the future returns in private equity.