Relationships offer clues on private equity funds, paper says

CAMBRIDGE, Mass. — Private equity general partners use strict contract provisions banning transfer of limited partnership interests as a way of identifying the limited partners with the deepest pockets for subsequent funds, according to a new paper by two finance professors.

The paper also found that sophisticated limited partners gain knowledge about the quality of the funds in which they invest, allowing those with extensive investing experience to generally predict the success of a fund.

"Our starting point is that in private equity, the relationship between the investor and the general partner is very important, and the way money is raised can actually send a signal to the market," explained Antoinette Schoar, associate professor of finance at the Massachusetts Institute of Technology, Sloan School of Management, Cambridge. "If a limited partner, halfway through the life of a fund, decides not to renew (in a follow-on fund), it sends a potentially negative signal to the other investors."

Outside investors don't know if the original investors failed to renew because they had other needs for the money — a "liquidity shock" — or because the fund is a lemon, said Josh Lerner, the Jacob H. Schiff Professor of Investment Banking at Harvard Business School, Cambridge. Ms. Schoar and Mr. Lerner co-wrote "The Illiquidity Puzzle: theory and evidence from private equity," a paper that will be published in the April edition of the Journal of Financial Economics. The market generally interprets the failure of an incumbent to invest in a subsequent fund as a signal that the funds are bad, Mr. Lerner said.

Regarding the bans on transferring interests, the study found that when limited partnership agreements do contain these restrictions, they are often stricter than those required by securities and tax laws.

"The presence of these curbs is particularly puzzling, given that partnership interests are very illiquid to start with because of the large stakes held by each limited partner," the paper said.

What the professors found in their study of 250 U.S. private equity partnerships is that these contract provisions are used as a screening device to deter less desirable investors. These restrictions help the general partners find investors who are more likely to invest in future funds. Restrictions on transfers of limited partnerships are less common in a private equity firm's later funds because by then the private equity firm has established a track record. Moreover, private equity funds that invest in industries with longer investment cycles, like biotechnology funds, have more constraints on transferring limited partnerships than do funds in industries with shorter cycles, like software and Internet funds.

"Investors who expect to face many liquidity shocks in the future would find these restrictions especially onerous and therefore would avoid investing," the paper noted.

Most of the contracts — 89% — indicated the general partner must approve any transfer, and 73% said the general partner must approve a new limited partner, and 33% gave other limited partners the right of first refusal.

General partners want to restrict transfer of limited partnership stakes because they want limited partners that are most likely to reinvest in the manager's next fund.

"The recurring theme that we heard when talking to practitioners is that GPs want to avoid partnership stakes ending up in the hands of unsophisticated investors without a long-term commitment to the asset class," the paper noted.

And for their part, sophisticated investors gain inside knowledge by participating in private equity funds, allowing them to predict subsequent performance, the study showed.

"Given that GPs do not need to disclose any information about their performance to the general public, the best way to find out about the quality and returns of a fund is by being invested in it. Therefore, insiders are natural candidates to invest in the GP's next fund, if the GP turns out to be a high (quality) type," according to the study.

Professors Lerner and Schoar looked at the picks of two large and sophisticated limited partners and found the funds the investors passed on underperformed the market by an average of 36%, while the funds in which they invested outperformed the market by an average of 21%, Mr. Lerner said.

They also determined that the funds the sophisticated LPs passed on were, on average, larger than those in which they reinvested. And the funds they stayed with subsequently raised larger funds than the ones that were rejected, although many of the sophisticated LPs tend to drop funds once they become extremely large, the paper noted.

"This result suggests that these discontinued funds encountered difficulties, or that the decision of the sophisticated LPs not to invest served as a negative signal to other LPs," the paper concluded.

"By investing in a fund, a limited partner has a better ability to obtain information about the funds they invest in and is able to act on this private information to either reinvest or not," Ms. Schoar said.

"One of the reasons Yale and Harvard endowments are seen as desirable investors among the private equity community is because they have deep pockets, plus the aspect that both institutions have been investing in private equity for a long time and understand how it works," Mr. Lerner said. "Some limited partners invested in private equity in the late 1990s, did not understand it and got scared away."