Academic writing can be … challenging, to put it politely, with papers offering headlines that are obscure. However, sometimes the title of a study provides more than a narrow technical description of an investigation.
In the case of a new paper from Timothy Riddiough, a professor of real estate and urban land economics at the University of Wisconsin-Madison and doctoral student Da Li, the name of the paper is almost clickbait in its simplicity: “Persistently Poor Performance in Private Equity Real Estate.” The abstract is as stark and harsh:
“We compare Buyout (BO), Venture Capital (VC), and Private Equity Real Estate (RE) funds. RE funds underperform BO and VC, as well as the public market alternative. In RE, worse-performing fund managers survive at a high rate. They are also susceptible to diseconomies of fund scale, with no skill-based persistence to offset the negative scale effects. Analysis of noisy fund manager selection indicates that RE investors are not disadvantaged relative to BO and VC. LP investors in RE funds seem to be optimizing something other than, or in addition to, investment return when selecting fund managers.”
The authors look at 2,738 liquidated funds, for which internal rate of return (IRR) and total value to paid-in capital (TVPI) were available, from 1,205 general partners. Fund vintages date through 2011 and performance analyzed through the third quarter of 2021. Total fund capitalization was more than $1 trillion. Of that $612 in 944 funds was in buyout, $149 billion in 1,021 funds was in venture capital, and $257 billion in 773 funds in private equity real estate.
Buyout was found to be the best-performing category with an average-weighted IRR of 14.50% and mean direct alpha—a measure of outperformance, presumably attributable to the fund management, with positive values showing better performance—of 4.56%. VC real estate fund performance had an IRR of 10.92% and direct alpha of -2.30%. In last place was PE real estate funds, with 7.02% return and direct alpha of -4.63%.
The buyout sector showed funds increasing by five to eight times as they advanced from fund 1 to 7 or higher. Performance remained in a tight range, and so suggests high scalability.
VC fund sizes increased by a factor of two over the same range. “By keeping a tight lid on fund size, surviving VC fund managers’ performance improves dramatically, increasing from approximately 15% (the overall average) to 30% on average for fund sequences #6 and higher,” they wrote.
The PE real estate funds increased three to four times, but performance deteriorated more as the fund sequence increased, so not terribly scalable.
Additional measurements also supported the conclusion that PE funds on the whole lagged in performance.
The difference seems to be that buyout and VC funds look to “operational, governance, and financial engineering” to take purchase riskier properties and then turn them around.
The private equity funds, on the other hand, tend to look at core and core-plus properties that are less risky but don’t offer the same opportunities for profit from knowledgeable operators. When the PE funds do take on value-add or opportunistic projects, they frequently partner with a “local sharpshooter,” who knows operations and local conditions and have political connections. Except they can take fees that can run more than 10% of the project cost, leaving less room for returns.
