The above chart from Pitchbook shows the relationship between a manager’s prior fund returns and the eventual returns of their future funds.
But what do these scatter plots actually tell us? Well, an uncomfortable truth. The relationship between a fund’s prior returns and its future returns is a lot weaker than we may like to think. You can see that in the seemingly random cloud of dots instead of a highly correlated, upward-sloping line.
That isn’t to say that looking at past returns is unhelpful when diligencing a fund. In my opinion, it is still some of the best information that we have to go off of when looking at a fund. Plus, the trend lines in each chart do show some correlation. But the variance is high and the correlation is weaker than one may expect.
The data in table form (below) has some other interesting takeaways hidden in it.
Take a look at the numbers in the top left and bottom right of each quadrant. What we see is that a top-quartile fund only has a ~34% chance of having its successor fund be a top-quartile fund. This is just a little bit better than what random chance would lead you to expect (25%). It is somewhat elevated, but in a perfect world, it would be higher.
What is very interesting, however, is that bottom quartile funds, across all four of the different types of funds examined, have a roughly 40% to 50% chance of having their successor funds also be bottom quartile.
Essentially, a good fund may or may not have its next fund be good. But if it’s a shitty fund, there is a very good chance its successor fund will also be shitty.
So what do I take away from this?
First, past returns are not the best way to determine if a fund you are considering allocating to will perform well. You need to look at the fund holistically considering the team, thesis, deal attribution, competitive environment, macro-economic conditions, etc.
Second, avoid funds that have generated bottom-quartile returns. Why risk it given the huge number of options on the market? It may be hard to know who will be a top-quartile fund, but you can potentially get some reasonable indication of who may be a bottom-quartile fund and avoid them.
Third, and this may run counter to what a lot of allocators like to think or may tell you, it is very hard to estimate how well a PE fund will perform. Just like predicting public stock performance, past return data is not as indicative of future results as we like to believe. One should do all the due diligence they can and invest in funds that they have conviction in, but it is extremely important to get exposure to a diversified set of PE funds that are solid. That way you can maximize your chances of getting exposure to top-quartile funds while avoiding being dragged down by bottom-quartile funds.
So how does this impact what we do at OneFund?
When thinking about how to incorporate this information to best help our customers, we decided to come to market with a diversified PE portfolio. Based on this data and more, we wanted to maximize our customers’ diversification and increase the likelihood of exposure to top-quartile funds while minimizing the likelihood of exposure to bottom-quartile funds.
Has index investing finally come to the PE world? We hope so.