What Drives Private Equity Returns? - Fund Inflows, Skilled Gps, And/Or Risk?

Abstract

This paper analyzes the determinants of returns generated by private equity funds. It starts from the presumption that this asset class is characterized by illiquidity, stickiness, and segmentation. As a consequence, Gompers and Lerner (2000) have shown that venture deal valuations are driven by overall fund inflows into the industry giving way to the so called 'money chasing deals' phenomenon. It is the aim of this paper to show that this phenomenon explains a significant part of variation in private equity funds' returns. This is especially true for venture funds, as they are more affected by illiquidity and segmentation than buy-out funds. Actually, the paper presents a WLS-regression approach that is able to explain up to 47% of variation in funds' returns. Apart from the highly significant impact of fund inflows into the industry, it can also be shown that private equity funds' returns are driven by market sentiment, GP's skills as well as stand-alone investment risk. Moreover, returns seem to be unrelated to stock market returns and negatively correlated with the growth rate of the economy. In the context of a bootstrapping inference we can show that most of these results are quite stable.