A common, if oversimplified, view is that PE funds invest based on numbers, VC funds based on narrative. New research suggests that LPs might benefit from placing the qualitative over the quantitative, at least early on.
Communicating Performance: Textual and Financial Disclosures in Private Equity, published in October by researchers at Harvard, MIT and Carnegie Mellon, found that LPs who pay closer attention to descriptive language in investor letters and memos, particularly in the early years of an investment, could gain an informational advantage beyond what valuations provide.
The researchers used a large language model to read thousands of PE reports from vintages 2009 to 2018 to measure whether the language GPs used to describe each company was positive or negative. They then compared that to the valuations in the same reports and tracked which one, the written commentary or the valuation, better predicted how the company performed.
Within the first three years of an investment, how GPs described their portfolio companies tended to be a better predictor of performance than their valuations, the paper found.
Even the topics GPs address give a clue about future performance. A focus on cash flow and business models was associated with significantly better performance at exit, while communication about capital structure pointed to a worse outcome. The most powerful predictor of poorer returns was negative macroeconomic commentary.
“People don’t want to say, ‘We made a mistake and chose to back the wrong entrepreneur.’ It’s perhaps a little more convenient to say, ‘Let’s just blame it on the macro economy,’” said Josh Lerner, a professor at Harvard Business School and co-author of the study.
The tendency for language to predict outcomes reversed after three years. This is in part because of GPs’ tendency to value assets conservatively in the early days of a fund’s life, Lerner said.
The benefits of aggressive marking are marginal in the early period. Management fees are calculated as a percentage of committed capital, not assets under management, and carried interest doesn’t become a factor for several years.
Overoptimistic valuations aren’t great for LPs either. Most endowments and pension funds calculate the amount they distribute to their beneficiaries using formulas based on GPs’ self-reported net asset values. These distributions are hard to claw back if it turns out that early valuations were too optimistic.
Hedge funds have created a science out of piecing bits of public information into a coherent narrative and acting on them, but LPs in private market funds haven’t quite hacked it. In part, this is because they haven’t had the tools. The development of AI means “the potential for using this information today in private markets is much bigger than it’s been historically,” Lerner said.
But he also sounded a note of caution about the widespread adoption of these practices.
“If everyone starts trying to read the tea leaves, GPs might be more circumspect in how they communicate things going forward,” he said.
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