Decreasing Returns or Mean-Reversion of Luck? The Case of Private Equity Fund Growth

In private equity fund data, there exists a strong negative association between fund growth and performance at the partnership level. As a consequence, there is a consensus that decreasing returns are particularly large. I argue that this inference is unwarranted. In essence, Bayesian-informed expectations reveal that the partnerships whose funds grew the most were on average lucky in the past; as that luck reverts to zero, a spurious negative association between growth and returns is generated in the data. Controlling for this bias, the effect of growth on performance is about 80% smaller and statistically insignificant for both buyout and venture capital funds. Furthermore, I show that, historically, decreasing returns do not seem to have played a major role in the erosion of performance persistence in private equity. These results have implications for fund managers’ and investors’ decisions, and for our understanding of the private equity industry.