GMO is a Boston asset manager co-founded in 1977 by Jeremy Grantham with Richard Mayo and Eyk Van Otterloo, known for valuation-driven dynamic asset allocation built on long-horizon mean reversion. Grantham is famous for calling historic bubbles, warning publicly ahead of both the 2000 dot-com crash and the 2008 financial crisis. Flagship publications include the GMO Quarterly Letter (now written by Asset Allocation co-heads Ben Inker and John Pease), Grantham's Viewpoints essays and the 7-Year Asset Class Forecast.
This article explains why the old approach of picking top private equity managers to beat the market no longer works. Research shows fund performance persistence—the chance that past winners will keep winning—has sharply declined. For ordinary investors, this means paying high fees for star managers may not pay off. It's worth reading because it challenges a common myth with data and makes you rethink your investment strategy.
GMO research points out that in recent years, many institutional investors who once outperformed the private equity (PE) composite index have been unable to sustain excess returns. This is commonly attributed to specific selection and hiring decision biases, but a more likely reason is a significant
This chapter explores a core issue faced by institutional investors in private equity (PE) investing: whether the past strategy of relying on selected managers to generate excess returns has become invalid due to declining performance persistence. The author notes that many institutions that previously outperformed the PE composite index have been unable to sustain excess returns in recent years. While this is commonly attributed to specific selection biases, the more likely cause is a significant decline in the performance persistence of PE managers.
The author's central investment thesis is that the performance persistence of PE managers has declined substantially, and may have even largely disappeared. This implies that, although return dispersion among different PE funds remains wide, the likelihood of institutional investors consistently outperforming the composite index through manager selection is minimal. This is a counterintuitive judgment—the market generally believes that manager selection is the core value of PE investing, but the author argues that this premise is unraveling.
1. Academic Evidence of Declining Performance Persistence: Multiple scholars have shown that, since 2000, the performance persistence of PE funds has declined significantly, and the decline has been more pronounced than in venture capital (VC). Crucially, interim performance during the middle of a fund's life cycle is completely unhelpful in predicting subsequent fund returns—yet such interim data is precisely the information investors rely on most when evaluating a manager's next fund.
2. Historical Context: The author cites David Swensen's Pioneering Portfolio Management (2009), noting that Swensen never claimed an inherent return premium for PE. Swensen argued that PE carries higher risk than public equities (due to high leverage) and that historical median returns have been disappointing. The value of PE investing lies entirely in finding "extraordinary managers," a premise that depends on performance persistence.
3. Quantitative Simulation: The report references a study by Braun, Jenkinson, and Stoff (2017), which uses charts to illustrate the implied alpha of diversified PE portfolios under different levels of performance persistence. The conclusion is: if performance persistence is very low, even if return dispersion among funds is large, the overall return of an institution will almost always be close to the median.
1. Raise the Bar for Hiring PE Managers: Investment committees should encourage institutions to significantly raise the standards for hiring PE managers. If there is less than full confidence in a manager, high fees should not be paid.
2. Reevaluate the Rationale for PE Allocations: If PE allocations are based on the belief that the investment team can consistently identify the best managers, and performance persistence has disappeared, then the core rationale for such allocations is called into question. Institutions should seriously ask themselves: "What makes us believe we can find these extraordinary managers and secure meaningful allocations?"
3. Public Markets as an Alternative: When confidence is lacking, investing in public markets at lower cost is a better option than paying high PE fees. This suggests that investors should reduce PE allocations or shift to passive strategies.
This section focuses on the changes in the persistence of performance among private equity (PE) and venture capital (VC) managers, and the profound impact this has on the expected excess returns (Alpha) that institutional investors can generate when constructing PE/VC portfolios. The report points out that in the post-2000 sample, performance persistence in PE has largely disappeared, while in VC, although persistence remains, it has significantly weakened. This fundamentally alters investors' ability to generate excess returns through manager selection.
The author's central judgment is: The difficulty for institutional investors to generate significant excess returns through selecting PE managers has substantially increased, making it highly unlikely to significantly outperform the PE composite index in the future. Even assuming institutions possess a "magical" ability to select new managers, the excess returns achievable by their PE portfolios are extremely limited (approximately 55 basis points). The author argues that the bar for investing in PE managers should be higher than for active public market managers, as once committed, investors are locked into high fees for years.
The author constructs an expected Alpha model under different scenarios, based on research by Braun, Jenkinson, and Stoff (2017). Key assumptions and results are as follows:
Performance Persistence Assumptions (Based on Historical Data)
Expected Alpha Comparison Under Different Investment Strategies
| Investment Strategy Scenario | Expected Alpha for PE Portfolio (Basis Points) | Expected Alpha for VC Portfolio (Basis Points) |
|---|---|---|
| Only re-up with existing top managers (assuming very low performance persistence) | 3 | Data not explicitly given, but implied to be similarly very low |
| Assume institution has "magical" ability to select new managers (40%/30%/20%/10% probability of selecting 1st-4th quartile) | 55 | Data not explicitly given, but implied to be higher than PE |
| Institution allocates its entire 20% PE/VC allocation to such "magical" new managers | 55 | Data not explicitly given |
Key Data Interpretation:
This section does not mention specific companies; it primarily discusses asset classes:
1. Significantly Raise the Bar for Selecting PE Managers: Given the disappearance of performance persistence, investment committees should require investment teams to have "high conviction" in each PE manager before investing; otherwise, they should not invest. The bar should be higher than for active public market managers.
2. Re-evaluate Target Allocation: Do not feel compelled to invest in managers with low conviction just to meet a preset PE allocation target (e.g., 25%). The PE allocation should be viewed as a ceiling, not a target to be achieved. If enough high-quality managers cannot be found, it is better to be under-allocated.
3. Establish a Belief Validation Mechanism: Investment committees should require investment teams to clearly articulate their beliefs for each asset class (including expected Alpha) and conduct regular reviews (e.g., every 3-5 years) to validate whether these beliefs hold true.
4. Beware of VC's "False Persistence": Although VC still shows performance persistence, it has weakened significantly. Investors should not overly rely on historical performance to predict the future and must still conduct rigorous due diligence.
5. Abandon the Illusion of "Beating the Index": For most institutions, the likelihood of consistently generating significant excess returns in PE is extremely low. The report implies that rather than paying high fees to PE managers with low conviction, it may be better to allocate capital to lower-cost public markets.