Capital Investment: Myth and Reality

Oliver Gottschalg, Professor of Strategy and Business Policy - February 15th, 2008
Gottschlag - Capital Investment

Contrary to popular belief, capital investment funds perform, on average, less impressively than those on the stock markets. This is the conclusion  of a survey into 1,328 funds, conducted by Oliver Gottschalg and Ludovic Phalippou. An investigation into a popular misconception. 

Oliver Gottschalg ©HEC Paris

Oliver Gottschalg qualified in engineering from the University of Karlsruhe (Germany), and  also holds a PhD from INSEAD (France). Professor at HEC Paris since 2005 and (...)

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For a number of years, capital investment has had a reputation for offering particularly attractive returns, and there is an increasing number of  investors who choose to allocate part of their capital to this type of asset. For example, according to  the 2006 Report into the activity of capital investment in France1, French capital investment rose  by 26% between 1997 and 2006. And yet, when they  carried out an empirical survey into 1,328 of these  funds, Oliver Gottschalg and Ludovic Phalippou  realised that a high performance could not be taken for granted and could sometimes even drop below  that of the stock markets. Here is Professor Gottschalg’s explanation... 


The private equity returns that are much vaunted in the financial press are largely based on indices published by Thomson Venture Economics, a respected source on the matter. And yet, the methodology applied in assessing the performance of these funds seems to overestimate their returns. On the  one hand, the evaluation method consists of aggregating internal rate of return (IRR) of multiple funds, without taking into account that the funds have variable life cycles2; those with longer life cycles have greater influence than others. On the other hand, the characteristics of the database used to arrive at the statistics create a problem: firstly, the  performance of the funds is augmented by residual  values (investments kept in portfolios) which, although treated as final cash flow in performance  calculations, turn out in reality to be ‘living dead’ investments. Secondly, the standards used in publishing Thomson Venture Economics’ statistics  over-represent the best-performing assets. We did, in fact, notice that the samples chosen for founding the industry’s benchmarks included assets  with higher than average performance. Therefore, when a traditional assessment method is applied to the performance of capital investment funds, the results need to be relativized. 


Using the traditional method, the average performance of these sample funds attains an annual IRR  of 15.2%. This attractive performance only partially reflects the real return on investment. The first adjustment consists of using a more suitable evaluation method that uses a profitability index (the  real value of cash flow received by investors divided by the current value of capital paid by investors). When we correct the bias relating to the nature of  the sample, the performance levels are, on average, 3% higher than those of the stock exchanges. However, the charges applied by the finance managers to investors strongly decrease their return. So, with a management charge of 6% per annum, the under-performance of private equity funds is really at 3% when compared with stock markets. In other words, while the capital investment funds create, on average, greater value than the stock markets, the accounts managers extract the added value, to the detriment of the investors. Professor  Gottschalg emphasizes that although the method used for the survey cannot be applied to the most  recent funds (it would be necessary, in fact, for the  fund to mature in order to interpret its performance), extrapolating the results enables one to  anticipate comparable results on current funds. 


These results call into question the interest of private equity for investors. Oliver Gottschalg explains the enthusiasm for capital investment in two ways. Firstly, the under-performance of these funds is relatively unknown, because few people have access to unadjusted databases that enable them to question the indices published by fund managers (which  are then repeated in the financial press). Lastly, and maybe most importantly, it would seem that  investors tend to overestimate their own ability to  choose the best performing assets. Indeed, the survey showed that a quarter of capital investment  funds had an average IRR of 35% at the highest performance rates. In other words, those who identify  the most profitable assets can expect very attractive investment returns. That said, the other three  quarters show fairly disappointing results. When Professor Gottschalg is asked about whether he  thinks his research and his new perspective on capital investment performance will have an impact on investor behaviour, he is not convinced. He reminds us that research tends to have a delayed impact on the real economy, and he is hopeful that it will encourage people to reflect on ways of improving the arbitration between the various investments on the financial markets.

Based on an interview with Oliver Gottschalg and on the article he co-wrote with Ludovic Phalippou, "The  Performance of Private Equity Funds" (Review of Financial Studies ), partially published in Harvard Business Review  in December 2007. 

1. Report on capital investment activity in France in 2006 —  Survey by AFIC and PricewaterhouseCoopers   

2. The IRR gives information on the investment’s return rate, but provides no information on the temporal horizons of returns.   


Oliver Gottschalg and Ludovic Phalippou studied the net return (cash flow to investors after charges) of a sample of 1,328 capital investment funds that matured in 2003. The performance of these funds was compared to that of the stock markets using the S&P 500 (stock exchange index created by Standard & Poor’s, based on 500 listed major American companies).