By Sean Wolfe

Private equity funds continued to out-perform public markets in the third quarter of 2006, according to a recent study. The figures, released Monday from Thomson Financial and the National Venture Capital Association show average short-term returns of later stage venture capital funds, and most buyout funds outstripping those of the Nasdaq index, and the Standard & Poor’s 500 public companies.

That said, it was no 2005. Short-term (1-year) returns have softened substantially from the year-ago quarter, in all but later-stage venture funds, and medium-sized buyout funds. Small buyout funds fell the hardest. In the year-ago quarter, those funds were racking up one-year returns in the 32.9 percent range. In the third quarter, returns plummeted to just 11.3 percent. Mezzanine funds also took a shellacking in single-year returns, falling from 11.2 percent in Q3-05 into negative territory (-8.2 percent) in Q3-06.

The sweetest spots for short-term investors were in later-stage venture and medium-buyout funds. One-year returns for later-stage VC came in at 27.8 percent, while medium buyouts over the same period rang up 37.8 percent returns. The highest three-year returns were notched by large and mega-sized buyout funds. The best 5-year returns were also in the mega-buyout category. For those with longer planning horizons, 10-year returns for early and seed VC commanded 38.3 percent. For the 20-year horizon, small buyout funds (25.2 percent) and early/seed VC funds (20.5 percent) commanded the best returns.

Private equity’s historical weakness—bubble-era investments, where 5-year returns continue to trail public market performance—continued to improve. Mezzanine, and all categories of venture and buyout showed improvement over the Q3-05 to Q3-06 time frame, as they inched toward positive territory. Five year returns for venture funds continued to improve and inch towards positive territory at -1.0 percent in Q3-06, up from negative 3.7 percent in Q2-06—a marked improvement from the negative 9.3 percent in Q3-05.

There was some cause for concern in the performance of venture capital funds, where short-term performance continued to ebb. Returns in one-year venture capital funds, fell to 10.8 percent in Q3-06, down from 17 percent in the year-ago quarter, and continuing to trail the 13.7 percent from Q2-06. Ten-year performance also took a hit across all categories of venture. Overall venture funds in the 10-year performance window fell from 26.1 percent returns in Q3-05 to 20.5 percent in Q3-06.

Darrell Pinto, director of Global PE Performance at Thomson Financial said there may be choppy water ahead for buyout fund investors.

“Short-term buyout returns are under increasing downward pressure. This pressure, coupled with the increase in five year and relative stability of ten and twenty year returns, indicate that competition within this asset class is causing turbulence in returns to investors,” he said. “It is worth noting that this volatility in short-term rates is most pronounced for funds less than $500 million in size which posted an aggregated 37.2 percent one year return in the quarter.”

The survey results were recently reflected in a survey of limited partners conducted by Coller Capital (See our recent story). That survey showed investors as most bullish on buyout funds targeting Asia-Pacific and European companies. Venture and buyouts in North America were their third and fourth choices respectively.