The Quantitative Approach to Private Equity (Part 2)

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Once again I am happy to welcome Markus Derenthal as a co-author. Markus is the CEO of Excentrica, an investment firm he founded three years ago after his time at the University of Cambridge and Goldman Sachs in London. He advises Family Offices and helps entrepreneurs to achieve higher investment returns at lower risk compared to the standard offer of big banks.

In the first part of our Series, Markus and I tried to make sense of private equity’s historical performance. From a simple comparison, the average private equity fund managed to outperform broad stock indices, like the S&P 500. But as always, things aren’t so easy: Such a simple comparison doesn’t take into account the differences in risk, where we were able to demonstrate that private equity is more concentrated in companies with certain common characteristics, and that PE uses significant amounts of leverage to boost returns. 

With that newfound knowledge, we want to look at a different question: What (excess) return should an investor expect from their private equity investment to be properly compensated for the risk that they take?

We’ll consider it from two perspectives: First, the practical viewpoint, and then, the quantitative viewpoint.

The Practical Viewpoint

While any investment decision should in the end be made on quantified, rational behavior, it can be worth also looking at things in simple, practical ways. The same applies for private equity.

The first practical viewpoint that I experienced was when an entrepreneur compared a PE fund investment to a different type of PE investment: Entrepreneurship, or more specifically, his own business. Many individuals who end up investing in private equity built their business as a private company (with or without funding) and have seen the associated challenges, just as electing the right management team or picking the right growth initiatives. Accordingly, some entrepreneurs voiced to me that the return they achieved on this business (which can be tremendous given the initial investment might just be their notional capital) is their true benchmark for private equity - which can be 25% p.a. before fees or even higher (so significantly above public equities, as well as the private equity figures we previously shared). 

However, if one were to use this 25% p.a. figure as a reference, there’s two things to keep in mind: First, for every successful entrepreneur that achieved such returns, there are nine others who failed with their business - so 25% p.a. might be an unreasonably high bar. Second, even assuming that some companies can achieve such a return, it’s unlikely that a diversified portfolio (which you would always try to have as a PE investor) as a whole can achieve such returns.

On the other side, a much more pragmatic viewpoint: If an investor believed that an illiquid investment can outperform its liquid counterpart by just 1% p.a., and is not reliant on investing this capital in liquid assets, it is unsurprising that they might aim to maximize their allocation to illiquid assets. Of course, there is no guarantee that the historical outperformance of illiquid investments will continue, and investors might underestimate if and when they actually require liquidity at a future point in time. In addition, it brings us back to our previously mentioned point on risk-adjusted returns - under which the average PE fund might actually struggle (but more on that below).

From my point of view, an adequate PE return goal is probably somewhere in between: To me, 25% p.a. can never be a realistic return assumption without having capital at serious risk of loss. But equally, just 1% higher returns might probably not be worth the significant work involved in managing a PE portfolio. 

So we return to our starting question: What is the necessary excess return? For that, we finally turn to academia one more time.

The Quantitative Viewpoint (and the importance of Manager Selection)

As we outlined last week, both AQR and Harvard saw a return difference between public and private equity of about 2.0% to 2.5% p.a. At the same time, we highlighted that private equity has been much more risky than public equity on a number of factors - one of them being leverage.

The average PE buyout fund uses 100% to 200% of leverage. In other words, for every dollar of equity they invest, they would borrow one to two additional dollars. As we also outlined in the last post (when looking at the PE replication portfolios created by AQR and Harvard), such levels of leverage are challenging for the traditional private investor. But those levels might not be relevant: To get to the Cambridge US PE benchmark return of 9.9%, we would’ve needed to add “just” ~60% leverage to our unlevered S&P 500 return of 7.5% to achieve the same returns. 

While of course riskier than a traditional public equity investment, the leverage and the volatility of a leveraged S&P 500 investment is still lower than the actual leverage employed by the average PE fund, and their assumed volatility. Not to mention that a small-cap strategy might have achieved average PE returns without the use of leverage (if we trust the backtests).

Also, our analysis wouldn’t be complete to also highlight a key characteristic of private equity: Illiquidity. Your liquid investment, even if it’s leveraged, can be liquidated on a daily basis - something that private equity does not offer. Accordingly, the required excess return should be even higher than the figures that we’ve shown you in this piece. 

Which brings us back to the question of the illiquidity premium: Does private equity properly compensate investors for having their capital locked-up as opposed to investing in public, tradable equity?

For the average private equity investment, the answer today is no. You could just as well focus on cheap small-cap stocks with low, positive profitability. Even without leverage, such a portfolio would historically achieve PE’s average returns. Private equity firms then use leverage to boost returns, but those extra returns are almost fully offset by fees.

After reading this, you might rightfully ask yourself: Why should I even bother with Private Equity if I can get the average PE return through a less risky, liquid equity investment? The answer to that is a key aspect of private equity: Manager Selection - the practice (and art) of picking the right active managers, from which you expect outperformance and/or superior risk-adjusted returns. 

Manager Selection: What it takes for PE to be worth the effort

In public equities, manager selection has become less important than it used to be, especially for retail investors, as the many studies that outline the challenges of active management drive investors to easily accessible index funds. In private equity, such products don’t exist, given that an individual PE fund tends to have much fewer underlying companies (10-20). Accordingly, investors need to invest significantly more time in identifying, screening and accessing high-quality managers, out of which they then try to build a sufficiently diversified portfolio - and which can hopefully generate long-term outperformance ascribed to private equity.

To assess the impact of manager selection, we can use a paper by the National Bureau of Economic Research (NBER), in which the authors compare managers based on the “public-market equivalent” (PME). In the PME method, you assume that fund capital calls are invested into a comparable equity index, which is sold when distributions take place. If PME equals 1, a PE fund generates returns identical to investments in the S&P 500 at similar points in time.

Using the results of the NBER paper, we can see how well private equity might need to perform to be worth the effort:

Source: NBER, Cambridge Associates. MOIC taken from NBER study. Return p.a. calculated as CAGR using MOIC and an Avg. Holding Period of 5.8 Years. LT Interest Rate and Loan Margins are assumptions by the authors. Add. Return p.a. is the difference between the Return p.a. of the PE Fund Quartiles minus S&P 500. Required Leverage is calculated using the Add. Return p.a. under consideration of LT Interest Rate p.a. and Loan Margin p.a.

As we outlined in the prior section, an average PE fund investment might offer worse relative risk-return given that PE, on average, uses 100% to 200% leverage, while a leveraged S&P 500 investment would “only” require 60% leverage to reach the same return (while also offering daily liquidity). However, as we move from average into first- and second-quartile returns, our S&P 500-based replication becomes challenged: As visible above, second-quartile returns would require 125% leverage (already in the same range as PE), and first-quartile returns would require a whopping 287% leverage to have historically achieved equivalent returns. At those levels, using a traditional margin loan makes it almost certain for such a leveraged portfolio to hit margin calls even during a small drawdown. Whether those returns are luck or truly manager skill is a question that is hard to answer - but it becomes clear that historically, first- and second-quartile PE funds achieved returns that were hard, if not impossible, to replicate with publicly traded strategies.

So you might think that it’s easy - I just have to pick first- and second-quartile managers. (And of course, all managers tell you that they are in the top 50% of funds). But as always, it’s not that easy - and also answered by the NBER paper, which analyzed whether a prior fund’s quartile could predict the quartile of the following “vintage”. The answer, to the most part, was no: With the performance data at the time when investors committed allocations to the next fund vintage, there was no telling how the following fund would perform. 

Interestingly and against common lore, increasing fund size had no impact on performance. And equally, a newly launched PE fund was as likely to end up above or below median, which calls into question the common practice among many LPs of not investing in first-time funds.

The only finding they were able to show was that fourth-quartile managers were more likely to stay below average. And maybe this last piece of information is a tiny sliver of hope: As third-quartile managers perform roughly in line with public equities, avoiding future fourth-quartile managers would mean that your PE portfolio should at least achieve public market-equivalent performance. Not risk-adjusted, of course.

Does Private Equity make sense for you?

After everything we analyzed and discussed, the conclusion may still be simple:

Always remember that both public and private equity investments are long-term oriented. Accordingly, if you are looking to invest for 10, 20 or even 50 years, illiquidity ideally should not concern you as long as you are properly compensated, especially on the risk-adjusted basis as outlined here. Illiquidity might even help or force you to leave emotions aside and stay committed when markets go against you.

Which also brings us to a final consideration: Whether private equity can continue to generate its outperformance in today’s market and economy. In the beginning of the 30-year period of the PE figures from AQR’s paper, PE was still an nascent industry - but today, it is a massive, established industry, with considerably more competition for fewer deals. We’re also leaving an economic period of super-low interest rates and rising multiples, from which private equity benefited significantly. Finding an answer to this question is not easy (although academia, once again, has a view) - but perhaps that’s for another time.

So for our readers, some final advice: Think about whether investing in private equity is worth the effort and risk for you if you had generated “just” the average outperformance, or worse, if you end up with the same return as your public equity benchmark (which could periodically be seen for PE’s sub-asset class of venture capital when comparing VC to the NASDAQ). Consider whether you can really stomach the long-term illiquidity and the challenges of cash flow management. And lastly - and not just for PE - think about what your investment objectives are. I personally am cautiously optimistic that high-quality PE funds can deliver outperformance worth the effort - but they are only worth assessing if you are actually dependent on the potential excess return they are generating. 

Outperformance or not, it’s always good to consider whether there is an easier - and perhaps, less risky - way to achieve your investment objectives.

Liked what you read? If you enjoyed this piece, make sure to subscribe by adding your email below. I write about topics covering the world of family offices, asset allocation, and alternative investments. And of course, follow Markus on LinkedIn as well.