The Quantitative Approach to Private Equity (Part 1)

Welcome to this week’s edition of Cape May Wealth Weekly. If you’re new here, subscribe to ensure you receive my next piece in your inbox. If you want to read more of my posts, check out my archive. The first version of this article was published in March 2024.

Just three weeks ago in Private Equity for the Masses, I wrote that private equity continues to be en vogue despite the challenging environment it finds itself in. Whether its private equity, private credit or infrastructure, the trend towards a higher share of illiquid, ‘private’ assets within client portfolios continues at a steady pace.

There’s many reasons for why private equity has been such a success over the last decade, with the biggest one likely being the performance figures thrown around by both GPs and fintech platforms. But as I’ve also written before, those performance figures should be taken with a grain of salt: The often-used “IRR” metric used by private equity (and other private asset classes) differs significantly from the cash-on-cash returns of public equities. Hence, investors need to ensure that they are comparing apples to apples - and subsequently ensure that they are being properly compensated for the risks and illiquidity that private equity brings.

But that raises an important question: What excess return should investors expect from private equity, especially in relation to its public counterpart? And what  actually drives this outperformance - is it the often-mentioned “illiquidity premium”, or another factor? Lastly, if there really is a stable source of excess return, is it simply a consequence of a structural advantage inherent to private equity, or are there actually additional risks that investors should be aware of?

This and next week, my co-founder Markus and I will do our best to answer these questions, and of course, also share our view on the matter. But before we can answer that question, let’s take a look at something slightly different: At how academia looks at stock performance.

Understanding the “Illiquidity Premium”

The very basis of risk and return is that if you accept a higher risk, you should expect a higher long-term return. Historically, the “Capital Asset Pricing Model” (CAPM) suggested that the performance of public equities can be explained by just two factors: the risk-free rate (i.e. the interest rate on “risk-free” cash or government bonds) and the equity market risk premium. Depending on whether a stock or a portfolio of stocks was more (or less) risky than the overall market, you could expect a higher (or lower) return.

Curiously enough, certain types of stocks performed continuously better or worse than suggested by the simple logic of the CAPM. More clarity arose through the discovery of so-called “factors”, including but not limited to Value, Small Size or Momentum, which could better explain stock performance. But beware: They can and will underperform for prolonged periods of time before they deliver you the desired excess return. They are called “Risk Premia”, after all.

This brings us back to the “illiquidity premium”: Pairing CAPM with those factors, we should be able to better understand the performance drivers of Private Equity. And if additional unexplained performance remains, it might be the elusive illiquidity premium, which is supposed to compensate an investor for taking on the risk of an illiquid as opposed to a liquid investment. 

And indeed, some of the factors can help us better understand PE market performance:

Small Size Factor: smaller companies’ stocks outperform larger ones’, even when adjusted for their higher volatility. 

Value Factor: cheaper stocks outperform more expensive ones. The PE industry is particularly focussed on low EBITDA multiples as a key measure.

Leverage: PE firms use borrowed money and aim to generate returns above the funding costs. This can boost returns dramatically, but equally increases risk.

Low, positive profitability: while not a traditional academic factor, Private Equity firms have shown a selection preference for companies that have low but positive earnings, leaving them room to grow profitability.

From a practical standpoint, this sounds about right. PE tends to buy smaller businesses with more growth and optimization potential (“Small Size”, “low positive profitability”). They usually do so at lower valuations (“Value Factor”), and often facilitate those transactions through the use of debt funding (“Leverage”).

But of course, we don’t just want something that sounds right in theory. We want real-world data to show us whether PE managed to outperform its public counterpart (and to ideally show if and when that will continue in the future), and how much risk those investments entailed.

From Theory To Practice (And Performance)

(As always, any comparison between asset classes should be “apples to apples”. PE usually reports performance as internal rate of return (“IRR”), which is based on a series of cash flows, whereas public equity performance is usually cash- and time-weighted. To make them comparable, you need to turn IRR into a cash- and time-weighted return, or you need to convert the public equity return into an IRR-like figure. More on the IRR vs. Compound Return Debate, read the third article of our Rise of Permanent Capital series.)

Academia has been tackling the question of PE’s long-term performance and risk, and two research papers stand out.

The first paper was published by investment firm AQR, in which they converted PE returns into cash- and time-weighted figures and compared them to its public counterparts. They show that from 1986 to 2017, the Cambridge US PE benchmark (which shows the aggregate performance of a large number of US buyout funds) posted a 9.9% p.a. return. During the same time period, the S&P 500 averaged 7.5% p.a. It’s an impressive difference, especially if assuming a 30-year compounding. However, the S&P 500 does not reflect PE’s bias for small, value stocks: AQR used the standard academic factors to construct a small-cap value strategy in public equities, which would’ve yielded average returns of 11.4% in the same time period - ahead of private equity. (Perhaps worth noting that AQR founder Cliff Asness is not necessarily known as a fan of private equity- which I understand, but only to a degree.)

The second paper comes from Harvard University and helps us answer the question of risk. They went to great lengths to analyze the almost 700 public-to-private transactions by PE firms from 1984 to 2017 in order to understand PE firms’ selection criteria and create a mimicking public equities portfolio. This way, they arrived at probably the most adequate risk estimates of Private Equity, yet: Using 2x portfolio leverage comparable to the analyzed PE transactions, their replicating public equity portfolio sees a volatility of around 27% and a maximum drawdown in this time period of -78%. Roughly twice the numbers you get for the S&P 500. (Harvard’s fictional portfolio also beat PE’s 11.4% p.a. net IRR by achieving a 14.8% p.a. net IRR.)

There are two interesting take-aways from those two papers:

First, that PE success, on average, is less driven by operational efforts (i.e. the often-mentioned “value-add”) but rather by a focus on the aforementioned factors. One view to support this comes from Dan Rasmussen of Verdad Research, who invests into public equities according to a similar approach after he discovered during his time at PE giant Bain Capital that most of PE profits were driven by cheap deals, and not other factors such as management or company quality. (But of course, buying cheap isn’t the only thing you need to look out for. One of my favorite PE fund of funds managers, who invests almost exclusively on opportunities with above-average valuation multiples, says that there’s almost always a reason for why an asset is trading below market, and that it won’t just simply reprice itself just because it changes hands.)

Second, that PE is much more volatile than many GPs say. Markus and I have seen more than one “chart crime” where GPs show PE as an asset class outperforming public equity with lower volatility - because they compare public equities with mark-to-market pricing with PE’s quarterly NAVs. The paper shows a more realistic figure, with volatility figures for PE that are approximately twice as high as public equities:

Sources: Moonfare, Bloomberg, MSCI, Cambridge Associates, KKR, AQR, Kenneth French Data Library, Harvard Business School, Cape May Wealth, Excentrica. As of 12/03/2024. * Moonfare notes: “From 1Q86 to 4Q20 where data is available, deemphasizing 2008 and 2009 returns at one-third the weight due to the extreme volatility and wide range of performance, which skewed results. Using MSCI AC World Gross USD for Listed Equities; Barclays Global Agg Total Return Index Unhedged USD for Fixed Income; Cambridge Associates Global Private Equity for Private Equity; HFRI Fund Weighted Composite Index for Hedge Funds; and Barclays US T-Bills 3-6 Months Unhedged USD for Cash.” For educational purposes only.

Of course, any backtest should be taken with a grain of salt. Consider the mentioned use of leverage: Anyone invested into risky small caps would almost certainly face a margin call, if not much more likely a liquidation, when incurring a 78% maximum drawdown (As the author admits as well). At the same time, maximum drawdown or changes in value matter a bit less in a loan to a PE-backed asset - as long as debt and interest keep on getting paid, and as long as the company isn’t worth less than the outstanding loans (even with your equity impaired), they’d likely prefer working with you to see their debt repaid rather than push the company into default. 

(Perhaps also a remark in this regard: While many investors say that they can apparently generate PE’s long-time returns through methods such as buying cheap but heavily leveraged small-cap stocks, I’ve yet to see a fund that has done that properly over the long time. If you have done it, please feel free to reach out, I’m happy to be proven wrong.)

Nevertheless, we do have two sets of numbers that we can work with: AQR’s 2.4% PE outperformance p.a. for a time- and money-weighted return, and Harvard’s 1.8% PE outperformance p.a. on an IRR basis versus the S&P 500. While both have shown that their respective replication strategies managed to beat those PE figures, we do get a partial answer to what we were looking for: That the average investment into private equity, historically, has managed to outperform its public counterparts.

But as always, things are not that easy. We’ve already outlined that PE is considerably riskier than public equities, standing at roughly twice the leverage of the S&P 500. We know that they use significant leverage. And we haven’t touched the question of fees, which some studies estimate at as much as 6% p.a. (split between management fee, carry, and portfolio-level fees).

So let us rephrase that question: What (excess) return should an investor expect from their private equity investment to be properly compensated for the risk that they take?

More on that next week.

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