New Insight into Private Equity

After the hiatus of the credit crunch, when private equity (PE) investors were rudely reminded that illiquidity can magnify downside risks, PE is now back in favor, with fundraising at record levels. According to the Towers Watson/Financial Times Global Alternatives Survey 2015, PE assets are catching up with real estate for second place when comparing the assets under management (AUM) of the top 100 alternative asset managers. Abundant capital and cheap finance means deals are now richly priced in both the United States and Europe as pension funds recover their taste for PE. Yet the survey notes the continued evolution of the manager-investor relationship and lingering pressure on fees as the asset class matures. Increased co-investing, secondary activity, and strategic partnerships are also increasingly common innovations among sophisticated asset owners.

Rajibul Hasan, an independent financial researcher, surveyed PE investment practices for the Journal of Private Equity and his work has been condensed and summarized in CFA Digest. Hasan notes how PE has grown from humble origins into an established cornerstone of the investment management profession which demands specific skills, knowledge, and commercial mindset. Private equity as an investment practice offers investment opportunities around the globe not just in its US heartland.

Some might say that PE has hardly begun to achieve its full potential to enter investor portfolios and catalyze global capitalism. Thomas Meyer, a director of LDS Partners, has published a commendably thorough and practical survey, “Private Equity Unchained: Strategy Insights for the Institutional Investor.” Focusing on PE’s investment merits, Meyer aims to develop a better informed private equity strategy, mainly from the perspective of the limited partner, the primary route into private equity for most institutions. Controversially, Meyer cautions against adapting public market investment strategies and tactics, derived from modern portfolio theory, to private equity. His view is that PE has an even longer time perspective than public equity and a structurally unique aspect deriving from its illiquidity. Both are points to ponder even if you disagree.

If all this piques your interest, how has private equity really performed on a risk-adjusted basis versus the public market? This fundamental question must be answered by any investor deciding whether to abandon the deep liquidity of public equity markets for illiquid private equity. Measures critical to this question are explored in “The Public Market Equivalent and Private Equity Performance,” a recent article in the Financial Analysts Journal, by two researchers, Morten Sorensen at Copenhagen Business School, Denmark and Ravi Jagannathan at the Kellogg School of Management. The authors provide a theoretical foundation for the use of the public market equivalent (PME) measure, which is often used to evaluate private equity performance. The PME gives an estimate of the risk-adjusted performance of PE funds without having to calculate any betas.

Another challenge for investors is the sometimes surprisingly large gulf between targeted investment and committed private equity capital. Disinvestments begin to reduce invested capital even before the capital commitments are fully called. A portfolio investor may struggle to get the invested capital amount closer to the targeted asset allocation without exceeding the cash available to commit within the portfolio. A new study, “Private Equity Asset Allocation: How to Recommit?” by Adrian Oberli, CFA, at Harvard Business School, was summarized recently in CFA Digest and proposes a private equity recommitment strategy. The proposed strategy maintains a much greater investment degree, with a higher ratio of invested cash to committed capital, than prior strategies.

As PE investors know, there are many moving parts that impact risk, and some factors can act across the portfolio and affect exit and entry prices: For example, portfolios may be impacted by systemic influences that encourage co-movement between supposedly diverse industries and asset classes. Deeper down within portfolios, constituent corporate capital structures can be far from stable over time. New research recently summarized in CFA Digest evaluates “How Stable Are Corporate Capital Structures?” by Harry DeAngelo of the University of Southern California (USC) and Richard Roll of Caltech and UCLA. While academic literature might often assume that corporate capital structure is stable over time, DeAngelo and Roll demonstrate a contradictory conclusion that has several implications for practitioners. If capital structure is not stable over time, then the present capital structure cannot be used to confidently predict the future.

Finally, prevailing investor sentiment plays a role in all investment decision making, and consequently investor greed and fear may be quantified and utilized as a predictive measure. New research, by scholars at Singapore Management University, Washington University, and Central University of Finance and Economics has just been summarized in CFA Digest. It uses established proxies and new statistical tools to construct an aligned investor sentiment index which turns out to be a robust predictor of market performance, outperforming macro variables.

Related readings, including recent CFA Digest summaries for interested readers to research, are summarized below:

• Private Equity Investment Practices: A Comprehensive Study: Private equity has grown from its humble beginnings into a significant subset of the investment management profession, demanding a specific skill set and entrepreneurial mindset. No longer only a US phenomenon, private equity as an investment practice offers investment opportunities around the globe.
• Book Review: Private Equity Unchained: Strategy Insights for the Institutional Investor: Private equity (PE), whether in or out of market favor, perennially remains a magnet for advocates and critics ranging from investment professionals to economic, political, and policy analysts. In Private Equity Unchained: Strategy Insights for the Institutional Investor, Thomas Meyer does not enter this fray, instead focusing on PE’s investment merits. He aims to develop a strategy for institutional investors, primarily from the perspective of the limited partner, which is the principal entry point into private equity for most institutions
• Investor Sentiment Aligned: A Powerful Predictor of Stock Returns: Sentiment makes an impact on the kind of investment choices people make, and therefore, investor greed and fear can be potential predictors of market performance. The challenge of investor sentiment not being observable is addressed by the authors’ finding the appropriate proxies and formulating an index of investor sentiment. Such indexes tend to predict markets better than conventional indicators.
• Private Equity Asset Allocation: How to Recommit? To get the invested capital amount closer to the targeted asset allocation without exceeding the cash available to commit within the portfolio, the author proposes a private equity recommitment strategy. The proposed strategy maintains a much greater investment degree (0.7–0.8 average ratio of cash invested to committed capital) than prior strategies have (0.55 average ratio or less).
• The Public Market Equivalent and Private Equity Performance: The authors show that the public market equivalent approach is equivalent to assessing the performance of private equity (PE) investments using Rubinstein’s dynamic version of the CAPM. They developed two insights: (1) one need not compute betas of PE investments, and any changes in PE cash flow betas due to changes in financial leverage, operating leverage, or the nature of the business are automatically taken into account; (2) the public market index used in evaluations should be the one that best approximates the wealth portfolio of the investor considering the PE investment opportunity.
• Portfolio Selection in the Presence of Systemic Risk: A reward-risk measure that accounts for systemic risk is proposed. In particular, the authors address the portfolio diversification problem when systemic risk is high by performing reward–risk portfolio optimization on simulated data. The profitability of several strategies based on the forecasted evolution of returns is examined.
• How Stable Are Corporate Capital Structures? Analyzing whether corporate capital structures are stable over time, the authors find that many firms have varying levels of leverage at different times. They show that capital structure stability is the exception and that it primarily occurs at low levels of leverage and is almost always temporary. In addition, they find that industry median leverage ratios also vary widely over time and that target leverage models that place little or no weight on maintaining a particular leverage level are the best at modeling the instability of actual leverage across firms.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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