Practical analysis for investment professionals
03 December 2018

Private Equity: The Emperor Has No Clothes

From Bust to Boom

The private equity industry had an abysmal outlook in 2008 and many portfolio companies were at the brink of collapse. Carlyle Capital, a listed affiliate of the US buyout giant The Carlyle Group, defaulted on its debt.

Fast-forward to 2018 and such global financial crisis–related difficulties seem almost forgotten and private equity is flourishing. Indeed, alternative investment firms have $1.8 trillion in “dry powder” waiting in reserve and more than half of that is held by private equity funds.

The fondness for private equity among institutional investors is easy to explain: It comes down to high returns, low volatility, and a lack of correlation to traditional asset classes. Of course, such attributes also evoke some skepticism: Don’t they sound just too good to be true?

To explore that question, we set out to replicate private equity returns with public stocks.

Private Equity Returns vs. The S&P 500

Private equity returns in the United States have outperformed various equity and bond benchmarks over the long term, according to data from Cambridge Associates. Private equity returns are compiled from 1,481 US private equity funds and are available net of fees on a quarterly basis.

Using this data, we construct a US Private Equity Index that has outperformed the S&P 500 by a significant margin since 2000.

US Private Equity Returns vs. The S&P 500

US Private Equity Returns vs. The S&P 500

Source: Cambridge Associates, FactorResearch. Private equity returns are only available as IRRs and not CAGRs, so should be viewed as an approximation when comparing to public equity returns.

Not only has it outperformed, the US Private Equity Index also has much lower volatility than the S&P 500. This no doubt has an appeal for institutional investors. Unfortunately, it is more illusion than reality. After all, private equity portfolio companies are typically valued on a quarterly basis so lack a daily time series. In addition, most portfolio company valuations are smoothed as they are conducted by external appraisers using business plans from the private equity firms.

If private equity firms valued their portfolio companies on a daily basis using public market multiples, volatility would be much higher and more reminiscent of the S&P 500.

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Explaining Private Equity Returns

Bryan Burrough and John Helyar immortalized the private equity industry in Barbarians at the Gates, their account of the 1988 buyout of RJR Nabisco. The deal, which involved many prominent Wall Street characters, was valued at a then-unprecedented $25 billion.

Although private equity today is renowned for enormous buyouts, take-over targets historically were much smaller simply because private equity funds held much less capital. The average transaction size was much more in line with small-cap equities.

Based on this data point, we create an index of the 30% of the smallest US public companies with market capitalizations over $500 million. As it turns out, the small-cap equity index and the US Private Equity Index have almost identical returns. The performance profiles also demonstrate that private equity returns are not as uncorrelated to public equities as institutional investors might like them to be.

Replicating Private Equity with Small-Cap Stocks

Replicating Private Equity with Small-Cap Stocks

Source: Cambridge Associates, FactorResearch

Maybe the US Private Equity Index only represents average returns and not those of the top-performing funds. But ample academic research shows that fund selection is challenging across all asset classes. Choosing the funds with the best historical returns is rarely a winning strategy. Therefore, average returns are likely reflective of the actual returns that investors should expect from private equity allocations.

Liquid Private Equity Alternatives

In addition to their smaller size, private equity target companies have also tended to share other characteristics, among them lower valuation multiples and the ability to carry debt.

Companies trading at lower valuations often have temporary or structural issues that private equity firms see as opportunities. By swooping in and addressing them, the private equity firm can unlock value.

Although much less leverage is applied in private transactions today than when the sector got rolling in the 1980s, recouping the initial equity investment quickly through a dividend recap financed by additional debt remains a popular strategy. Companies with proven cash flows and the ability to take on debt are still popular targets.

So we create two portfolios: one with small and cheap stocks and another with small, cheap, and levered US stocks. Cheap stocks have low EV-to-EBITDA multiples and levered stocks high debt-to-EBITDA multiples.

What did we find? From 1988 to 2018, the liquid private equity alternatives portfolios outperformed the US Private Equity Index. They provide daily liquidity and require minimal initial due diligence and ongoing monitoring. They can also be rebalanced quarterly and managed internally or outsourced to any asset manager for a few basis points.

Liquid Private Equity Alternatives

Liquid Private Equity Alternatives

Source: Cambridge Associates, FactorResearch

Further Thoughts

Exposure to small caps likely explains private equity returns. Liquid alternatives to private equity can be created simply by buying small, cheap, and levered stocks.

Some have reached similar conclusions and proposed that the nature of locked-up capital is what makes private equity so advantageous. It keeps investors from redeeming their funds at market lows and helps private equity firms weather storms like the global financial crisis. But the same fund structure can be replicated through public equities at a fraction of private equity fees.

Furthermore, with $1.8 trillion sitting on the sidelines, too much money may end up chasing too few deals, creating high acquisition multiples that don’t augur well for expected returns.

Of course, high valuations are now the rule in both private and public markets. And corporate debt levels are at all-time highs.

Small, Cheap, and Levered Stocks: Valuation and Debt Multiples

Small, Cheap, and Levered Stocks: Valuation and Debt Multiples

Source: FactorResearch

Neither of these developments bode well for expected returns. So investors might be wise to reconsider direct private equity allocations and their liquid alternatives altogether.

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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.

Image credit: Stamps of Germany (DDR) 1975

About the Author(s)
Nicolas Rabener

Nicolas Rabener is the managing director of FactorResearch, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focused on real estate across asset classes. He started his career working for Citigroup in investment banking in London and New York. Rabener holds an MS in management from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

18 thoughts on “Private Equity: The Emperor Has No Clothes”

  1. Sylvia van de Kamp-Vergeer says:

    I would like to know if the returns presented in the analyses are net or gross.

    1. Hi Sylvia, the private equity returns are net of all fees (fees, expenses and carried interest). The public equities are net of transaction costs. Other fees are marginal for the replication strategies given the simplicity and quarterly rebalancing.

      1. Peer Borsky says:

        Hi Nicolas,

        How did you model transaction costs for public equities?

        1. Hi Peer, we modelled 10 basis points for each stock transaction. The public equities indices can be rebalanced on a quarterly or less frequent basis and transaction costs do not have a significant impact.

  2. Mike says:

    Interesting article. With regard to the last chart, is there a secondary y-axis missing for the debt/ebitda multiple? Not sure how it can be higher than EV/ebitda for so many year. thanks

    1. Nicolas Rabener says:

      Hi Mike, thanks for pointing out the issue with the chart, where you were naturally correct. We fixed the chart.

  3. Jamie says:

    Nice article. Merrill Lynch used to have a PE proxy index in the 1990s that focused on the performance of small cap stocks. I think they discontinued it after the tech bubble burst. It is true that the average PE fund performance is just that and for most investors in PE, the desire to diversify reduces overall returns. The way to win in PE as an investor is through good timing and selectivity and concentration. Throw in a healthy dose of good luck. Have you checked to see what percentage of the small cap stocks that you screen still have PE funds on the board and or have a large PE shareholder? Is there any evidence to suggest that you are screening for publicly traded PE-backed companies and you may actually be picking up PE exposure?

    1. Nicolas Rabener says:

      Hi Jamie, I wasn’t aware of the ML PE proxy index, thanks for sharing. You make good suggestions for further analysis, but we currently don’t have the data for systematically screening for PE involvement in the small cap stocks. However, skimming the latest portfolio doesn’t seem to indicate a large proportion of PE ownership.

      1. Jit Hoong Lim says:

        Thank you for sharing this Nick. very interesting article. I would throw in a bit of skepticism in this. If I throw in a good dose of logic , then I am questionning about survivorship bias. Since PE requires heavy leverage, so during the two big market corrections (dotcom and Great Recession), many of these firms would have gone bust. The fact that this is not reflected (much) in the lower IRR returns during recessions makes me a skeptic. So the lack of variability in the PE valuations simply means the Lack of transparency (or efficiency) of this asset class.

        1. Nicolas Rabener says:

          Hi Jit, the PE data from Cambridge Associates includes liquidated partnerships, but reporting of IRRs is voluntary and often stops when funds go under, so your concerns on survivorship bias are valid. The same concerns apply to hedge fund returns, which are also overstated.

  4. Kevin Collins, CFA says:

    Thank you for the article. This makes sense intuitively.

    Can smaller investors replicate the two-part strategy described? One can come close with one of many small cap funds – active or index. But a diversified
    “levered” portion seems difficult for smaller investors to replicate. I would be interested in observations or suggestions in this regard. Thanks

    1. Hi Kevin, the liquid private equity alternatives can be replicated efficiently via small cap value-focused smart beta ETFs (or funds), which are available at very low cost. The portfolio that sorts for small, cheap and levered stocks could be easily replicated via stocks, but is perhaps more difficult to find as an ETF or fund. However, the analysis also highlights that most PE returns were already captured by screening for cheap and small stocks, adding leverage did not contribute significantly more.

  5. Emilian Belev says:

    Hi Nicolas,

    Interesting idea. One critical point is, as your article points out PE returns are an estimate, not an observation. The CA index uses the PME methodology for calculating “PE” returns, the math of its calculation can make any time series appear correlated with the stock market, or a subset by picking the appropriate public market “discount rates”. Using the PME approach, one can make e.g. the sale of Taylor Swift records appear highly correlated to the stock market. The point is that PME should be used and compared to with high caution.

    I was wondering how this inherent bias is treated in your work.


  6. Hi Emilian, I’m not sure if you’re referring to index we constructed based on CA data or one from CA directly. The CA index featured in this article is one we created by using quarterly IRR data from CA. Naturally we’re aware (and also noted) that transforming IRRs and comparing them to public market indices can be challenged easily. Thanks.

  7. JC Berkindale says:

    interesting article , thank you. Two other points relevant for most investors: 1. few non-institutional (large) can replicate the PE returns due to the timing and amounts needed to diversify among managers, and 2. the drag of returns on cash required to be held while awaiting the capital calls can materiallt reduce return.
    Furthermore the tax efficiency of PE for taxable investors is essentially not manageable. The suggested small cap alternative is advantaged further in taxable situations.

  8. Well done. Thank you for sharing your research. Timing and luck are critical performance variables for PE funds. The fund’s vintage, relative to the economic cycle, determines much of a fund’s performance. As one PE fund managing director shared, “People think I am a rockstar for the returns the fund is generating today. The reality is the returns are on investments we made at the time of the crisis several years ago. Yeah, it took guts to buy then, but we got the tailwind of growth plus multiple expansion when we exited.” What I heard was the following: market-timing (which can be difficult), concentrated bets, illiquid and long-term positions. For these reasons, I appreciate the proxy, alternative strategy of small cap stocks presented in article.

  9. Jonathan says:

    Great article and analysis. Just out of interest did you mean companies with a market cap of less than $500m? And if you meant more what was the reason for that cut-off?


    1. Hi Jonathan, we only selected stocks larger than $500 million in market capitalization as companies below that to tend to be more problematic, i.e. are fallen angels, recently IPOed stocks, etc, and don’t represent typical PE targets, i.e. stable cashflows that can be levered . Naturally $500m today are far less than $500m in 1990, so we could enhance the analysis by adjusting for inflation.

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