When only the best are good enough
Many arguments have been made for investing in private equity – perhaps the most significant is its potential to outperform the public markets.
Among other factors, this outperformance has been said to be attributable, variously, to the informational inefficiencies that exist in the private marketplace, to the stronger talent pool of managers attracted by the greater incentives on offer, to the impact of active shareholders, or simply to the use of leverage (in the case of buyout, if not venture, funds). Furthermore, it has been said that low correlation between private equity investments and the public markets can provide important diversification benefits in managing a portfolio.
This article proposes a fresh methodology for comparing private and public markets and uses it to chart the relative performance of the two asset classes over a 20 year period. It also compares the performance of top quartile private equity funds with the private equity market as a whole.
The results when this methodology is applied demonstrate that the need to benchmark private equity is perhaps greater than in any other asset class, given the far wider disparity of the returns its best and worst players can produce. They also show that if an investor in private equity funds fails to outperform significantly the private equity market as a whole then the likelihood is that its portfolio is also falling short of the quoted index in returns. Should such a shortfall occur, the question arises whether it is worthwhile for such an investor to allocate the substantial financial and human resources required to access private equity.
To undertake this analysis we used performance data for private equity from Venture Economics. This is an incomplete and un-audited dataset; however it is, to our mind, the largest set of private equity fund performance data in existence. We have used the data for all US private equity funds raised between 1983 and 2002. We chose the US because we believe the Venture Economics data for the US to be more comprehensive than the data for Europe, especially with regards to earlier funds. For our public comparator we selected the MSCI USA Index, which aims to capture 85% of the free-float capitalisation of the US quoted universe.
We used the total return index, which includes the reinvestment of gross dividends.
One of the problems in accurately comparing private and public equities is that investors are exposed to them in profoundly different ways. The public market investor, even if investing through an independently managed vehicle, retains macro control over investment and distribution timing. By contrast, the private equity fund investor relinquishes this control at the point of commitment for a period of up to 12 years.
The investor receives unpredictably timed distributions that need to be re-invested in order to keep all of its assets at work. A private equity investor cannot simply keep its un-drawn commitments and any distributions on cash deposit for the duration of the fund’s life or its returns, in IRR terms, may be significantly diluted.
We attempted to construct a private equity index that behaved like a quoted total return index, ie, with a single investment point and a single valuation point, without interim investment or distribution. We committed a single amount (spread pro rata across all the private equity funds raised) in one vintage year and then simply re-committed each year’s distributions to the next vintage year. However, re-committing is not the same as re-investing and over time an idle cash balance builds up, while in the quoted index capital is never redeemed and dividends are re-invested instantly, allowing all assets to work all the time. In private equity portfolio management, ensuring that the maximum amount of a portfolio’s assets is actually invested, whilst maintaining the free cash flow to meet drawdown notices, is a perennial problem.
Many investors try to combat this through a planned over-commitment strategy. We could not adopt such a strategy in building a private equity index since it may not eliminate the idle cash balance altogether and, if it does, there is a risk it will leave insufficient cash to fund draw-downs.
Instead of constructing a private equity index that mimics a quoted index we turned to constructing a quoted index that mimics private equity’s unpredictable behaviour. We took the pooled private equity cash flows for all funds raised in a particular vintage year and invested the same amounts at the same times to acquire units in the MSCI index. Whenever there was a private equity distribution, whatever proportion that distribution bore to the total eventual distributions, we sold an identical proportion of the quoted index units we were ultimately to acquire. In this way our assets were exposed to the quoted markets for the same durations and in the same proportions as they would have been held by the private equity managers. All unrealised private equity assets were assumed to have the valuation given to them by their managers at December 2002. All quoted index units were deemed to have their market value at December 2002.
The results are displayed graphically in Figure 1. We have shown the multiple of investment that would have been achieved as at December 2002 by investing in an identical way in the two different asset classes. We have also displayed two ‘total’ data points that average the entire 20 year period. The ‘weighted total’ pools the actual cash flows of these 20 vintages and, because of the very significant increase in investment in the late 1990s and 2000, gives these vintages greater weight than earlier ones. The ‘straight’ total gives equal weight to the performance of each vintage year, as if the same amount had been committed to each.
The results of this benchmarking exercise are stark, in two ways: first, the quoted index out-performs the private equity returns over the period, both on a straight and weighted basis, and second, there appears to be a high degree of correlation between the two. If investors are looking to the private equity markets for out-performance and diversification from the public markets, they are unlikely to be satisfied on either count.
It should be noted that part of the reason for apparent lower performance in more recent vintage years is the immaturity of those investments; this is also demonstrated by the much higher proportion of residual (unrealised) value in the later vintages. We have used multiple of cost rather than IRR as our relative measure, since our quoted investment timescales have been matched to the private equity timescales. This means that a direct capital comparison is appropriate within each vintage year. However, it is inappropriate to make a direct capital comparison between different vintage years as the durations differ.
There are two main caveats to these results: first, by using the investment and divestment timing of the private equity managers to inform our quoted investment benchmark it might be said that we are benefiting from a particular skill set of the private equity manager – that of market timing. We informally tested this hypothesis by applying a single standardised private equity drawdown and distribution schedule to the quoted index beginning in a number of vintage years. There did appear to be a slight drop in performance (around 1% in IRR terms) compared to investing in the MSCI index with the timing that was actually employed by the managers. This suggests that there may be some genuine timing skill being exercised by the private equity managers.
The other caveat is that part of the reason why some of the older vintages appear to under-perform the quoted market by so much is that a residual non-performing rump of 5-10% of assets by value have remained undistributed even at December 2002. Therefore, according to our methodology, a similar proportion of quoted units have remained invested until that date. These units have performed well and, given the substantial time period, have generated significant compounded returns.
Although this explains some of the out-performance there is no reason, in our view, for adjusting the methodology to exclude it.
Another issue that should be considered is that of leverage: the degree of gearing in buyout investments is usually significantly higher than in quoted companies. Were we to leverage our investments in the quoted index similarly, we might enhance or depress our quoted returns (depending on whether our cost of borrowing is below or above the unleveraged quoted return). However, higher gearing is not typically used with venture investments. Since this analysis combines both buyout and venture funds we did not consider it appropriate to test the effect of leverage here, although we certainly intend to include it in future separate analyses of buyout funds.
Despite the relatively unimpressive returns of the private equity market taken as a whole, there is another attraction to private equity investing that continues to make it popular and gives the potential for real out-performance. The same inefficiency that makes buying private companies attractive to private equity fund mangers makes investing in private equity funds attractive to sophisticated investors. Many LPs claim to be uninterested in simply tracking the private equity market, and our benchmarking exercise above suggests that they are right to set their sights a little higher. They claim to be able to select top quartile funds by employing their experience, proprietary research and privileged access in a way that would be almost impossible in the public markets.
To test whether faith in the best-performing private equity managers is misplaced, we revised our benchmarking exercise above to include only top quartile private equity funds and, using the timing of the cash flows of these funds, bought and sold units in our MSCI index. Theresults are detailed in Figure 2.
Not only is the top quartile of private equity performance generally significantly better than the quoted index, but the degree of observable correlation is lower. Indeed, the correlation coefficient with the MSCI is 0.50 for the top quartile of private equity as opposed to 0.85 for all private equity.
So it appears that the claims of out-performance and low correlation can be supported by the empirical evidence – but only if we are dealing with the top quartile of private equity funds. The questions remain: can the investors who claim to able to select only the best funds, consistently achieve this goal? If so, is the inefficiency that creates such a competitive advantage sustainable?
Laurence Zage is head of research at Helix Associates in London