Returns from private equity result in part from acquiring assets at lower prices than public alternatives. The required return for a diversified private equity portfolio in an institutional portfolio should be at least 5% above the expected return for public equities.
Once the allocation to private equity has been approved, the sponsor should have in place an internal staff of experienced investment professionals who will set up a structure and create a framework in which investments opportunistically can be made. If re-sources are not sufficiently available, outsourcing the management of the portfolio or using a fund of fund approach should be considered to get access to the best funds and leave time-consuming corporate governance to dedicated experts.
Top-down and bottom-up investing in this asset category goes hand in hand as the sectors (venture capital, buyouts, expansion capital or distressed securities) are as important as geographical and industry selection and are recognised as systematic risk. The primary unsystematic risk and most important decision is still the partnership selection which is obviously key to the final return of the portfolio as discrepancy between top quartile managers and the median exceeds easily 1,000 basis points.
Qualitative risk assessment by performing extensive macro research as well as consequent systematic due diligence on the private equity groups form a key element in the ultimate results. Legal and fiscal issues also play a dominant role in this risk controlled implementation process.
Institutional investors in the private markets cannot count on relatively efficient markets to set fair prices. They must gauge risk themselves and set required, or hurdle rates of return for private equity. Risk forecasts for this asset class are especially challenging because short term returns cannot be calculated due to infrequent partnership valuations. Risk estimates based upon accounting data consistently understates risk. To craft a return/risk model which can support the investment decision quantitatively, parallels can be drawn to the public markets while adjustments should be made for any added risk contributed by financial leverage, illiquidity, or greater business risk.
The primary difference between buyout and publicly quoted companies is the greater use of debt financing in the capital structure of buyout companies. Debt represents 35-40% of assets for the average MSCI Europe industrial company, but 75% of assets for the average buyout company. Via an algebraic procedure, the MSCI Europe, or any other equity index, can be converted into a market-based benchmark with the same risk profile as a buyout company or buyout fund where business and financial risks are mirrored.
Table 1 provides an example of a market-based benchmark for a large buyout fund. The market-based ‘Large Buyout Index’ combines four public market indices and the index weights are unusual in that they include negative values, indicating short positions or borrowing. The weights are selected to convert the capital structure of the MSCI Europe, which has a low debt-to-equity ratio, to a high debt-to-equity structure with significant high yield borrowings typical of buyout companies.
Financial theory tells us that the performance of this benchmark will capture the stock and bond market risks found in a large buyout fund but not the value added that general partners contribute. The large buyout index’s return, which can be calculated for any time period, provides a risk-adjusted required return, or cost of capital, that general partners must exceed to adequately compensate limited partners (investors) for the added market-related risks they take. The market-based benchmark methodology is superior to today’s reliance upon universes of buyout or venture capital returns where success is defined solely as being above the median return.
Private equity markets are growing rapidly as more sponsors express their interest and as more opportunities become available. Unlike the public markets, these investments have not been subject to an underwriting pro-cess or independent analyst assessment. If sponsors are to be involved in the due diligence function, either through gatekeepers or internal staff, they need (1) to measure risk, (2) establish a required return to compensate for risk, and (3) evaluate in-vestments relative to required return instead of universe ranking. Market-based benchmarking should aid in this process.
Arianne Leuftink is vice president at Wilshire Associates in Amsterdam