By Andrew Lebus
One of the much touted benefits of investing in private equity was its low correlation to other asset classes, particularly public equities. Thus private equity made its way into many institutional asset allocations in the 1990s because of its presumed diversifying effect within portfolios. To some extent this was correct; valuations of private equity investments were, at that point, generally held at cost until an actual realisation event. Specifically, they were not adjusted up or down even in rising or falling equity markets. The theory was that illiquidity made private equity not only “alternative” but also uncorrelated.
In 2007 new accounting standards forced managers to mark-to-market their investments and it soon became apparent that private and public equity were indeed correlated – highly correlated in fact. A tumbling global equity market made private equity valuations fall and the “ah-ha” moment occurred – public equity and private equity are the same corporate assets subject to the same company-specific issues and macro-economic trends. The historic lack of private equity valuation adjustments had created the false perception of uncorrelated returns, and with this new insight, private equity’s ability to diversify was discredited.
So, if private equity offers few diversification benefits, why should investors bother to include this illiquid asset class in their portfolios?
To paraphrase a famous US presidential campaign theme, “It’s the alpha, stupid!”
For over 30 years, quality private equity managers have proven that they can generate excess returns on a risk-adjusted basis. They do this by improving the operations and management of their portfolio companies, optimising the alignment of management incentives, introducing initiatives to grow revenues and optimise margins, expand overseas and re-investing cash flow at the expense of short-term earnings. It’s an activist ownership model on steroids that public ownership typically can’t deliver. Private equity’s alpha is the component of performance that cannot be replicated by simply leveraging a portfolio of publicly traded securities.
The concept of alpha is often misunderstood with respect to private equity, so here’s a simple illustration. Top quartile funds are expected to have higher risk adjusted returns than bottom quartile funds.
So, while private equity may have much more limited diversification benefits than initially thought, a portfolio of top quartile funds adds significantly to the return profile of a portfolio if investors are able to consistently pick the best managers.
But how can investors determine that a fund will be top quartile? Fortunately, the techniques that specialist private equity fund investors employ enable them to get to the heart of the matter by isolating and analysing the manager skills responsible for prior performance as well as the likelihood of a manager’s ability to replicate them. Then, absent a significant unexpected change in the firm’s talent pool, their out-performance tends to be persistent (Kaplan and Schoar, 2005)*. As a result, without some exogenous factor, with private equity investing past performance is generally a good predictor of future results.
Professionals use numerous dimensions to evaluate manager capability – from alignment of interest and turnover to investment team talent and organisational dynamics.
The key tool used to evaluate private equity manager skill is the construction and analysis of a “value bridge” for historical investments. In essence, the value bridge breaks down the various components of how a manager created value in an investment from the point of entry to the point of exit namely: revenue growth, margin improvement, debt pay down, dividends, multiple expansion and FX movement.
The most replicable elements of value creation are those over which the manager has control, so the impact of revenue growth and margin improvement are usually the most important. However, a manager can also impact other elements, such as multiple expansion, where executing a buy-and-build or other strategy could allow for a re-rating of a company in terms of its valuation multiple.
If you expend the time and effort to analyse each of the transactions in a managers’ track record, you will have developed a good idea of whether they will be able to give you the alpha that private equity is capable of providing.
* The journal of finance, Volume LX No. 4. August 2005. “Private Equity Performance Returns. Persistence and Capital Flows” by Steven N. Kaplan and Antoinette Schoar.
Andrew Lebus is managing partner at Pantheon International Participations
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