The return on private equity (PE) investment is not reliable or predictable. Many of my clients are ready to accept these as true. But it is difficult to dispel the resilience of the PE sector to a private equity myth.
Unlike other asset classes, the legend says, private equity can weather the ambiguity of the economic cycle.
Myth III: Private Equity Performance Elastic
Where does this popular belief come from? This comes in part because some practitioners believe (and report) that PE is not related to the public market.
As an idea, the reciprocity is simple enough. When the value of assets moves in the same direction at the same time, they are positively related. If they move in the opposite direction, they are negatively related. If they are consistently out of sync, their correlation is low. Two assets are considered to be fully correlated with fully saturated price movements with a correlation of class 1 or 100%. On the other hand completely incomplete assets have a coefficient of 0, or 0%. A portfolio of price movements that has nothing to do with the public market is market neutral. A person with a positive correlation is called a positive beta portfolio.
There is no reciprocity or relationship, that is the question
So what is the relationship between the public market and private equity?
The May 2020 Ernst & Young (E&Y) report, “Why Private Equity Can Endure the Next Economic Recession,” made a startling claim about the PE sector:
“The industry’s long track record of strong, incomplete returns is now widely acclaimed across the investment community.”
This is not the first time that E&Y has made the point.
“We find evidence that PE returns are in the slightest unrelated to other asset classes. . . . As a result, PE remains attractive for institutional investors looking for diversification, ”E & Y’s“ Global Private Equity Watch 2013 ”report said. They added that the correlation between private equity was “about 30% to 40% with equity.”
E&Y offered little detail to substantiate his decision, but such an ish on the subject of PE is inconsistent with most academic literature on the subject.
High relationship with the public market
“In European Private Equity Funds – A Cash Flow Based Performance Analysis,” by Christian Dealer and Christoph Cassar The approximate relationship between about 800 European PE funds and PE and the public benchmark (MSCI Europe) is based on the 0.8 public market equivalent (PME).
“Other studies have shown that private-equity returns have become highly correlated with the public market,“Personal equity: changing perceptions and new realities,” three authors noted in the McKinsey study. “
These findings come from a white paper by Asset Manager Capital Dynamics: “Over the past 15 years, the average correlation between European and US buyout markets and public equity has been 80%.”
Although the authors state that “since 2014, the correlation has been on a downward trend (88% to 75%), highlighting the diversification benefits of personal equity,” the downward move actually occurred between 2014 and 2016. So it is a very short period of time to reach a meaningful conclusion. The trend may only be temporary.
The paper has another drawback, which we saw in the first part: the sample is small – covering only 340 US and European buyout funds. So it may not be representative of the PE fund universe.
Richard M. in the upcoming “Endowment Performance”. Ennis, CFA, examined 43 returns of the largest personal endowment. He observed that in the 11 years ending June 30, 2019, private equity was highly correlated with public stocks and offered no diversification benefits.
In the face of conflicting evidence, E & Y’s statement is difficult to support. Indeed, there is a simple explanation for PE’s high relationship to public equity.
Public evaluation as comparative
PE firms value their portfolio assets based on comparative analysis. Since asset values are in line with public comparisons, they are attached to them. There is no better way to relate to two asset classes than to use the other as a reference point. Why doesn’t PE show the perfect relationship? This is because PE fund managers pay quarterly prices to their portfolios rather than daily.
But that’s not all. In the first three months of 2020, the public market experienced extreme instability. The S&P 500 and Russell 2000 indices fell 20.5% and 1%, respectively, for the quarter ended March 31, 2020. As a result in April and May, Blackstone’s PE segment’s valuation fell 22%, as did Apollo. KKR decreased by 12% and Carlyle by 8%. These results confirm a high correlation between private equity and the public market.
Research firm Triago has reviewed all first-quarter reports of private capital fund managers across private equity, credit, growth, real estate and venture capital. It found that the sector has seen a net asset value (NAV) decline of 7.2%, which is more than 20% for most global stock market indices. Why are fund managers reporting less volatility and fluctuations in the NAV than in the public market? There are two main reasons:
First, the decline in “recorded” valuations was less pronounced because fund managers reported their quarterly figures in late April and early May, Later Unprecedented government securities and large-scale printing by the central bank helped revive the public market. The S&P 500 index rose 18% in April, halving its year-to-date decline to just 10% for the first four months of 2020.
So private capital fund managers used a much higher comparative mark than they reported on March 31, 2020. They have been soft on identifying their portfolios since public valuations overstated in March. They can wait a few weeks before reporting the value of their underlying assets to investors. Public stocks, which are quoted daily, lacked this facility. In fact, as of March 1, 2020, shares of Apollo and Carlyle were up 2 %% and shares of Blackstone and KKR were down 1 %% from the previous quarter. So public investors did not, in fact, consider the PE business model to be all that elastic.
The second reason goes without saying: the quarterly reports of PE fund managers are not audited. So no independent third party reviews their numbers. Unlike public stock indexes, with their openly available and market-tested price information, private capital provides its own information. Even the annual audited numbers depend on the in-depth knowledge of the underlying portfolio assets of the fund managers. Auditors will always have difficulty judging the underlying value of these assets.
If there is any doubt that PE managers return if the public market is good, a paper by researchers from the Sloan School of Management at State Street and the Massachusetts Institute of Technology (MIT) puts it to rest. The authors explain that buyout fund managers have some prudence in calculating the effectiveness of investments and are influenced by the public equity gains posted after the end of a quarter. When public markets move upwards later, PE executives rate their own performance higher in the last quarter, as they did in the first quarter of 2020.
The Private Equity Index on the State Street Global Exchange represents more than half of all global PE assets, and the authors use these company-level data to prove that valuations were higher when public markets performed well after the end of the quarter. But when subsequent public market performance declined, the valuation was not affected. The authors reach a diplomatic conclusion: “We do not claim that this behavior is intentional…. It is very reasonable that private equity managers subconsciously make positive biased assessments because they are optimistic.
Although researchers have given practitioners the benefit of the doubt as to whether this positive diagonal approach is intentional, their findings further provide evidence that some PE fund managers may manipulate performance data.
“Private equity managers are not interested in biased appraisals when faced with an audit,” they wrote. “For example, we should expect private equity production to return on average more than the public market in the first three quarters compared to the fourth quarter.” The audit is done systematically towards the end of the year, i.e. in the fourth quarter.
Thus, E & Y’s approach is not consistent with industry research. To be sure, the firm probably wanted to emphasize the sector’s resilience, adding in its March 2020 report that “private equity is infinitely adaptable.” Capitalism is not alone in the development of plasticity.
High failure rate
When was the last time you heard of PE funds failing? The absence or relative lack of funding closures is another data point that seems to support the ability of the asset class to stay.
But he also has a good reason. Fund managers know their public relations. They use PR when setting up shop, but tend not to make any public disclosures when closing.
In the spring of 2018, not a single major financial newspaper reported on the liquidation of Candover Investments plc. Why the lack of coverage? Because after raising funds in 2011, the firm effectively became a shell company. After years of inactivity, Candover fell off the radar of journalists. It was a similar story with New York-based LBO firm Fortman Little. Fortsman Little announced that it would stop raising new funds in 2004 and stop trading in little media coverage a decade later.
So again, conventional views about private equity are fundamentally wrong. PE returns are highly correlated with public markets and PE firms go out of business. Frequently. Following the global financial crisis, for example, according to Bain & Company’s February 2020 Global Private Equity Report, 25% of PE firms have failed to raise funds. Such creative destruction rarely proves that personal wealth is more resilient than other wealth classes, but quite the opposite.
If you liked this post, be sure to subscribe Entrepreneurial investors.
All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Photo Credit: © Getty Images / Coryford