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Risk and Expected Returns of Private Equity Investments - Evidence Based on Market Prices

Risk and Expected Returns of Private Equity Investments - Evidence Based on Market Prices. Narasimhan Jegadeesh Goizueta BS, Emory University and NBER Roman Kräussl VU University Amsterdam Joshua Pollet Goizueta BS, Emory University 12 October 2009 @ Inquire Europe.

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Risk and Expected Returns of Private Equity Investments - Evidence Based on Market Prices

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  1. Risk and Expected Returns of Private Equity Investments -Evidence Based on Market Prices Narasimhan Jegadeesh Goizueta BS, Emory University and NBER Roman Kräussl VU University Amsterdam Joshua Pollet Goizueta BS, Emory University 12 October 2009 @ Inquire Europe

  2. Innovation / Contribution First study that uses market prices (objective measure) to estimate the true risk and expected return on PE investments Previous research provided (just) interesting insights into past performances of PE funds But investors are interested what they can expect to earn in the long run through PE investments Unique database of 710 listed private equity vehicles Sample free from selection bias and survivorship bias We determine the value of PE investments from market prices and have not to rely on self-reported data for valuation Construction of first and transparent (L)PE index 2

  3. The Private Equity Market Conventional “wisdom” in investor community: PE investments promise high returns and low correlation with other asset classes; vital hedging opportunities NVCA reports strong long-term performance: 20-year period ending 2005, PE funds averaged annual return of 14.3% after fees, outperforming both S&P 500 (11.2%) and NASDAQ (12.6%) Large institutional investors increasingly looking to private equity to diversify their portfolio Capital committed to PE investments increased from $5 billion in 1980 to over $3 trillion as of September 2008 Biggest growth in AUM over 2000s: HF and PE funds 3

  4. Prior Literature I Gompers and Lerner (1997, 2000, JFE): PE investments adds substantial value to portfolio; 5% abnormal returns Ljungqvist and Richardson (2003, NBER WP): S&P 500 outperformance by more than 5% Kaplan and Schoar (2005, JF) report 6% to 8% abnormal returns Cochrane (2005, JFE): 32% abnormal returns Phalippou and Gottschalg (2009, RFS): previous optimistic results triggered by biased sample (just liquidated funds); PE funds underperform S&P 500 after fees by -6% to -3% Wide range of historical return estimates 4

  5. Prior Literature II All previous studies focus exclusively on non-listed PE funds Value of investments in PE is not known publicly at all times (just at start of investment, new funding round, and at exit) No directly beta estimates for unlisted PE funds are available in the literature since market prices are unobservable No single binding standard for valuing unrealized investments exists; previous studies estimate cost of capital based on: Industry betas Post-IPO betas Estimate from constructed PE indices (sensitive to assumptions) Previous findings: Betas range from .5 to 4.66 !! Lack of widely accepted PE performance benchmark 5

  6. Prior Literature III All samples subject to selection bias and survivorship bias Organized as LPs, PE funds are not required to report results (voluntary information through databases, e.g. Thomson VE) Self-reported data: Poorly performing funds may not make it into database; stale pricing, aggregation of data (backfilling) Statistical methods used to correct for survivorship bias are very sensitive to assumptions Non-exited funds valued based on funds’ estimate of terminal value likely to be overstated Performance results highly subjective 6

  7. Listed Private Equity Definition: LPEs are vehicles in which the underlying business is PE investments but LPEs themselves are quoted on an exchange Evergreen: LPEs continually invest and reinvest; no fixed lifespan New buzzword in WS/City: permanent capital; recent years have seen numerous PE companies getting listed, e.g. KKR, 3i, Blackstone LPEs offer wide range of PE strategies and investment styles Investors’ 3 substantial advantages over traditional PE investments Accessibility Transparency Liquidity Plus: Availability of daily market prices allows to assess performance (risk & return characteristics) with standard finance methodologies 7

  8. Data I Starting point: Collection of potential LPEs from numerous sources to overcome sample selection bias and survivorship bias Databases: Thomson VE, VentureXpert, SDC Platinum; Dow Jones LP Source, DJ Galante, DJ PE Analyst; PREQIN Bloomberg and Reuters Stock exchanges Reports by NVCA, EVCA, BVCA, etc. Industry reports by PE analysts: JPMorgan CAZENOVE (Chris Brown), RBS (Mark James), among others 12,500 potential LPEs 2nd step: Matching with Thomson Financial Datastream 1,400 listed vehicles potentially active in PE 8

  9. Data II 3rd step: Decision on LPE LPE: Listed vehicles whose core activity is the provision of PE capital 3 categories of organizational structure: (1) LPE companies; (2) LPE funds; (3) LPE funds of funds Checking by hand: Websites, annual reports, IPO prospectuses 4th step: Matching with Thomson Financial Datastream Elimination of all LPEs without full pricing information (e.g. volumes) Unique database 710 LPEs (incl. 13.4% dead) Free of sample selection and survivorship bias Listed on various exchanges around the world; entire range of financing stages and investment strategies including geographical and sector exposure (numerous classifiers) 9

  10. LPE Universe • Sample of 710 LPEs, 1988 - 2008 • Number of listed vehicles (RHS); market cap in USD billions (LHS) • Highly pro-cyclical market 10

  11. Data III Final step: Liquidity requirements - LPEs have to meet 4 liquidity criteria (at moment of rebalancing of LPE index) Minimum number of price observations available over the year prior to rebalancing: 150 Maximum bid-ask spread: 4% Minimum average market capitalization: $20m Minimum average trade volume relative to market cap: 0.06% 11

  12. LPE Sample 129 listed private equity funds (LPEs): Closed-end funds that invest in PE and trade on exchanges Similarities between LPEs and unlisted PE funds Both invest in private equity (same opportunity set) Both charge similar management and performance fees Differences PEs: not exposed to agency costs associated with diffusely owned publicly traded firms PEs: fixed lifespan (LPEs evergreen); commitment to return fund to investors, reputational concerns (follow-up funds) Expected returns on LPEs likely provide a lower bound on expected returns on PE funds 12

  13. LPE Sample Statistics I 13

  14. LPE Sample Statistics II 14

  15. LPE Sample Statistics III 15

  16. Construction of the LPE Index I Construction of LPE total return index 129 LPE funds; have to fulfill 4 liquidity criteria Total return series obtained from Datastream (dividends reinvested) Period: January 1, 1989 to December 31, 2008 Monthly frequency One value-weighted: weights determined by relative market cap; vary a lot: VW allocates excessive weight to only a few LPEs One equally weighted: weights determined by 1/n LPE indices rebalanced semi-annually (end-June, end-December) 40 rebalancing moments: 12/1988 to 06/2008 16

  17. Construction of the LPE Index II LPE Index, 1989 - 2008 17

  18. Performance Analysis I Table: Return Statistics, 1989 - 2008 18

  19. Performance Analysis II What are the asset pricing risks of PE investments? Period 1994 to 2008, 180 monthly observations Systematic risk: CAPM and Fama-French and Carhart four-factor models : fund index return : risk-free rate, 1m T-bills SMB, HML, MOM: size, book-to-market, and momentum factor portfolios, obtained from Ken French’s website (no international factors) 19

  20. Performance Analysis III 20

  21. Performance Analysis IV 21

  22. Performance Analysis V PE fund returns move in tandem with standard asset classes such as stocks and bonds (only limited market downside risk hedging) Very high betas of .84 (MSCI World) and .71 (S&P 500) SMB: LPEs behave more like small firms than large firms; many PE investments in firms that are smaller than typically listed firm HML: LPEs more sensitive to value than growth firms; significant investments in buyouts (value); separate regressions VC funds not sensitive to growth factor Negative alphas: Market not surprised ex-post by performance of PE funds 22

  23. LPEs and the Economic Environment I Sensitivity to macroeconomic conditions Where : percentage real GDP growth Higher growth attracts more PE financing/investments; might have negative impact on performance, “money chasing deals” (Gompers and Lerner, 2000, JFE) Expected net effect: unclear : yield spread on BAA and AAA rated corporate bonds Indicator of business conditions; measure of ease of borrowing money; ability to go public (risk-financing, hot issue markets) Credit spread is countercyclical (Koopman et al., 2009, JEF); Fama (1990, JF): widening spread signals deteriorating business conditions Expected net effect: neg. relation between performance and spread 23

  24. LPEs and the Economic Environment II 24

  25. LPEs and the Economic Environment III LPE fund returns exhibit positive correlation with GDP growth and negative correlation with credit spread PE investments seem not to provide a substantial hedge in downturn markets Neither based on asset pricing risk characteristics nor on widening credit spreads PE fund returns “flow” with the market 25

  26. (L)PE Index? I Do market prices have the ability to predict unlisted PE funds’ self-reported NAV changes? Does this niche market (LPEs total 5% of PE investments) has similar characteristics to traditional/unlisted PE investments? Can we assume our LPE index mirrors the overall PE market? Private Equity Performance Index (PEPI) Published by NVCA in cooperation with Thomson Financial based on PE data from Thomson ONE Banker Based on 1,900 unlisted U.S. PE funds 26

  27. (L)PE Index? II Partial adjustment hypothesis (PAH) Self-reported book values by unlisted PE funds may not reflect changes in their market values in a timely manner; may only partially adjust to changes in their true value Phalippou and Gottschalg (2009, RFS): Self-reported book values tend to be overstated LPE index should be able to predict changes in PEPI under PAH Delayed adjustment hypothesis / lead-lag relation Relation between PEPI returns (LHS) and contemporaneous and lagged values of MSCI World index returns and LPE index returns (RHS) PEPI published 4x a year; quarterly regressions, 1994 to 2008 27

  28. (L)PE Index? III Figure 1. Listed private equity index and PEPI index, 1994 -2008 28

  29. (L)PE Index? IV 29

  30. (L)PE Index? V Delayed adjustment hypothesis supported Both lagged MSCI World and LPE index returns are substantial for predicting PEPI returns Contemporaneous and lagged market prices predict future changes in self-reported NAVs LPE index is a good proxy/benchmark for expected performance of the PE industry (L)PE Index = PE Index 30

  31. Summing Up LPE and unlisted PE (PEPI index) generate no significant return differences (see paper) Market expects 0% to marginally negative abnormal returns for PE investments (see paper) More extreme abnormal returns found in the literature do not reflect market’s expectations of future long term returns (e.g. 32% Cochrane (2005) due to survivorship bias, sample selection bias) Betas of PE investments close to 1 Sensitive to Fama-French SMB factor Sensitive to GDP growth (+) and credit spread (-) Only limited hedging potential of PE investments Market prices predict future changes in self-reported NAVs LPE index serves as solid benchmark for overall PE industry 31

  32. Thanks for your attention and Inquire Europe for research funding Feedback welcome Roman Kräussl Associate Professor of Finance VU University Amsterdam rkraeussl@feweb.vu.nl

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