A workgroup on private equity.

1. CASE 4A – The performance of private equity
Maastricht University
School of Business & Economics
Place & date: Maastricht
September 27, 2017
Name, initials: Hodjeff, TCB , Busch, RS,
Hüttenrauch, N,
Falchetti, EF
Fassmer, SJ
For assessor only
ID number: I6112082, I6112235, I6112390,
I6112826,
I6170814
1. Content
Tutorial group
number
10 2. Language structure
Course code: EBC2054 3. Language accuracy
Sub-group
number:
2 4. Language: Format &
citing/referencing
Writing tutor
name:
Juan Overall:
Writing
assignment:
4A Advisory grade
Assessor’s initials
Our UM email address: t.tatiana@student.maastrichtuniversity.nl,
r.busch@student.maastrichtuniversity.nl​, ​e.falchetti@student.maastrichtuniversity.nl​;
s.fassmer@student.maastrichtuniversity.nl​, n.huttenrauch@student.maastrichtuniversity.nl
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2. Table of Contents
Introduction:................................................................................................................................ 3
Summary statistics:..................................................................................................................... 4
Diversification potential:............................................................................................................. 4
Performance over time:............................................................................................................... 5
Performance on a risk-adjusted basis:......................................................................................... 5
Future Potential........................................................................................................................... 6
Conclusion:................................................................................................................................. 6
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3. 00 ​Introduction
Private equity is a separate investment class from the listed equity. High minimum
investment requirements are hurdle rate for many investors. Typically high net worth
investors and pension fund are the major contributors towards private equity fund. Similar to
mutual funds, a private equity fund is a pooled investment vehicle to make investments in the
best interests of the investors. The investment scope is however much longer compared to
mutual funds, generally from ten to twelve years. Since private equity fund are not registered
with the SEC and are therefore ​not subject to public disclosure requirements. The returns of
private equity firms substantially differ from other investment classes. In the early years the
cash flows are shaped by negative outflows and incoming flows in the later years, this is why
the returns follow a J-curve shape. Investors normally do not know upfront in which firm the
money will be investment. Pension funds as well as high net worth investors use private
equity fund to improve their portfolio diversification. Nonetheless is the performance of these
fund highly correlated to the abilities of the general fund manager.
The crucial intention of this essay is, to asses the overall profitability of private equity funds
and whether it is worth considering this asset class. First, the overall differences and
performance between listed and private equity will be examined. After that the focus will
shift to the second key aspect, whether further diversification can be achieved. Thirdly the
time-periods will be analyzed to see whether the performance of both assets change over
time. The fourth part of the paper will investigate, if private equity outperforms the listed
equity on a risk-adjusted basis. Lastly the future of private equity will be highlighted.
01 Summary statistics
This section of the paper will outline the summary statistics of the US Private Equity Fund
and market index. The sample data provides quarterly returns for these asset classes from
1986 to 2012. For analysis purposes the quarterly returns were annualized. First by looking at
the annual mean of the two return series (table 1 in the appendix), it can be said that private
equity has a higher annual mean return (8.21) than listed equity (6.89). Hence it can be
expected that the volatility of private equity should be proportionally higher compared to the
market. The actual findings however shows that the annualized volatility of the market is
higher. The standard deviation of the market index is 17,45, which is 79% higher; the private
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4. equity index only shows an annual volatility is 9,75. This results in the conclusion that
private equity has an improved risk-return performance. This can also be seen by looking at
the maximas and minimas, the market index shows more extreme values compared to the
private equity index. The maximum return for listed equity is 20,64% whereas private equity
has a lower maximum return of 16,49%. Nonetheless, the most negative return of listed
equity is higher (-24,32) than for listed equity (-15, 35). The minimum and maximum returns
fit therefore to the corresponding volatilities. Furthermore the sharpe ratio is the next variable
that will be outlined and defines the risk-adjusted return over time. In order to calculate the
sharpe ratio a constant risk free rate of 3% is assumed. Private equity has a sharpe ratio of
0,84, which shows that the average annualized return in redundant of the risk free rate 0,84
per unit of volatility. Hence the excess return is 84% higher per unit of risk. The market index
shows also a positive sharpe ratio 0,39 which is significantly lower. However, both
investments shows excess returns per unit of volatility compared to risk free investments. The
maximum drawdown also reflect that general pattern, that private equity outperforms the
market index. The maximum drawdown of private equity is 36,52%, whereas the maximum
drop for the listed equity is 50,24%. The market index reflect therefore compared to private
equity a more extreme volatility.
Concluding it can be said, that just by comparing the summary statistics, private equity
appears to be the dominating asset class, it clearly shows a better risk-return performance.
02 Diversification potential
Diversification plays an important role for investors who decide to allocate their fund in
private equity. Considering that private equity is not directly driven by the efficient market
hypothesis and the listed equity market, the most crucial impact on returns are the overall
macroeconomic developments. The diversification is however marked by the long time
horizon and therefore is not suitable for short term diversification during high volatility
markets. Uncertain cash flows also play an important role, since after legally binding to the
private equity fund, the promised investment has to be paid in after the demand. Hence it can
be the case that several month can pass before the money is demand, the contributions needs
therefore be hold in the form of cash or highly liquid assets,. This can affect the
diversification in a negative way and can suppress returns.
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5. The correlation matrix (Appendix X) shows that the overall correlation between private and
listed equity is neither weak nor strong. The private equity correlates with the listed equity
with a magnitude of 0,70. It is important to remark that the correlation is highly driven by the
macroeconomic factors, when the overall market development is extreme then the two
equities tend to move together. This is illustrated by looking at the financial crises of 2001
and 2008. During the dotcom bubble burst, the correlation between listed and private equity
increased to 0,80. Whereas this correlation is even higher during the sub-prime mortgage
crises, there the correlation peaked at 0,95 (see Appendix XX). Significant macroeconomic
developments affect the listed but also private equity. On the other hand is the effect of
market developments low during less volatile markets.
Summarized can be said, that private equity does increase diversification, but has significant
disadvantages regarding the uncertain cash flows and the long time horizon. Times that are
characterized by non extreme market developments result in an improvement of
diversification. Extreme macroeconomic developments affect the listed as well as the private
equity equally. During those periods is the marginal improvement of diversification relatively
low.
03 Long-term performance evaluation
In order to examine the performance over time of both listed and private equity, we computed
graph 1 (see appendix) with the average returns for the period of 1986-2012. In general, we
can observe that private equity reports significant lower fluctuations in returns than listed
equity. This confirms our claim that private equity is less volatile compared to listed equity
for the whole period. The period from 1997 to 2008 is characterized by significant
macroeconomic events such as the dot-com bubble and the financial crisis. Prior to the burst
of the dot-com bubble, the private equity index had higher returns than the market. Later,
during the period between the two crises, the private equity fund almost consistently
outperformed the market. Again, during the financial crisis, we can observe a decrease in
returns for both private and listed equity. Both listed and private equity have been affected by
the crises, but listed equity suffered more than private equity. Overall, this analysis shows
that private equity provides investors with attractive diversification opportunities as well as
options for market outperformance.
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6. 04 Outperformance of Private Equity
The intention of this paper is to analyse whether private equity outperforms listed equity on a
risk-adjusted basis. In order to answer that statement a multi-factor regression model will be
used. That regression model follows the Fama & French approach by considering the
following three predictors: market, small minus big and high minus low indexes. The Fama &
French model describes the reality better than the capital asset pricing model (Fama &
French, 2012). The multi-factor model is used to assess the exposure of non-listed equity.
Private equity is highly dominated by venture capital funds and leveraged buyouts, these are
comparable to listed equity investments. Venture capital investment can be compared to
small firms with a growth potential and a low book to market value. Buyout can be compared
to growth stocks that are big companies with a high book to market value and have a low
growth perspective (Joost Driessen, 2007). Hence the Fama & French model should be highly
applicable to predict the returns of private equity. The regression output (see Appendix Table
4) shows that the ANOVA test is highly significant at a 1% confidence level. The adjusted
r-square shows that 49,07% of the dependent variable variation can be explained by this
model. Considering that the data consists of real life data from different asset classes over
time is the resulting adjusted r-square moderately high. About half of the dependent variable
variation can be explained. The important parts of the regression are the predictors with their
coefficients and the intersect. The regression model results in a positive intersect, an alpha,
with a annualized magnitude of 5,80%. This shows that the return of the private equity
consistently outperforms listed equity. This result is also statistically significant and the null
hypothesis can be rejected at a 1% confidence level. The market coefficient has the highest
correlation (0,38) of all three predictors and is the only significant coefficient at a one percent
significance level. The high minus low strategy is significantly important only at a 5%
confidence level. The correlation with the private equity index is however non existing. The
small minus big strategy of the Fama & French three factor model does also not show any
significant correlation, since the p-value is insignificant.
Summarized can be said, the Fama & French three-factor model does not perfectly exhibit the
returns of private equity. The three betas of the predictors do not have a strong correlation
towards the returns of private equity, the only beta that shows some significant correlation is
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7. the market index. Nonetheless can be said that private equity outperform listed equity on a
risk-adjusted basis.
05 Our view on the future potential of private equity funds
Investment in private equity experienced a severe growth, especially investments in venture
capital and buyouts. Since 1992, the investment class’ assets have increased from 30 billion
dollars to 4.3 trillion. Moreover, in 2017 Forbes stated that an unprecedented number of
investors are in the process of increasing their allocation to private equity. Private equity
provides a higher return-risk ratio and allows for diversification in an investment portfolio.
Nevertheless, much concern still exists around the transparency of private equity. Increased
transparency will be required in the future. Also, there is a growing threat of increased
competition from corporates. Corporates are often competing against PE funds in the
acquisition of target assets. Due to this high competition, PE funds are finding it harder to
find good deals, and returns will suffer. This is why private equity funds will have to adapt to
the new environment. Overall, based on our analysis, we claim that the future potential of
private equity is positive.
06 Conclusion
This paper has investigated the performance of private equity compared to listed equity. The
summary statistics revealed that on average private equity outperforms listed equity on a
risk-adjusted basis. The overall development of private equity is more stable and less volatile
than listed equity. The regression analysis also supported that with statistically significant
results, the alpha (intersect) revealed to be positive and significant. This shows that private
equity consistently outperforms the listed equity. Diversification can also be achieved by
holding positions in private equity. There are however some drawbacks considering the
uncertain cash flows and the illiquid position. The diversification effect also changes during
volatile and stable times. During stable times is the diversification effect significant, during
stress periods, that are defined by macroeconomic factors, is the diversification effect low.
Overall can be said that the performance of private equity on the basis of risk-adjusted
returns is good. Private equity shows a consistent outperformance of listed equity.
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8. Reference List
Bodie Z., A. Kane and A. Marcus, Essentials of Investments, 9 5 edition, 2013 (BKM)
Forbes (2017). Ten predictions for private equity in 2017. Retrieved from:
https://www.forbes.com/sites/antoinedrean/2017/01/25/ten-predictions-for-private-equity-in-2017/#32
3cbf617db9
Forbes (2016). Private equity is set to grow much bigger. Retrieved from:
https://www.forbes.com/sites/antoinedrean/2016/11/08/private-equity-is-set-to-grow-much-bigger/#57
6e2ec275f5
Private Equity Education Series, UBS Alternative Investments, Parts 1-4, 2011
Sciencedirect (1998) Size, value, and momentum in international stock returns. Retrieved from:
​http://www.sciencedirect.com/science/article/pii/S0304405X12000931
ECB Europe (2007) Estimating the performance of risk exposure of private equity funds: a new
methodology. Retrieved from:
http://www.ecb.europa.eu/events/pdf/conferences/ecbcfs_conf9/PE_estimation_DLP.pdf
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9. Appendix
Table 1: summary statistics
Private equity Listed equity
Annual mean 8.21 6.89
Annual standard deviation 9.75 17.45
Sharpe ratio 0.84 0.39
Maximum 16.49 20.64
minimum -15.35 -24.32
Max drawdown 36.52 50.24
Table 2: correlation analysis
Private equity Market SMB HML
Private equity 1
Market 0.6963 1
SMB 0.3076 0.4585 1
HML -0.2161 -0.1076 0.0566 1
Table 3: correlation analysis during crisis
1999-2003 2006-2009
Listed equity Listed equity
Private equity 0.803 0.952
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10. Table 4: regression statistics
Graph 1: yearly returns of private & listed equity
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11. Graph 2: Portfolio Developments
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