Risk and Expected Returns of Private Equity Investments: Evidence Based on Market Prices (original) (raw)
Risk governance & control: financial markets & institutions, 2013
A number of scholars of private equity (“PE”) have sought to assess the performance of PE firms by adopting an ex-post perspective of asset pricing. In doing so a set of phenomena has been recognized that is thought to be specific to the PE sector. However, by continuing to draw on an ex-post perspective few scholars have considered the possible extent to which PE phenomena may affect expected returns from investments. To address this issue this article draws on an ex-ante perspective of investment decision-making in suggesting how a number of drivers and factors of PE phenomena may produce “abnormal returns”, and that each of those drivers and factors should therefore be considered in accurately assessing the required risk premium and expected abnormal returns of PE investments. Based on research of a PE investment in Italy and a telephone questionnaire to 40 PE firms in Italy and the UK the article suggests principally that while size is the most important driver in producing abnormal returns, illiquidity alone cannot explain the expected returns of PE investments. A predictive model of PE decision-making was then developed that draws on an ex-ante perspective of asset pricing and takes into account PE phenomena and abnormal returns.
What Really Drives Risk Premium and Abnormal Returns in Private Equity Funds? A New Perspective
Journal of Private Equity, 2013
In the past two decades a number of private equity scholars have attempted to assess the ex-post returns (performance) of private equity funds (PEs). Such studies have produced contradictory conclusions that have included a wide spread of abnormal realized returns ranging from -6% (Phalippou & Gottschalg, [2009]) to 32% (Cochrane, [2005]). Moreover, this research has been concerned with assessing realized returns instead of the required risk-premium. By contrast, more recent research on the performance of PEs has found a set of phenomena unique to the PE sector that influences performance, and this research suggests that illiquidity is an important, additional factor to include in asset pricing models. This article seeks to critique and draw together the various strains of research on the performance of PEs to help managers understand the drivers and determinants of risk-premium and expected abnormal returns in PE investments. A model is proposed that will allow PE managers to identify the drivers and determinants of their investments, thus enabling a more rational and thorough approach in defining portfolios and assessing deals.
Risks, Returns, and Optimal Holdings of Private Equity: A Survey of Existing Approaches
CFA Digest, 2014
We survey the academic literature that examines the risks and returns of private equity (PE) investments, optimal PE allocation, and compensation contracts for PE firms. The irregular nature and limited data of PE investments complicate the estimation and interpretation of standard risk and return measures. These complications have led to substantial disparity in performance estimates reported across studies. Moreover, studies suggest that the illiquidity and transaction costs inherent in PE investments have substantial implications for optimal holdings of these assets. While incentive fees in PE address moral hazard and information agency problems, total fees in PE investments are large and incentive fees account for a minority of total compensation.
Giants at the Gate: On the Cross-Section of Private Equity Investment Returns
SSRN Electronic Journal, 2000
We examine the determinants of private equity returns using a newly constructed database of 7,500 investments worldwide over forty years. The median investment IRR (PME) is 21% (1.3), gross of fees. One in ten investments goes bankrupt, whereas one in four has an IRR above 50%. Only one in eight investments is held for less than 2 years, but such investments have the highest returns. The scale of private equity firms is a significant driver of returns: investments held at times of a high number of simultaneous investments underperform substantially. The median IRR is 36% in the lowest scale decile and 16% in the highest. Results survive robustness tests. Diseconomies of scale are linked to firm structure: independent firms, less hierarchical firms, and those with managers of similar professional backgrounds exhibit smaller diseconomies of scale.
The Private Equity Market: An Overveiw
Financial Markets, Institutions and Instruments, 1997
The private equity market is an important source of funds for start-up firms, private middle-market firms, firms in financial distress, and public firms seeking buyout financing. Over the past fifteen years it has been the fastest growing corporate finance market, by an order of magnitude over the public equity and public and private bond markets. Despite its dramatic growth and increased significance for corporate finance, the private equity market has received little attention. This study examines the economic foundations of the private equity market, analyzes its development and current role in corporate finance, and describes the market's institutional structure. It examines the reasons for the market's explosive growth over the past fifteen years and highlights the main characteristics of that growth. It provides data on returns to private equity investors and analyzes the major secular and cyclical influences on returns. It describes the important investors, intermediaries, issuers, and agents in the market and their interactions with each other. Drawing on data from trade journals, the study also estimates the market's size as of year-end 1995. 1 Some studies of particular sectors of the market, such as venture capital, and leveraged buyouts of large public companies, have been made. On venture capital, see Sahlman (1990) and special issues of Financial Management (Autumn 1994) and The Financier (May 1994). For a summary of the LBO literature, see Jensen (1994).
Leaving Money on the Table: A Theory of Private Equity Fund Returns
2011
Evidence indicates that private equity funds, unlike mutual funds, deliver persistent abnormal returns and that top performing funds are often oversubscribed. Why do private equity funds appear to leave money on the table, rather than, say, increasing fund size or fees? We argue that private equity funds are fundamentally different from mutual funds because their success is contingent on matching with high quality entrepreneurial firms, and these firms are looking to match with high ability managers. When entrepreneurs cannot distinguish managers' ability to add value from managers ability to select good firms, fund manager exerts more effort to select firms. They do this in order to manipulate entrepreneurs' beliefs about managerial ability to add value, even though firms are not fooled in equilibrium. The model provides several novel time series and cross sectional predictions about performance persistence, fund structure in addition to addressing the questions raised above.
Private Equity: Its Role in Portfolio Optimization
2017
Alternative investments have increasingly been used to complement a traditional portfolio of stocks and bonds. Among them, Private Equity is found to be able to provide diversification benefits and higher expected returns. This study uses the traditional mean-variance portfolio optimization process with several inputs: "equilibrium" returns for the traditional assets as a neutral starting point generated by the Black-Litterman model; and a range of expected returns of private equity fund types. We find that private equity funds in earlier stages are more suitable for investors seeking higher expected returns and with higher levels of risk appetite, while private equity in later stages are more suitable for investors with lower risk appetite, seeking for more modest levels of returns. In both cases, it is notable that the portfolio gains efficiency after the inclusion of private equity. The diversification benefits from low correlations are also observed.
Private investment and public equity returns
Journal of Economics and Business, 2012
Because of external financing costs, private business owners often need to self-finance new investment projects. These self-financing needs create an incentive for business owners to hold financial assets whose payoffs are positively correlated with self-financing needs. If this effect is aggregated, expected returns on financial assets should be negatively correlated with aggregate private investment self-financing needs. To test the cross-sectional asset pricing implications of this conjecture, we use realized noncorporate investment growth and future forecasted noncorporate investment growth as proxies for self-financing needs. We find that our private investment model can explain a good share of the cross-sectional returns of size-, value-and distress-sorted equity portfolios, almost as well as the Fama-French factors. In contrast to the Fama-French model, however, we find the signs on our estimated coefficients to be consistent with our theoretical predictions.
Journal of Modern Accounting and Auditing, 2015
Over the last decade, the private equity (PE) industry, primarily venture capital and leveraged buyout investments, has matured massively. Consequently, public interest towards that particular asset class has increased rapidly. This study seeks to empirically assess the determinants of private equity funds' (PEFs) performance around the world. The study comprises a panel data of 103 publicly traded PEFs globally for the period of 2007-2013. Generalized least squares (GLS) technique is employed to regress the explanatory variables. The objective is accentuated on the major contributing factors that make a PEF successful. The analysis, in this paper, examines the effect of fund size, investment size, geographical focus, and industrial specialization on return. The empirical results provide evidence that: (1) Fund size and industrial specialization were observed to have an insignificant influence on the funds' returns in our panels; (2) Investment size is positively related to fund performance, indicating that larger deal sizes exhibited superior performance level; and (3) Geographical focus exhibited a negative association with fund performance, leading to the conclusion that limited geographical deployment of funds or absence of market diversification resulted in a fall in funds' returns. Consequently, to proxy for return of funds, stock prices of listed PEFs under LPEQ listings were employed.
The economics of the private equity market
Staff Studies, 1995
The private equity market has become an important source of funds for start-up firms, private middle-market firms, firms in financial distress, and public firms seeking buyout financing. Between 1980 and 1994, the amount of private equity outstanding rose from less than $5 billion to ...
Investor Scale and Performance in Private Equity Investments
SSRN Electronic Journal, 2012
We document that defined benefit pension plans with significant holdings in private equity (PE) earn substantially greater returns than plans with small holdings in both the 1990s and the 2000s. A one standard deviation increase in PE holdings is associated with 4% greater returns per year. Up to one third of this outperformance comes from lower costs that we link to economizing on costly intermediation by avoiding fund-of-funds and investing directly. The bulk of the outperformance comes from superior gross returns only partially explained by access and experience. We conjecture that larger PE investors have superior due diligence and ability to bridge information asymmetries in PE.
We develop a new methodology to estimate abnormal performance and risk exposure of non-traded assets from cash ‡ows. Our methodology extends the standard internal rate of return approach to a dynamic setting. The small-sample properties are validated using a simulation study. We apply the method to a sample of 958 private equity funds. For venture capital funds, we …nd a high market beta and underperformance before and after fees. For buyout funds, we …nd a relatively low market beta and no evidence for outperformance. We …nd that self-reported net asset values signi…cantly overstate fund values for mature and inactive funds. JEL classi…cation: C51; G12; G23 J a n -0 0 J u l -0 0 J a n -0 1 J u l -0 1 J a n -0 2 J u l -0 2 J a n -0 3 S&P 500 VC div yield BO div yield
Open-market purchases of public equity by private equity investors: Size and home-bias effects
Journal of Economics and Business, 2010
This paper analyses 689 open-market purchases of public equity by private equity investors (PEIs) between 1999 and 2008. On average, we find a positive market reaction to the public announcement of such purchases in both the short and long term. Based on the longterm event study approach of Mitchell and Stafford (2000), we also found that a portfolio of stocks bought by private equity investors achieves a yearly alpha of between 8.5% and 13.5%. In general, the short-term alphas and the long-term alphas are more pronounced when private equity investors buy a listed stock of their home country than when they invest abroad. This justifies a home bias in private equity investments. We also found that investment in small capitalized stocks produces higher excess returns than an investment in large stocks. The abnormal returns are lower for longer time periods, but they are significant in the short-term and over a 1-year horizon. Thus, we find evidence for a size effect in private equity investments.
Private equity benchmarks and portfolio optimization
Journal of Banking & Finance, 2013
Portfolio optimization with private equity is based on one of three different indices: listed private equity indices, transaction-based private equity indices, and appraisal value based private equity indices. We show that none of these indices are appropriate for portfolio optimization. We introduce a new benchmark index for buyouts and venture capital. Our benchmark is updated monthly, adjusted for autocorrelation (desmoothing) and available contemporaneously. We show our benchmark enables superior quantitative portfolio optimization.
Institutional investment in listed private equity
European Financial …, 2011
This paper examines institutional investors' propensity to invest in a relatively unknown asset class of listed private equity. Based on data provided by LPEQ and Preqin covering 100 institutional investors in Europe in 2008, we find allocations are primarily a function of size, type, location, decisionmaking authority and liquidity preferences. Investment in listed private equity is more commonly made by institutions that are smaller, private (not public) pension institutions, institutions that have a preference for liquidity, and institutions that are based in the UK. As well, institutions are more likely to invest in listed private equity when investment decision-making is not empowered to a private equity team, an alternative asset class team, or a board / investment committee, but are more likely when decision-making is delegated to an equities team.
Revisiting private equity performance computation for multi-asset investors
Journal of Asset Management, 2019
Private equity has increasingly been used in portfolio for all types of investors as family offices or ultra-high net worth individuals. Financial Literature proposes different ways to compute private equity performances with results that can question the promised over-performance on public equities. The investment process in private equity funds with the system of committed capital and called capital can have a huge impact of the private equity performance in the whole portfolio and in multi-assets framework. This paper proposes an empirical study that integrates the Jcurve effect on the private equity part of a portfolio and its scaling effect with the low rate environment.
Are Private Equity Investors Boon or Bane for an Economy?-A Theoretical Analysis
European Financial Management, 2011
In this paper, we provide a theoretical foundation for the controversial debate about the economic consequences of private equity transactions. For this purpose, we separately consider six major characteristics that typically distinguish private equity investors from standard investors. Applying a simple model framework, we compare both the maximum acquisition prices of private equity and standard investors for the takeover of a target firm as well as the subsequent optimal investment volumes. This analysis intends to reveal reasons for an inefficient behavior in the sense that private equity investors acquire a company even though afterwards they will invest less than standard investors would do. We find that most of the usually offered arguments against private equity transactions, such as a higher target return, a short-term investment perspective, a lower risk aversion or operational improvements cannot explain an inefficient behavior by private equity firms. In contrast, a high amount of leverage and informational advantages of private equity firms can result in inefficient outcomes.
Investing Outside the Box: Evidence from Alternative Vehicles in Private Capital
2018
This paper undertakes a comprehensive analysis of alternative investment vehicles in private equity, using unexplored custodial data about 112 limited partners over four decades. We differentiate between alternative vehicles that are GP-directed versus those where the LP has some discretion. Of the roughly 5500 distinct investments made by the LPs in our sample, 32% of investments (17% of capital commitments) were in such alternative vehicles; the allocation increased by more than 10 percentage points over the last decade. Alternative vehicles were far more likely to be offered by larger and North America-based buyout funds. The average performance of these alternative vehicles lagged that of the GPs' corresponding main funds. The best LP performance was among endowments, private pensions, and insurers. Finally, LPs with better past performance invested in alternative vehicles with better performance, even after conditioning on the GPs' past records. This result suggests that bargaining between GPs and LPs leads to gradation in investment performance based on the parties' outside options.
Long-run underperformance following private equity placements: The role of growth opportunities
The Quarterly Review of Economics and Finance, 2009
We investigate whether the documented earnings management preceding public equity offerings applies to private placements of equity. We also investigate whether earnings management can help explain long-run stock performance following private placements. Our main findings are: (1) little evidence of upward earnings management around private equity placements, and (2) little predictive power of abnormal accruals for long-run stock performance following private equity placements. These results suggest that earnings management is not responsible for post-offering underperformance, if any, for firms issuing equity privately. Our results are robust to two alternative measures of earnings management and three measures of abnormal returns estimated over two sample periods.
Varieties of funds and performance: the case of private equity
The European Journal of Finance
Within the growing body of literature on private equity, there is intense debate as to whether, and by how much, the industry really adds value. However, much of the diversity in results can be ascribed to a tendency to combine very different fund types. This study explores variations in performance according to fourteen different types of fund, a much bigger range than preceding studies in the academic literature. We find that funds that focus on riskier areas of activity are not only are associated with divergent outcomes, but generally underperform. In other words, there is variety in degree of underperformance, but in general, high risk is married with poor returns. We explore why such funds continue to attract significant investment. Since the wave of post-financial crisis quantitative easing, there has been a growing divergence between multiples of invested capital and internal rates of return, with the former doing significantly worse than the latter, suggesting possible changes in funds' holding period strategies and, possibly, that it has become harder to optimise returns other than through borrowing. However, there is much more to fund performance than potential risk and debt, and evaluate which specific types of fund do better or worse when, and why, as well as which types of fund are associated with greater unpredictability in returns. We apply agency theory to help understand general partner behavior in private equity partnerships, and draw on the literature on the economics of expectation and of systemic evolution to explain limited partner behavior, and draw out the implications for theory and practice. Highlights • An analysis of the relationship between a much wider range of PE fund types than preceding studies, and performance. • Explanatory application of agency, expectations and evolutionary theories. • Funds that signal riskier status through their scope and focus often are associated with more diverse, but generally sub-optimal outcomes, yet seem persistently capable of attracting significant investor capital; we explore why this might be the case. • We explore possible explanations behind mediocre or superior returns for specific fund types and why levels of return for some exhibit much more diversity than others.