Private equity (PE) investment returns are neither reliable nor predictable. Many of my clients are prepared to accept these as facts. But one private equity myth is harder to dispel, that of the PE sector’s resilience.
Unlike other asset classes, the legend goes, private equity can weather the vagaries of the economic cycle.
Myth III: Private Equity Performance Is Resilient
Where does this popular belief come from? It is derived in part from the fact that some practitioners believe (and report) that PE is uncorrelated to the public markets.
As a concept, correlation is simple enough. When asset prices move in the same direction at the same time, they are positively correlated. If they move in opposite directions, they are negatively correlated. If they are consistently out of sync, their correlation is low. Two asset classes with wholly aligned price movements are considered perfectly correlated, with a correlation of 1, or 100%. Totally uncorrelated assets, on the other hand, have a coefficient of 0, or 0%. A portfolio with price movements that have no correlation with those of the public markets is market-neutral. One with a positive correlation is called a positive beta portfolio.
Correlation or No Correlation, That Is the Question
So what about private equity’s correlation to the public markets?
A May 2020 Ernst & Young (E&Y) report, “Why Private Equity Can Endure the Next Economic Downturn,” made an astonishing claim about the PE sector:
“The industry’s long track record of strong, uncorrelated returns is now widely appreciated throughout the investment community.”
It was not the first time E&Y had made the point.
“We find evidence that PE returns are marginally uncorrelated with most other asset classes. . . . As a result, PE remains attractive for institutional investors seeking diversification,” E&Y’s “Global Private Equity Watch 2013” report asserted. They added that private equity’s correlation was only “approximately 30% to 40% with equities.”
E&Y offered little detail to substantiate its conclusions, but such a bullish take on PE is inconsistent with most of the academic literature on the subject.
High Correlation with Public Markets
In “European Private Equity Funds — A Cash Flow Based Performance Analysis,” Christian Diller and Christoph Kaserer analyze nearly 800 European PE funds and show the approximate correlation between PE and the public benchmark (MSCI Europe) was 0.8 based on the public market equivalent (PME).
“Other research has found that private-equity returns have become highly correlated with public markets,” a trio of authors note in the McKinsey study, “Private Equity: Changing Perceptions and New Realities.”
These findings tally with those from a white paper by the asset manager Capital Dynamics: “Over the past 15 years, the average correlation between the European and US buyout markets and public equity has been 80%.”
Although the authors state that “From 2014 onwards, the correlation is on a downward trend (88% to 75%), underscoring the diversification benefits of private equity,” the downward move actually happened between 2014 and 2016. It is therefore over too short a time period to reach any meaningful conclusions. The trend might only be temporary.
The paper has another drawback, one that we saw in Part I: The sample is small — only covering about 340 US and European buyout funds. So it may not be representative of the PE fund universe.
In the forthcoming “Endowment Performance,” Richard M. Ennis, CFA, examines the returns of 43 of the largest individual endowments. He finds that over the 11 years ending 30 June 2019, private equity was highly correlated to public stocks and offered no diversification benefits.
Given the wealth of contradictory evidence, E&Y’s assertion is hard to support. Indeed, PE’s high correlation with public equity has a simple explanation.
Public Valuations as Comparables
PE firms value their portfolio assets based on a comparables analysis. Since asset values are benchmarked to public comparables, they are linked to them. There is no better way to correlate two asset classes than to use one as the point of reference for the other. Why does PE not show perfect correlation? Because PE fund managers value their portfolios quarterly rather than daily.
But that isn’t all. The public markets experienced extreme volatility in the first three months of 2020. The S&P 500 and Russell 2000 indexes plunged 20.5% and 31%, respectively, in the quarter ending 31 March 2020. When all the major listed private capital groups reported their first quarter results in April and May, Blackstone’s PE division’s valuation dropped 22% as did Apollo’s. KKR’s fell 12% and Carlyle’s 8%. These results confirm the high correlation between private equity and public markets.
The research firm Triago reviewed all the first-quarter reports from private capital fund managers across private equity, credit, growth, real estate, and venture capital. It found that the sector fell 7.2% in net asset value (NAV) versus over 20% declines for most global stock market indexes. Why were fund managers reporting lower volatility and swings in NAV than the public markets? There are two main reasons:
First, the “recorded” valuation declines were less pronounced because fund managers reported their quarterly figures in late April and early May, after unprecedented government bailouts and large-scale money printing by the central banks had helped the public markets recover. 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 simply used much higher comparable marks than they would have had they reported on 31 March 2020. They were lenient when marking their portfolios since public valuations had overshot in March and were reversing course. They could wait several weeks before reporting their underlying asset values to investors. Public stocks, which are quoted daily, lacked this advantage. In fact, on 31 March 2020, Apollo’s and Carlyle’s share prices were down 29%, and shares of Blackstone and KKR were off 16% from the previous quarter. So public investors did not, in fact, consider the PE business model all that resilient.
The second reason is even more telling: The PE fund managers’ quarterly reports aren’t 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 set of data. Even annual audited numbers depend heavily on fund managers’ deep knowledge of the underlying portfolio assets. Auditors will always be at a disadvantage when judging the intrinsic value of these assets.
If there’s any doubt that PE managers inflate returns when public markets do well, a paper from researchers at State Street and the Massachusetts Institute of Technology (MIT)’s Sloan School of Management puts it to rest. The authors explain that buyout fund managers have some discretion in calculating investment performance and are influenced by public equity gains posted after a quarter has ended. When public markets are subsequently up, PE executives rate their own performance higher for the quarter gone by, as they did for the first quarter of 2020.
State Street Global Exchange’s private equity index represents more than half of all global PE assets, and the authors use this company-level data to prove that valuations were higher when public markets performed well immediately after the quarter ended. But when subsequent public market performance declined, valuations weren’t affected. The authors reach a diplomatic conclusion: “We make no claim that this behavior is intentional . . . It is quite plausible that private equity managers subconsciously produce positively biased valuations merely because they are optimistic.”
While the researchers give practitioners the benefit of the doubt as to whether this positively skewed method is deliberate, their findings offer further evidence that some PE fund managers may manipulate performance data.
“Private equity managers are less inclined to produce biased valuations when they are faced with audits,” they write. “As such, we should expect private equity to produce, on average, higher returns relative to the public market in the first three quarters than in the fourth quarters.” Audits systematically occur at the year end, that is in the fourth quarter.
Thus, E&Y’s view does not align with the industry research. To be sure, the firm probably wanted to emphasize the sector’s resilience, adding in their March 2020 report that “private equity is infinitely adaptable.” It is not alone in promoting the plasticity of capitalism.
High Failure Rate
When was the last time you heard of a PE fund failing? The absence or relative scarcity of fund closures is another data point that would seem to support the asset class’s staying power.
But there’s a good reason for that too. Fund managers know their public relations. They use PR when setting up shop, but tend not to make any public disclosures when shutting down.
Not a single major financial newspaper reported on the liquidation of Candover Investments Plc in the spring of 2018. But at its peak a decade earlier, the firm was among the 10 largest PE firms in Europe. Why the lack of coverage? Because after it ceased fundraising in 2011, the firm effectively became a shell company. After years of inactivity, Candover had fallen off journalists’ radar. It was a similar story with Fortsmann Little, the New York-based LBO firm. Fortsmann Little announced it would stop raising new funds in 2004 and ceased trading a decade later amid little media coverage.
So again, the prevailing views about private equity are largely wrong. PE returns are highly correlated to the public markets and PE firms do go out of business. Frequently. In the aftermath of the global financial crisis, for example, 25% of PE firms failed to raise a fund, according to Bain & Company’s February 2020 Global Private Equity report. Such creative destruction is hardly evidence that private equity is more resilient than other asset classes, but quite the opposite.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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