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Risk, returns, and biases of listed private equity portfolios
Abstract
This is the first empirical paper investigating a comprehensive sample of listed(i.e. publicly traded) private equity companies, covering 287 companies in thetime period 1986 to 2003. After imposing liquidity constraints, and aftercorrecting for non-surviving vehicles, we get a sample of 114 instruments. Therisk and return characteristics of three portfolio strategies, two partiallyrebalanced and one fully rebalanced, are compared. We moreover addresspotential biases resulting from thin trading, the bid-ask spread, and sampleselection. We show that the adjusted performance figures differ substantiallyfrom standard estimates. But even after correcting for these biases, we find ahigh risk-adjusted performance of this asset class before 2000, and dramaticdifferent results between the three indices if we extend the time period to 2003.Listed private equity, Private equity, Performance biases
... The literature on LPE is very limited. Bilo et al. (2005) and Lahr and Herschke (2009) study the risk and return characteristics of LPE companies. Bilo et al. (2005) calculate an average CAPM beta of 1.2 and a corresponding alpha of -1.2% per year for their sample of 283 LPE companies. ...
... Bilo et al. (2005) and Lahr and Herschke (2009) study the risk and return characteristics of LPE companies. Bilo et al. (2005) calculate an average CAPM beta of 1.2 and a corresponding alpha of -1.2% per year for their sample of 283 LPE companies. Lahr and Herschke (2009) find an average Dimson beta 3 of 1.7 and no significant alpha, but they also report a large variation depending on the LPEs' organizational form. ...
... However, some private equity companies started listing shares in public markets, allowing any investor to own a part of their business. An example of this process is the public listing of a Kohlberg Kravis Roberts & Company' (KKR) fund in 2006, which raised five billion dollars. 1 There has been a sound increase in the number of listed private equity firms over the last 30 years (Bilo et al., 2005), and in the last few years other famous names in the industry, such as Blackstone or Apollo Management, have followed this route. ...
The public listing of shares from private equity houses and funds has dramatically changed the corporate governance structure of these entities. These changes aggravate the information asymmetry between investors and general partners, and as a result most of these companies trade at high discounts to their net asset value. We hypothesize that exits of portfolio firms can be seen as a mechanism to mitigate such information asymmetries and to signal quality to uninformed investors. Consistent with our hypotheses, we find that exit announcements trigger significantly positive abnormal returns of almost 1% around the announcement day, and that these are higher when an IPO is the mechanism chosen, the stock runup is lower, and the listed private equity entity is of smaller dimension or lesser reputation.
... be done with any numerical method and software, including Excel. Finally, inference is tricky due to a lack of time-series. DLP use a bootstrapping technique on the assumption that errors are not cross-sectionally correlated. They show a diagnostic test that indicates that it is a reasonable assumption in their sample but it may not always be true. Bilo et al. (2005) is the only comprehensive study I know of that estimate the risk profile of listed vehicles and their work is behind the creation of a private equity index called LPX. They report 287 vehicles in their article but their inclusion criterion is not specified. 6 They form an index with all the selected vehicles and report a CAPM beta of 1. ...
IntroductionThe DataMethodologyResultsAdditional DiscussionConclusion
Appendix 12.A: Discussion on Staleness CorrectionNotesAbout the AuthorAcknowledgments
We develop a new methodology to estimate the alpha and risk exposure of private equity funds. In contrast to existing work, our methodology mainly uses direct cash ow data and avoids the use of self-reported net asset values. Our GMM methodology is based on pricing restrictions for the cross-section of funds. We apply our methodology to a unique dataset comprising 23,296 cash-ows from 941 private equity funds between 1980 and 2003. We …nd a high market beta, especially for venture capital funds and report evidence that returns resemble those of long positions on call options. We also …nd evidence that venture capital funds loads positively on SMB and negatively on HML while buyout funds loads negatively on SMB and positively on HML. Only buyout funds are exposed to systematic liquidity risk.
This literature review covers the issues faced by private equity fund investors. It shows what has currently been established in the literature and what has yet to be investigated. In particular, it shows the many important questions to be answered by future research. The survey shows that the average investor has obtained poor returns from investments in private equity funds, potentially because of excessive fees. Overall, investors need to gain familiarity with actual risk, past return, and specific features of private equity funds. Increased familiarity will improve the sustainability of this industry that plays such a central role in the economy.
Infrastructure is often deemed a natural hedge against inflation due to monopolistic pricing power, supporting regulatory regimes, and limited variable cost exposure. In contrast to this often cited yet not empirically corroborated proposition, we find that domestic listed infrastructure hedges inflation just as good (or bad) as other equities. This result holds across infrastructure sectors, time and estimation methods. Only portfolios of infrastructure firms with high pricing power can slightly improve inflation hedging compared to equities and average infrastructure. Our study is based on a rich dataset covering 1,400 infrastructure firms, 45 countries and over 30 years. Pricing power is proxied by country, time and sector specific OECD data on entry barriers, vertical integration and market structure in infrastructure industries. We apply spatial correlation consistent standard errors and correct for overlapping data using a matrix transformation. Ultimately, infrastructure as an enhanced inflation hedge appears to be rather wishful thinking than empirical fact.
The motivation of this paper was to support a prospective Private Equity investor in his selection of LBO (leveraged buyout) funds and to give practical insights into the buyout market's recent transactions. More precisely, the hypothesis was that the combination of both high-level operating risks and financial leverage risks would be disadvantageous for investors. In general, buyout funds from the US with investment focus on the media industry and the consumer-related industry as well as EU buyout funds focusing on the industrial/energy industry and the consumer-related industry achieved strong excess returns from the mid-1980s to the early 2000s. These findings confirm this paper's hypothesis that the combination of both high-level operating risks and financial leverage risks - mainly present in funds investing in the high-technology sector - would be disadvantageous for investors. By regressing the vintage-specific funds' IRR on the corresponding S&P 500's CAGR (compound average growth rate) as of end-2006, one can note with statistical significance (at the 5 percent significance level) that most buyout fund segments are positively depending on the stock market's long-term returns. For buyout investors, a conservative approach may be to choose LBO funds and corresponding management companies which have (or aim to have) a major part of their portfolio companies within the consumer-related industry and which are at least partly geographically diversified. Concerning the buyout cases, low-valued target companies - measured by EBITDA multiples - with extensive cash available tend to be top-ranked regarding the potential IRR. Future - including those which are still pending - LBO transactions may create substantial shareholder value provided that these are carried out by adhering to reasonable market multiples and focusing on stable industries. Contrarily, the deals majorly completed for the reason of the attractive debt financing environment may potentially prove to be unsuccessful. Future LBOs of publicly-listed companies could increasingly take place in the energy industry and the refining industry which - positively affected from low EBITDA multiples and strong free cash flows making early debt redemptions possible - both reveal the highest potential IRRs on median average with 27 percent and 21.3 percent, respectively.
This paper investigates the stock performance of listed private equity vehicles which are grouped into subsamples according to their organizational structure. We identify 274 liquid listed private equity entities in the period from 1986 to 2008. Listed private equity shows an aggregate Dimson beta of 1.7 without any significant excess return on a value-weighted basis in an international CAPM context. Entities differ strongly dependent on their organizational form. Market risk is high in internally managed vehicles but low in externally managed ones. We conclude that different sources of cash flow such as management fees and carried interest can account for these risk characteristics. Precautions must therefore be taken when using listed private equity as a proxy for traditional private equity funds.
Institutional investors supply the bulk of the funds which are used by venture capital investment firms in financing emerging growth companies. These investors typically place their funds in a number of venture capital firms, thus achieving diversification across a range of investment philosophy, geography, management, industry, investment life cycle stage and type of security. Essentially, each institutional investor manages a “fund of funds,” attempting through the principles of portfolio theory to reduce the risk of participating in the venture capital business while retaining the up-side potential which was the original source of attraction to the business. Because most venture capital investment firms are privately held limited partnerships, it is very difficult to measure risk adjusted rates of return on these funds on a continuous basis.
Using linear and nonlinear models, the authors examine two samples of bond funds--one sample designed to eliminate survivorship bias and a second much larger sample. Overall and for subcategories of bond funds, they find that bond funds underperform relevant indexes postexpenses. The authors' results are robust across a wide choice of models. They find that, on average, a percentage-point increase in expenses leads to a percentage-point decrease in performance. The nonlinear model weights closely match actual composition weights. The authors find no evidence of predictability using past performance to predict future performance for their unbiased sample. Copyright 1993 by University of Chicago Press.
Mutual fund attrition can create problems for a researcher because funds that disappear tend to do so due to poor performance. In this article we estimate the size of the bias by tracking all funds that existed at the end of 1976. When a fund merges we calculate the return, taking into account the merger terms. This allows a precise estimate of survivorship bias. In addition, we examine characteristics of both mutual funds that merge and their partner funds. Estimates of survivorship bias over different horizons and using different models to evaluate performance are provided. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
If returns on some stocks systematically lead or lag those of others, a portfolio strategy that sells “winners” and buys “losers”
can produce positive expected returns, even if no stock’s returns are negatively autocorrelated as virtually all models of
overreaction imply. Using a particular contrarian strategy we show that, despite negative autocorrelation in individual stock
returns, weekly portfolio returns are strongly positively autocorrelated and are the result of important cross-autocorrelations.
We find that the returns of large stocks lead those of smaller stocks, and we present evidence against overreaction as the
only source of contrarian profits.
We document the return to investing in U.S. nonpublicly traded equity. Entrepreneurial investment is extremely concentrated, yet despite its poor diversification, we find that the returns to private equity are no higher than the returns to public equity. Given the large public equity premium, it is puzzling why households willingly invest substantial amounts in a single privately held firm with a seemingly far worse risk-return trade-off. We briefly discuss how large nonpecuniary benefits, a preference for skewness, or overestimates of the probability of survival could potentially explain investment in private equity despite these findings. (JEL G11, G12, M13)
The effective (geometric mean) return of a periodically rebalanced portfolio always exceeds the weighted sum of the component geometric means. Some approximate formulae for estimating this effective return are derived and tested. One special case of these formulae is shown to be particularly simple, and is used to provide easily computed estimates of the benefits of diversification and rebalancing. The results are also used to show how classical Mean-Variance Optimization may be modified to generate the Geometric Mean Frontier, the analog of the efficient frontier when the geometric mean is used as the measure of portfolio return.
This article offers an objective mechanism for computing the periodic risk of a private investment portfolio. Such determination was derived by examining the dispersion of the portfolio investments’ terminal wealth. A portfolio manager can use the tools offered to compare the risks and returns of private and public market investments and to determine optimal asset allocation. Additionally, in evaluating private investment managers, a portfolio manager can use the equations derived in this article to determine the implied periodic risks being taken.
Venture capital (VC) has had a profound impact on the U.S and world economies. The landmarks of venture capitalism are the formation of the venture capital fund ARD in 1946 and the establishment of small business investment companies by the U.S. Small Business Administration in 1958. After a boom in the 1960s, the VC industry all but collapsed between 1970 and 1977. The VC industry revived in the 1980s and reached a peak in 1987 from which it declined. At the moment of its decline in 1990, the industry was radically altered and transformed and was at a crossroads from its recent shake-out. This book examines the state of the VC industry at this point in 1990, examining current trends, developments, and practices, and looking at future prospects for the industry, suppliers, and users of risk capital, as well as the nation's economy as a whole. The VC industry has been transformed by two changes. (1) New and specialized financial and investment strategies emphasize deal making, transaction crafting and closing, fee generating, and short-term gains. This "merchant capital" approach is oriented to investing in established firms, as opposed to the classic VC approach of providing equity financing in new, emerging, innovating, and technology-based firms. This change may be due to professionals entering the field from MBA backgrounds rather than business-building backgrounds. (2) The altered market has resulted in reduced opportunities, globalization, increase in available capital, and dominance of institutional money, and the VC industry is losing its classic company-building skills. The major virtue of the traditional VC industry, which has been a wellspring of innovation and great rewards, is the skills brought by the venture capitalists that add value in the firm's forming, building, and harvesting. Changes in the VC industry are seen in an explosion of investing activity, heterogeneity of industry structure, niche funds, declines in rate of return, and increased competition and shake-out. Examples of classic revolutionary industries financed by VC are the semiconductor, computer, and biotechnology industries. Some lessons from these industries are drawn. Lessons are also drawn from the case of the Winchester disc-drive industry, which represents a case of "capital market myopia." Historical VC returns have been in the 10% to 20% range, occasionally in the 20% to 30% range, and rarely higher. The main reason for the unsatisfactory returns on VC since 1983 has been the initial public offering (IPO) drought. The benefits and implications for the VC industry of syndicated investments are examined. The contribution of VC to economic development is explored in terms of internal and external factors. Some high-tech regions were not planned; some planned regional centers have failed. Three factors affect the flow of VC: investors who put up the money, entrepreneurs who form the company, and the venture capitalists. The value-added of classic VC investment lies in the guidance, contracts, know-how, and support of the backers. The relationship between the venture capitalist and management team critically affects the success of the venture. Also examined are relationships between flows of VC and public policy, capital markets, new technologies, and changes in industries. Most important in fostering VC are government policies. Since VC is vital element to entrepreneurship, the U.S. must actively foster classic venture capital by changing some national attitudes and policies in culture, education, and role of government, for which recommendations and suggestions are offered. (TNM)
The mean return computational method has a substantial effect on the estimated small firm premium. The buy-and-hold method, which best mimics actual investment experience, produces an estimated small-firm premium only one-half as large as the arithmetic and re-balanced methods which are often used in empirical studies. Similar biases can be expected in mean returns when securities are classified by any variable related to trading volume.
The returns to hedge funds and other alternative investments are often highly serially correlated. In this paper, we explore several sources of such serial correlation and show that the most likely explanation is illiquidity exposure and smoothed returns. We propose an econometric model of return smoothing and develop estimators for the smoothing profile as well as a smoothing-adjusted Sharpe ratio. For a sample of 908 hedge funds drawn from the TASS database, we show that our estimated smoothing coefficients vary considerably across hedge-fund style categories and may be a useful proxy for quantifying illiquidity exposure.
This paper measures the mean, standard deviation, alpha and beta of venture capital investments, using a maximum likelihood estimate that corrects for selection bias. Since Þrms go public when they have achieved a good return, estimates that do not correct for selection bias are optimistic. The selection bias correction neatly accounts for log returns. Without a selection bias correction, I Þnd a mean log return of about 100% and a log CAPM intercept of about 90%. With the selection bias correction, I Þnd a mean log return of about 5% with a -2% intercept. However, returns are very volatile, with standard deviation near 100%. Therefore, arithmetic average returns and intercepts are much higher than geometric averages. The selection bias correction attenuates but does not eliminate high arithmetic average returns. Without a selection bias correction, I Þnd an arith- metic average return of around 700% and a CAPM alpha of nearly 500%. With the selection bias correction, I Þnd arithmetic average returns of about 57% and CAPM alpha of about 45%. Second, third, and fourth rounds of Þnancing are less risky. They have progres- sively lower volatility, and therefore lower arithmetic average returns. The betas of successive rounds also decline dramatically from near 1 for the Þrst round to near zero for fourth rounds. The maximum likelihood estimate matches many features of the data, in particular the pattern of IPO and exit as a function of project age, and the fact that return distributions are stable across horizons.
This article employs the 1975-84 quarterly holdings of a sample of mutual funds to construct an estimate of their gross returns. This sample, which is not subject to survivorship bias, is used in conjunction with a sample that contains the actual (net) returns of the mutual funds. In addition to allowing the authors to estimate the bias in measured performance that is due to the survival requirement and to estimate total transaction costs, the sample is used to test for the existence of abnormal performance. The tests indicate that the risk-adjusted gross returns of some funds were significantly positive. Copyright 1989 by the University of Chicago.
This paper builds a venture capital index from 1987 to 1999 that consists of 12,946 rounds of venture financing with 5,643 venture-backed firms. The paper uses two innovative techniques, a re-weighting procedure and a method of moment repeat sales regression, to mitigates three problems - missing data, censored data, and sample selection. We report the time series of capital flows, net asset value, and returns of the venture capital index. We find that the venture capital industry experienced dramatic growth in the sample periods, in terms of capital flows, the number of financing rounds and venture-backed firms, and the net asset value of the index. In addition, the returns to venture capital are high and volatile. The geometric average return is 55.18% per year in the sample periods, with the lowest annual return in 1990 (-5.94%)and the highest in 1999 (681.22%). The venture capital index has much higher volatility than SP 500 and NASDAQ. Moreover, we find significant correlation between the venture capital index and NASDAQ for returns and volatility.
This article provides a comprehensive study of survivorship issues using the mutual fund data of Carhart (1997). We demonstrate theoretically that when survival depends on multiperiod performance, the survivorship bias in average performance typically increases with the sample length. This is empirically relevant because evidence suggests a multiyear survival rule for U.S. mutual funds. In the data we find the annual bias increases from 0.07% for 1-year samples to 1% for samples longer than 15 years. We find that survivor conditioning weakens evidence of performance persistence. Finally, we explain how survivor conditioning affects the relation between performance and fund characteristics. Copyright 2002, Oxford University Press.
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the cash flow, return, and risk characteristics of private equity. We document the draw down and capital return schedules for the typical private equity fund, and show that it takes several years for capital to be invested, and over ten years for capital to be returned to generate excess returns. We provide several determining factors for these schedules, including existing investment opportunities and competition amongst private equity funds. In terms of performance, we document that private equity generates excess returns on the order of five plus percent per annum relative to the aggregate public equity market. One interpretation of this magnitude is that it represents compensation for holding a 10-year illiquid investment.
Over the last half century UK defined benefit pension schemes have followed the cult of the equity by investing a large proportion of their assets in equities. However, since the turn of the millennium this cult has faced two serious challenges the halving of equity prices, and the complete rejection of equity investment by the Boots pension scheme in 2001. This paper summarises the history of the cult in the UK and the arguments advanced at the time to support its adoption. It then presents the case for the cult (excluding taxation, risk sharing and default insurance). This is followed by a detailed consideration of the validity of this case, including an examination of the relevant empirical evidence. It is concluded that, in the absence of taxation, risk sharing and default insurance, the asset allocation is indeterminate; and depends on the risk-return preferences adopted by the trustees.
This paper studies liquidity provision in the Alternative Investment Market (AIM) of the London Stock Exchange. Our analysis shows that it is possible to generate sufficient liquidity in a small company market. Indeed, a small group of AIM stocks are found to trade frequently, exposing the investor to minimal execution risk. At the same time, we find that the majority of AIM stocks trade infrequently, with trades often clustered around a few days. We find the latter group to be further characterised by higher price volatility and wider spreads, indicating that for the majority of AIM stocks, immediacy risk is an issue of concern.When studying AIM stocks that were transferred from the Rule 4.2. market, we report a significant increase in trading activity, but surprisingly little change in liquidity as measured by either price volatility or trading costs. Finally, we develop a statistical model to identify the main determinants of liquidity. We find that a higher market capitalisation and a higher free float both contribute to a larger number of trades, lower trade concentration, lower price volatility and lower effective spreads. There also seems to be a technology effect, in that technology firms are more actively traded and enjoy lower trading costs, in the form of lower average effective spreads. At the same time, our empirical evidence seems to indicate that there is no �average� AIM stock, and that liquidity is therefore difficult to predict.
Several recent studies suggest that equity mutual fund managers achieve superior returns and that considerable persistence in performance exists. This study utilizes a unique data set including returns from all equity mutual funds existing each year. These data enables the author to more precisely examine performance and the extent of survivorship bias. In the aggregate, funds have underperformed benchmark portfolios both after management expenses and even gross of expenses. Survivorship bias appears to be more important than other studies have estimated. Moreover, while considerable performance persistence existed during the 1970s, there was no consistency in fund returns during the 1980s. Copyright 1995 by American Finance Association.
This paper examines the relation between stock returns and stock market volatility. We find evidence that the expected market risk premium (the expected return on a stock portfolio minus the Treasury bill yield) is positively related to the predictable volatility of stock returns. There is also evidence that unexpected stock market returns are negatively related to the unexpected change in the volatility of stock returns. This negative relation provides indirect evidence of a positive relation between expected risk premiums and volatility.
Previous estimates of a 'size effect' based on daily returns data are biased. The use of quoted closing prices in computing returns on individual stocks imparts an upward bias. Returns computed for buy-and-hold portfolios largely avoid the bias induced by closing prices. Based on such buy-and-hold returns, the full-year size effect is half as large as previously reported, and all of the full-year effect is, on average, due to the month of January.
A dynamic model of insider trading with sequential auctions, structured to resemble a sequential equilibrium, is used to examine the informational content of prices, the liquidity characteristics of a speculative market, and the value of private information to an insider. The model has three kinds of traders: a single risk neutral insider, random noise traders, and competitive risk neutral market makers. The insider makes positive profits by exploiting his monopoly power optimally in a dynamic context, where noise trading provides camouflage which conceals his trading from market makers. As the time interval between auctions goes to zero, a limiting model of continuous trading is obtained. In this equilibrium, prices follow Brownian motion, the depth of the market is constant over time, and all private information is incorporated into prices by the end of trading.
Using a sample free of survivor bias, the author demonstrates that common factors in stock returns and investment expenses almost completely explain persistence in equity mutual funds' mean and risk-adjusted returns. Darryll Hendricks, Jayendu Patel, and Richard Zeckhauser's (1993) 'hot hands' result is mostly driven by the one-year momentum effect of Narasimham Jegadeesh and Sheridan Titman (1993), but individual funds do not earn higher returns from following the momentum strategy in stocks. The only significant persistence not explained is concentrated in strong underperformance by the worst-return mutual funds. The results do not support the existence of skilled or informed mutual fund portfolio managers. Copyright 1997 by American Finance Association.
Setting realistic expectations for potential returns – Part I Investing in venture capital. The Institute of Chartered Financial Analysts
- K R French
- D E Fischer
French, K.R., 1988. Setting realistic expectations for potential returns – Part I. In: Fischer, D.E.: Investing
in venture capital. The Institute of Chartered Financial Analysts, Washington, 23-25.