An Evaluation of Private Equity Investments
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An evaluation of private equity investments By Emily Ledeboer 10017216 19-01-2014 Abstract The private equity market has been a rapidly growing market over the past three decades. Some research has been done on its risk and return, but their results differ in many ways. In this paper I used listed private equity firms as a proxy for the private equity market. By calculating its risk and return profile and by comparing it to the public market, I have tried to find out whether it is possible to outperform the public market by investing in private equity. 1. Introduction In the last three decades, the private equity market has grown to an important source of funds for start-up firms, private middle-market firms, firms in financial distress and public firms seeking buyout financing. From 1980-2010, over $1,1 trillion has been raised by U.S. buyout funds and roughly $700 billion by venture capital firms (Fenn, Liang and Prowse, 2010) Despite its increased significance for corporate finance, the private equity market has received relatively little attention in academic literature and there is still a lot to gain from new studies. The lack of knowledge is due to the fact that data is very hard to come by. For when a firm is private its records are not reported in public records. As a consequence, results from different studies testing more or less the same, vary considerably. Reasons for these different outcomes are that data sets are individually gathered and therefore subject to various selection biases. Another feature that makes the results less accurate is that only book values are available, as market values don’t exist (Zimmermann, Bilo, Christophers and Degosciu, 2004). However, there is a form of private equity that is obligated to enclose its records publicly. These firms are called Listed Private Equity firms (LPE). It has established itself as an adequate proxy for traditional private equity (TPE), as the underlying business structure is the same. The advantage of this market segment is that since market prices and other figures are publicly available and regulated by authorities, performance measures are more reliable. To be ranked as a LPE firm, at least 50% of the firm’s equity block should consist of private equity investments, together with some other restrictions (Statman, 1987). The major advantage for investors of LPE to TPE is that its shares are traded on the public stock market. This creates the possibility for small investors to diversify their portfolio to the private equity market, which is not possible with TPE as only large investors have the required amount of funds to invest (Bergmann, Christophers, Huss and Zimmermann, 2009). However, besides their equal business structures, there are a few drawbacks of LPE to TPE. The underlying exposure of LPE can vary considerably from financing a portfolio with huge parts of borrowed money, to excess cash with no suitable investment options. The risk profile of the portfolio is heavily affected by the risk profile of the money used, which makes the risk profiles of 2 LPE and TPE less comparable. Nevertheless, LPE firms will be held as a proxy for TPE in this thesis as they share the most similarities. The central question to be answered in this thesis is the following: Can one, by investing in private equity, while considering its different approach to investing and portfolio setup, outperform the public equity market. First, former studies are evaluated to get some intuition about these two different kinds of investments. The results of the studies on TPE contradict each other in various ways. This is mainly due to their sample selection as they used different approaches to gather data to overcome selection biases. This bias was overcome in the two studies on LPE as data for these firms is available in public records. The first study by Zimmerman et al. (2004) created a benchmark for TPE. The risk and return profiles of LPE and TPE are outlined and compared and the study shows that their business structures are so similar, that they base their study on the assumption that the risk and returns calculated for LPE can be used to make assumptions about the performance of TPE. The second study by Lahr and Herschke (2009) extended this by subdividing the sample in internally and externally managed firms. The study of this thesis is based on the study by Zimmerman et al. (2004). A new sample is drawn using equal assumptions about liquidity constraints and its performance is measured. Thereafter, the study is taken a step further as the sample will be divided in sub-periods to be able to evaluate the performance more closely. This study will test the hypothesis that investments in private equity outperform the public equity market. Firstly, in chapter 2, former studies on TPE and LPE will be evaluated to develop some intuition about previous performance of private equity in general. In chapter 3 a new sample will be drawn of LPE from various selected sources. In chapter 4 an empirical study on the risk and return of LPE firms will be performed. The model used is based on the one used by Zimmermann et al. (2004). After graphing these regressions, the CAPM model (Womack and Zhang, 2003) will be applied to see if alpha is significantly different from zero. Then in chapter 5, the results are analyzed and finally in chapter 6 a conclusion will be drawn on whether private equity outperforms the public market or not. 3 2. Related literature Traditional private equity versus listed private equity Traditional Private equity (TPE), also referred to as unlisted private equity, is usually structured as a limited partnership. The two parties involved in this operation are limited partners (LPs) and general partners (GPs). LPs are the main capital providers of equity such as corporate and public pension funds, endowments, insurance companies and wealthy individuals. They commit to an illiquid investment during the lifetime of the investment, which is mostly around a decade. During this period they have no influence on the way the project is managed. If everything goes well, the partners are compensated with a positive return for their investment at the end of the lifetime. The part of GPs is mostly assigned to a PE firm that manages the acquired firm during its lifetime. The firm invests the money of the LPs, with which they restructure the acquired firm and are compensated with performance-based fees. These firms exist of professionals with a lot of field experience and have access to tools that a public firm has not, such as the possibility to increase leverage, reduce agency problems and increased incentives to monitor more closely (Kaplan and Strömberg, 2008). Listed private equity (LPE) funds are funds that exist for >50% of private equity funding. These private equity blocks provide GPs with a relative big vote in the way the organization is managed, but they have to work alongside the existing management. Private equity blocks in these kinds of funds result in immediate exposure to the risk and return of private equity investments to shareholders that hold shares in portfolio’s that invest martly in such funds. It basically provides shareholders with a more diversified portfolio (Bergmann et al., 2009). TPE and LPE firms have a lot in common when referring to their performance, which makes them good proxies. Besides that more than half of the organization’s equity is provided by a private source for LPE, its business model is set up in the same way and their investment and financing styles are highly comparable. Therefore, they exhibit the same risk and return potential as their unlisted counterpart (Bergmann et al., 2009). This is an important feature, as in contrast to TPE data on risk and return is available and can be used in several ways to imitate risk and return structures for TPE. 4 Fleming and Cumming (2010) summarized a number of important studies that differ in sample period, sample size, sample selection and model to determine the performance for traditional and listed PE firms. As can be seen in table 1, there are two methods evaluated for calculating performance with TPE, and one method used for LPE. It may be noted that less research is performed on LPE compared to TPE, and that the results obtained in TPE studies vary substantially. Apart from these studies, one additional study is added which is performed by Jegadeesh, Pollet and Kräussl (2009), who used a different approach to estimate the risk and return of TPE. They used market prices of exchange-traded funds of funds to measure performance, and the abnormal returns are determined by the market expectations from TPE fund investments, based on the net present value of these investments. Besides the two papers mentioned by Fleming and Cumming in table 1, no additional studies on the risk and returns of LPE were found. Table 1 Summary of empirical results in previous studies by Fleming and Cumming (2010) The table contains sample period and size for each study and relevant performance measures. G.O.F refers to gross-of-fees studies. 0* denotes no significant difference to corresponding benchmark. Beta may vary between single-factor models, Fama-French Three factor models and a Dimson Beta. For PME, the public market return equals 1.00. Standard deviations are presented in parentheses. TPE studies: sample sample abnormal Performance of period size return Beta Alpha GPs investments Woodward and Hall (2004) ’80-’04 - - - 8,5% Hwang et al. (2005) ’87-’03 15.583 0* 0,6 1% Cochrane (2005) ’87-’00 7.765 43% 1,9 32% TPE studies: sample sample abnormal IRR(%p.a.) .