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The Performance of a Private Equity-Replicating Strategy with Leveraged Small QARP-Equities in the Nordic Public Markets

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The Performance of a Private Equity-Replicating Strategy with Leveraged Small QARP-Equities in the Nordic Public Markets The performance of a Private Equity-replicating strategy with leveraged small QARP-equities in the Nordic public markets Linus Lehto Department of Finance Hanken School of Economics Helsinki 2021 i HANKEN SCHOOL OF ECONOMICS Department of: Type of work: Department of Finance Master Thesis Author: Linus Leopold Lehto Date: 28.3.2021 Title of thesis: The performance of a Private Equity-replicating strategy with leveraged small QARP- equities in the Nordic public markets Abstract: This thesis adds to the growing literature on value and quality investing, and the cross- section Quality At a Reasonable Price (QARP), in the Nordic markets. The research question of this thesis centers around whether a Private Equity-replicating investing strategy, which focuses on leveraged small- and mid-cap QARP-equities in the Nordic public markets, yields higher risk-adjusted returns than the market. Secondary research questions focus on the individual performance of value, quality and QARP strategies. Furthermore, the study aims to answer whether leverage and consequently debt paydown increase risk-adjusted returns in QARP-equities, or if company size affect risk-adjusted returns for QARP-equities or leveraged QARP-equities. The performances of the formed portfolios have been studied by using Capital Asset Pricing Model, Fama-French three-factor model and Fama-French five-factor model. The risk adjusted performance measures (Sharpe ratio, Treynor ratio, Sortino ratio and Information ratio) are also utilized. The study is conducted between 1.6.1991- 1.6.2020, utilizing data for 1692 public companies on OMX Stockholm, OMX Nordic Copenhagen, OMX Nordic Helsinki and Oslo Bors. First, the results of the study show that value companies have outperformed the market, when measured by EV/EBITDA. Second, the results show that high quality companies outperform low quality, and that high quality companies exhibit excess returns in comparison to the market. Furthermore, companies at the cross-section of value and quality seem to have yielded higher returns than purely quality companies. Third, the results show that the returns can further be juiced with the addition of leverage and consequent debt paydown. This is most prominent in small- and mid-cap companies. Finally, the main findings indicate that the Private Equity-replicating portfolio exhibits excess returns, even with volatility considered, with risk adjusted performance being higher than for the benchmark index. Transaction cost, capital gain taxes and other costs are excluded, which can contribute to a possible bias. The results support the mispricing hypothesis but cannot reject the assumption of efficient markets. Keywords: Value Investing, Quality Investing, QARP, Asset Pricing, Investing Strategy, Portfolio management, Private Equity replication ii SVENSKA HANDELSHÖGSKOLAN Institution: Arbetes art: Avdelning för finansiell ekonomi Magister avhandling Författare: Linus Leopold Lehto Date: 28.3.2021 Avhandlingens rubrik: Prestationen av en Private Equity-replikerande strategi med belånade små QARP- aktier på de nordiska aktiemarknaderna Sammandrag: Denna avhandling kontribuerar till den växande litteraturen om värde- och kvalitetsinvestering, och tvärsnittet Kvalitet till ett rimligt pris (QARP), på de nordiska aktiemarknaderna. Forskningsfrågan i denna avhandling handlar om huruvida en Private Equity-replikerande investeringsstrategi, som fokuserar på belånade små och medelstora QARP-aktier på de nordiska publika marknaderna, ger högre riskjusterad avkastning än marknaden. Övriga forskningsfrågor fokuserar på individuella prestationen av värde-, kvalitets- och QARP-strategier. Vidare syftar studien till att svara på om belåning och betalning av skuld ökar riskjusterad avkastning i QARP-aktier, eller om företagsstorlek påverkar riskjusterad avkastning för QARP-aktier eller belånade QARP-aktier. Prestationen av portföljen har studerats med hjälp av Capital Asset Pricing Model, Fama-French trefaktormodell och Fama-French femfaktormodell. De riskjusterade resultatmåtten (Sharpe-kvot, Treynor-kvot, Sortino-kvot och Informations-kvot) används också. Studien genomförs mellan 1.6.1991-1.6.2020 och använder data för 1692 publika företag på OMX Stockholm, OMX Nordic Copenhagen, OMX Nordic Helsinki och Oslo Bors. Resultaten av studien visar att värdeföretag, mätt med EV/EBITDA, har presterat bättre än marknaden. Resultaten visar också att företag av hög kvalitet presterar bättre än av låg kvalitet och att företag av hög kvalitet uppvisar överavkastning jämfört med marknaden. Dessutom verkar företag i tvärsnittet mellan värde och kvalitet ha haft högre avkastning än rent kvalitetsföretag. Resultaten visar även att avkastningen kan förbättras ytterligare med tillägg av hävstång och nedbetalning av skuld. Detta är mest framträdande i små och medelstora företag. Slutligen indikerar resultaten att Private Equity-replikerande portföljen uppvisar överavkastning, även då volatilitet beaktas. Portföljen har en riskjusterad prestation som är högre än för jämförelseindexet. Transaktionskostnader, kapitalvinstskatter och andra kostnader är exkluderade, vilket kan bidra till en möjlig partiskhet i resultaten. Resultaten stöder hypotesen om felprissättning, men kan inte avvisa antagandet om effektiva marknader. Nyckelord: värde investering, kvalitetsinvestering, QARP, prissättning av tillgångar, portföljförvaltning, replikering av Private Equity 1 CONTENTS 1 Introduction .............................................................................................................. 5 1.1 Background and motivation............................................................................... 5 1.2 Purpose of the study .......................................................................................... 6 1.3 Research questions ............................................................................................ 6 1.4 Contribution ....................................................................................................... 6 1.5 Limitations and main concerns of the study ..................................................... 7 1.6 Key terminology and definitions ........................................................................ 7 2 Literature overview .................................................................................................. 8 2.1 Value investing ................................................................................................... 8 2.1.1 Definition of value and value metrics ......................................................... 9 2.2 Quality investing .............................................................................................. 11 2.2.1 Quality definition and investing strategies .............................................. 11 2.3 Quality at A Reasonable Price .......................................................................... 12 2.4 Size-effect ........................................................................................................ 13 2.5 Leverage and capital structure ........................................................................ 13 2.6 Private Equity ................................................................................................... 14 2.6.1 Private Equity asset selection ................................................................... 14 2.6.2 Private Equity and LBOs ............................................................................ 15 2.6.3 Private Equity returns and performance .................................................. 16 3 Theoretical framework ........................................................................................... 17 3.1 Efficient Market Hypothesis and Modern Portfolio theory ............................. 17 3.2 Criticism of the Efficient Market Hypothesis ................................................... 18 3.3 Capital Asset Pricing Model ............................................................................. 19 3.4 Multifactor models .......................................................................................... 19 3.4.1 Arbitrage Pricing Theory ........................................................................... 20 3.4.2 Fama and French three-factor model ...................................................... 20 3.4.3 Carhart four-factor model ........................................................................ 21 3.4.4 Fama and French five-factor model ......................................................... 21 4 Previous research ................................................................................................... 22 4.1 Size Matters, If You Control Your Junk (2018) ................................................. 22 4.1.1 Data, method and results ......................................................................... 22 2 4.2 Global Return Premiums on Earnings Quality, Value, and Size (2013) ........... 24 4.2.1 Data, method and results ......................................................................... 24 4.3 A Bottom-Up Approach to the Risk-Adjusted Performance of the Buyout Fund Market (2016) ............................................................................................................. 25 4.3.1 Data, method and result ........................................................................... 25 4.4 Leveraged Small Value Equities (2015) ............................................................ 26 4.4.1 Data, method and result ..........................................................................
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