Does Private Equity Perform Better Than the S&P500?

Home , Corporate raid, Private equity

Private Equity Performance

“Does private equity perform better than the S&P500?”

Bachelor Thesis Finance

Name: Reynier de Pundert

ANR: 988816

Supervisor: M. Nie

Date: May 18th 2012

Program: Bedrijfseconomie

Inhoud 1: Introduction ...... 2 2: What is Private Equity? ...... 4 2.1 Venture Capital ...... 4 2.2 Leveraged buyout ...... 5 2.3 Structure of Private Equity ...... 6 3: Performance of Private Equity ...... 8 3.1 Introduction ...... 8 3.2 Overview of earlier research ...... 10 4: Data Analysis ...... 12 4.1 Methodology ...... 12 4.1.1 Fama and French ...... 12 4.1.2 Sharpe Ratio ...... 12 4.2 Data ...... 14 4.3 Results ...... 15 5: Conclusion ...... 20 5.1 Conclusion ...... 20 5.2 Limitations and future research ...... 22 5.2.1 Limitations ...... 22 Future research ...... 22 6: List of References ...... 23

1: Introduction The private equity sector has grown tremendously in the past 30 years. The first leveraged buyout known of was the purchase of Pan-Atlantic Steamship Company in 1955 by McLean Industries, Inc. Since then, the market has grown enormously. Whereas investors committed less than $10 billion to private equity partnerships in 1991, in 2011 more than $3021 billion was committed. The total amount raised by U.S. Private Equity Firms peaked in 2007 just before the credit crisis with a total amount of $ 347.7 billion2.

The biggest growth in the private equity sector was made in the 1980s. In this decade most private equity investments were seen as a “corporate raid”, especially those investments that featured a hostile takeover. Asset stripping, major layoffs and other corporate restructuring gave the private equity sector a bad name. One of the major hostile takeovers in the 1980s was the $31.1 billion takeover of RJR Nabisco by Kohlberg, Kravis and Roberts in 1989 (Kaplan, 2008). This was at the time, and would be for the next 17 years, the largest takeover in history.

The next boom for the private equity sector would happen in the years 2005-2007. Decreasing interest rates, loosening lending standards in the United States and regulatory changes for publicly traded companies were the perfect motivation for the largest boom in private equity history. Among the largest buyouts in these years were Equity Office Properties, HCA, Alliance Boots and TXU. New “largest buyout” records were set and surpassed several times in 2007 with TXU being the record holder for the amount of $44.37 billion. When the credit crisis started the amounts of capital committed to private equity tumbled to a low of only $95.8 billion in 2009 before climbing back up to the $302 billion committed in 20113. It is clear that large amounts of money are being spent in the private equity sector.

Even though large amounts of money are committed to the private equity sector, relatively little research has been done to compare the results of the private equity sector to other forms of investments like investing in stocks and bonds or currencies.

1 http://www.pegcc.org/education/pe-by-the-numbers/ 2 http://www.fis.dowjones.com/PEA/4QUSPEFundraising.html 3 http://www.dowjones.com/pressroom/releases/2011/101011-Q3VCFund-0162.asp 2

According to longstanding theories like the Efficient Market Hypothesis (EMH) the private equity sector should not perform better or worse than any other market since information is available to all parties at any given time (Malkiel, 2003). In the private equity sector however, this might not be true since these are mostly privately traded companies, which have no obligation to publicly share all information thus leaving an opportunity for investors. Therefore the research question that is going to be answered in this bachelor thesis is:

“Does private equity perform better than the S&P500?”

Because private equity investments are illiquid investments the performance of these funds might not be as good during times of an economic downturn. Therefore as a sub question, it will also be researched how private equity firms perform during the current credit crisis, resulting in the following question:

“How does private equity perform in times of economic crisis?”

In the next chapter, private equity will be explained as well as the structure of private equity and the different types of private equity. An overview of previous research will be given in chapter 3 as well as a short overview of the relative performance of private equity during the sample period. In chapter 4 the data analysis will be handled and the test methods used explained. Finally in chapter 5 the conclusion will be given as well as limitations and recommendations for future research.

2: What is Private Equity? This chapter will give a brief overview of the concept of private equity. The structure of private equity and the different types of private equity will be discussed. But first, the concept of private equity is explained in more detail.

Weidig, Tom, Mathonet, Pierre-yves (2004) define Private Equity as follows: “Private equity provides equity capital to enterprises not quoted on a stock market. Private equity can be used to develop new products and technologies, to expand working capital, to make acquisitions, or to strengthen a company’s balance sheet. It can also resolve ownership and management issues. A succession in family-owned companies, or the buyout and buying of a business by experienced managers may be achieved using private equity funding.”

Phalippou (2007) mentions that Private Equity can be divided into two main types of investments: venture capital (VC) and leveraged buyout (LBO). Phalippou mentions that although both VC and LBO are different types of investments, they are often studied together. The reason for this, and why both types of investments will be discussed, is because these are both used by private equity funds. Private equity companies invest with these strategies usually through different funds but with overlapping management teams. The same for both types of investments, and unique for private equity, is that the private equity firms play a management role in the companies held in their portfolio.

2.1 Venture Capital Venture capital is defined by Gladstone (2002) in his book as money that is invested in new companies. Typically these are investments in new businesses or buyout businesses, or existing businesses experiencing strong growth.

Investments in venture capital are done at reasonably well-defined stages (Sahlman, 1990). In his paper, Sahlman describes a total of 8 stages in which venture capitalists invest in companies. The stages are, in order of occurrence, seed investments, startup, first stage (early development), second stage (expansion), third stage (profitable, but cash poor), fourth stage (rapid growth), bridge stage (mezzanine investment) and the liquidity stage (cash-out or exit).

The seed investments are small investments provided to an inventor or entrepreneur to determine whether the idea deserves further consideration. The next stage, the startup phase, usually consists of company that are less than a year old. Investments are used for product development and test marketing. The first stage, or early development stage, follows when all

4 prototypes look promising and manufacturing can be set up. During the second stage a company has shipped enough products to receive good feedback and can focus on market penetration. Because the company is not making any money, or very little, in this stage, investments are needed to provide for equipment and financing.

The next four stages describe the further growth of the company. During the bridge stage, or mezzanine investment, the company may have some idea of an exit strategy, and may even have an idea of when this should take place. During this phase however, the company still needs more capital to sustain the rapid growth. Eventually during the liquidity stage, or exit, takes place. This may be in the form of a Public Initial Offering (IPO) or the acquisition by another company.

2.2 Leveraged buyout Public-to-private or so-called private transactions are defined as the transactions when a public company is bought and turned into a private company. When these transactions are financed by borrowing substantially beyond the industry average they are called leveraged buyouts. When the management team takes over the company, this is called a management buyout. Management teams from outside the company can also buy a company and take it private, this is called a management buy-in (Renneboog and Simon, 2005).

Another definition is given by Kaplan and Strömberg (2009): “In a leveraged buyout, a company is acquired by a specialized investment firm using a relatively small portion of equity and a relatively large portion of outside debt financing. In a typical leveraged buyout transaction, the private equity firm buys majority control of an existing or mature firm. This arrangement is distinct from venture capital firms that typically invest in young or emerging companies, and typically do not obtain majority control.”

It is possible for leveraged buyouts or management buyouts to be financed by private equity funds. Usually these buyout funds target to buy a significant portion or majority (>50%) control of the company. They invest in more mature companies that have established business plans to finance expansions, consolidations, turnarounds and sales, or spinouts of divisions. The risk of financing these buyouts is considered moderate and so are the expected returns (Huss, 2005). Most private equity funds use high leverage to compensate for the lower expected returns.

2.3 Structure of Private Equity Typically, private equity investing is done through Limited Partnerships (LP), where the Private Equity funds acts as a General Partner (GP). The Limited Partner consists mainly of wealthy individuals and institutional investors who provide the largest part of the capital. The General Partner than has a set time period in which to invest the capital committed by the LP and an agreed time period in which to return this capital to the limited partnership (10-12 years is usual) (Kaplan & Schoar, 2005). During the investment period the limited partnerships are passive and their main type of action consists of providing capital when the GP calls for it. How this works is clearly shown by Cumming & Johan in figure 1.

Capital Capital Investors (LP) Private Equity Fund Entrepreneurial Returns (GP) Equity, debt, Firm warrtens, etc.

Figure 1. Source: Cumming & Johan, 2009, p. 4

This structure began to dominate in the 1980‟s when the private pquity industry reached a more mature state. Finally limited partnerships were an attractive form because the restrictions that were active for SBIC-type investments did not count for these limited partnerships. Some of such restrictions were the fact that 25% of investments had to be directed to “small businesses” and only 10% may be invested in a single company.

Huss (2005) describes that investing in private equity can be done in two ways: a direct investment or an investment through a fund. A direct investor participates in privately placed offerings and is responsible for the investment process. Such an investment is not only very time consuming and costly, but it requires a certain know-how and experience in the private equity market.

When investing through a fund, one can be faced with problems due to asymmetric information between investors and entrepreneurs. These entrepreneurs have a better knowledge about the real conditions of the firm, the market and potential risk factors. Gottschalg and Phalippou (2007) describe the structure of private equity funds as follows.

Investors in private equity funds are principally institutional investors such as pension funds. These investors, called Limited Partners (LPs), commit a certain amount of capital to private equity funds, which are run by the managers of the funds, general partners. The GPs are specialized in either venture capital investments or buyout investments. When a GP sees an investment opportunity it calls (or draws down) the required investment amount from its LPs. 6

Once a fund has reached its target size in terms of committed capital, it is closed for any further investments and thus, keeps a fixed pool of capital to make investments. When the investment is liquidated, the GP distributes the proceeds to its LPs. A fund typically has a life of ten years. This structure has proven to be most effective due to the professional experience of GPs, when having to deal with information asymmetries and other difficulties tied to this market.

3: Performance of Private Equity In this chapter the performance of private equity will be discussed as well as what has been found on this topic in earlier research.

3.1 Introduction When looking at the dataset without running any regression but just summarizing the data from 1986 to 2011, some differences between the index (S&P500) and the Private Equity Index become visible.

Figure 2

The chart above shows that private equity outperforms the market in the long run. Especially during the economic crisis, the S&P500 and Industry Portfolios behave the same, whereas private equity seems to take a far bigger advantage of the upside potential after the dotcom crisis. However the results do not appear to be one-sided because US private equity and the Industry Portfolios behave about the same up until the point where the current credit crisis started. Based on this chart it is not possible to draw any conclusion about the performance of either investment option because these differences could be caused simply by the variance.

When looking at Table1 below it can be seen that quarterly returns for the Private Equity Index are considerably higher than returns of the Index. Over a period of 25 years, the Private Equity funds were able to gain 3,3212% every quarter. The S&P500 gained 2,081625% during the same period. Adjusting these returns for the risk-free rate (Rf) results in an outperformance of the private equity funds with 2,9867% versus 1,747125% for the S&P500. Considering these are quarterly results this implies a strong outperformance of the S&P500 by these private equity funds.

Table 1: quarterly returns of U.S. Private Equity and the S&P500

Variable Obs Mean

US Private Equity 100 3.3212

US Private Equity Excess Returns 100 2.9867

S&P500 100 2.081625

S&P500 Excess Returns 100 1.747125

The above results however cannot be looked at like this, since the amount of risk taken is not the same. Private equity firms tend to take more risk and use more leverage to increase their returns. In this thesis the research will check how private equity performs when adjusted for risk, and if it still performs better once it is.

So what drives the performance of private equity funds? As will be discussed in the next chapter, there has been much debate about this in previous research. Unlike investments in stocks and currencies, investments by private equity funds mean that the management (GP‟s) play an influential role in the companies held in the portfolios and therefor have a bigger influence on the outcome of the investment. These managers have a large influence on the performance of these companies and could therefor make a big difference.

3.2 Overview of earlier research Even though large sums of money are being invested in private equity, very little research has been done about the performance of private equity funds. Partly, this is because not all data is widely available. Some good research papers about the performance of private equity are Phalippou (2007), Kaplan and Schoar (2005), and Cumming et al. (2007). An important remark has to be made about this literature; no previous work has ever had access to very precise data about private equity funds investments and returns. Most of these papers relied on fund valuation data as can be found in the Thomson Financials Venture Economics database. The shortcomings in these papers are: the data are self-reported and thus possibly subject to selection biases. Also, they are based on both realized and unrealized investments, creating noise in the sample. Nonetheless these papers give a good insight in the returns that are realized by the private equity sector.

Ljungqvist and Richardson (2003) performed their research based on cash flow data for a fairly large dataset of private equity funds over the period 1981 – 2001. Their dataset includes precisely dated cash flows representing investments in portfolio companies, management fees, and distributions of capital gains to investors. Ljungqvist and Richardson analyze the cash flow, return and risk characteristics of private equity. Specifically, they ask: “(i) What are the capital investment and return patterns of private equity throughout the life of the fund ? (ii) What determines the speed with which funds invest their capital over time? (iii) How long does it take for returns to turn positive? (iv) What is the risk profile of 2 private equity funds, both in terms of systematic and unsystematic risk? And (v) are private equity returns impressive relative to their risk profile and various benchmarks?”

Ljungqvist and Richardson (2003) were the first to be able to give a definitive answer to these questions. According to their research, private equity funds outperform the S&P500 by almost 25% over their sample period (1983 – 2002).

Previous research shows mixed results about the performance of private equity funds. Ljungqvist and Richardson (2003), Kaplan and Schoar (2005) show that private equity funds outperform the market by quite a bit (23,8% over 10-years) while Phalippou (2007) is not so positive about the private equity market. In his conclusion he even states “If investors do not learn fast enough about selecting the right funds and/or designing more investor-friendly contracts, then the industry might collapse. It would be a terrible scenario because both types

10 of private equity funds are essential to the market economy: VC funds as growth catalysts and BO funds as healthy arbitrageurs.” showing his concerns.

Phalippou and Gottschalg (2007) conclude that Private Equity, when adjusted for risk, performs worse than the S&P500 index. However, their research used data from 1980 until 2000. Looking at the previous chart it becomes clear that private equity indeed does not perform better than the S&P500 in these years but shows an excessive outperforms of the S&P500 in the years after. Based on the larger sample (1986 - 2011) and these facts it is expected to find a better performance than what was shown in previous research.

Based on this short overview of previous research it becomes clear that many contradictions consists between various papers and more research needs to be conducted in order to be able to give a definitive answer to the question whether private equity actually outperforms the index.

4: Data Analysis

4.1 Methodology In this chapter the methods used will be described. The performance measures that will be used in this thesis are the Fama and French regression and the Sharpe Ratio, to calculate the risk adjusted returns. These will be explained in the next 2 sub-paragraphs.

4.1.1 Fama and French The Fama and French three factor model was designed by Eugene Fama and Kenneth French to explain the returns of a portfolio using three variables. Basically they took the CAPM model and added two factors. Fama and French (1992) argue size and the book-to-market equity ratio capture the cross-sectional variation in average stock returns associated with size, the earning-price ratio, the book-to-market equity ratio and leverage. While the book-to- market equity ratio has stronger explanatory power then size it is impossible for the book-to- market equity ratio to replace size in explaining average returns. The Three factor model is more evolved than CAPM. In addition to market risk or beta, it considers two more market factors namely size and book / market ratio.

The formula for using the Fama-French three-factor model is:

( ) ( ) [ ( ) ( )] ( ) ( ) ( )

SMB stands for „Small cap Minus Big‟ (historic excess returns of small cap instruments) and HML stands for „High minus Low Value (historic excess returns of value stocks). s and h are beta corresponding to small cap and large cap portfolio having values either 0 to 1. This means that a portfolio holding all small cap stocks s will be 1 and h will be 0 and for a portfolio holding all large cap stocks s will be 0 and h will be 1.

4.1.2 Sharpe Ratio The Sharpe Ratio is defined as: “A ratio developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance. The Sharpe ratio is calculated by subtracting the risk-free rate - such as that of the 10-year U.S. Treasury bond - from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.” (Hodges, Taylor, Yoder, 1997)

The Sharpe Ratio makes it possible to analyse a fund‟s performance based on the amount of risk it has taken. More specifically, the Sharpe Ratio tells us whether the return of a portfolio is due to a smart investment decision or the result of taking excess risk. This ratio will prove

12 to be very useful to analyse the performance of private equity funds because certain funds can gain a much higher return than others, it is only a good investment if those higher returns do not come with too much additional risk.

Basically, the higher the Sharpe Ratio, the higher the return per “unit” of risk an investor has taken. Investors look to maximize their sharp ratio. A negative Sharpe Ratio indicates that a risk-free asset would perform better than the fund being analysed.

The formula used to calculate the Sharp Ratio is as follows:

[ ] [ ]

√ [ ]

When comparing multiple assets E[R] against the same benchmark with return Rf, the one with the highest Sharpe Ratio gives the largest return for the same amount of risk.

4.2 Data The data that is needed to compare the performance of Private Equity funds compared to the S&P500 was pulled from different sources.

To analyse the performance of the private equity sector the Cambridge Associates U.S. Private Equity Index is used which was established in 1986. This index has monitored investments made by venture capitalists and other alternative asset partnerships. During the 25-year existence of this index, a total of 905 U.S. Private Equity firms were included in the sample. Financial statements and narratives of Limited Partnerships were used as the primary source of information concerning cash flows and net asset values (NAV) for both partnerships and portfolio company investments. The Cambridge Associates U.S. Private Equity Index uses both the internal rate of return (IRR) and the end-to-end performance calculation in its benchmark. This data was collected quarterly. Data from Q1 1986 to Q1 2011 is collected from this database.

The S&P500 was used to compare these results to. The S&P500 was chosen because all private equity funds in the sample are U.S. Private Equity funds, thus a US Index had to be used. The S&P500 was used because this is the largest US stock index and is known to be the most reliable stock index in the United States.

To analyse the performance of the private equity sector, relative to the S&P 500 the Fama and French regression and the Sharpe Ratio are used. To analyse the performance of the private equity sector, quarterly data was collected from the Cambridge Associates U.S. Private Equity Index. This index dates back to 1986 and gives us a longer time horizon than would have been possible if using the S&P 500 listed private equity index, which only dates back to 2007. The Fama and French factors were downloaded from the Fame and French website. The quarterly data on the S&P500 were collected from datastream. In total exactly 100 observations were collected.

4.3 Results First the returns of both the S&P500 and the US Private Equity had to be calculated to be able to calculate the excess returns of both indexes. After calculating the excess returns it becomes possible to run the Fama and French regression of which the results can be found in Table 2.

Table 2: US Private Equity and SP500 Fama and French Regression

Variables Fund_Excess SP500_Excess Mktrf 0.385*** 0.999*** (0.0468) (0.0129) Smb -0.0345 -0.193*** (0.0754) (0.0207) Hml -0.0720 0.0490*** (0.0491) (0.0135) Constant 2.389*** 0.126 (0.365) (0.100)

Observations 100 100 R-squared 0.484 0.986 Standard errors in parentheses

*** p<0.01, ** p<0.05, * p<0.1 When regressing the Fama and French factors on the S&P500 and the Cambridge Private Equity Index the above results are found.

What is first noticed is the large difference in the R-squared. The R-squared for the S&P500 Index is very large, which is to be expected. The R-squared for the Private Equity index is considerably lower. The adjusted r-squares for the S&P500 and the Cambridge private equity index are 0,9861 and 0,4677 respectively. When looking at the p-values of the coefficients it can be said that for the S&P500 all variables appear to be statistically significant at the 1% level, except for the constant. For the private equity however, only mktrf and the constant appear to be statistically relevant and thus interpretable. What also becomes visible is that the constant for private equity funds excess returns is very large, which is statistically significant, meaning that other factors then the ones regressed in this model have a big influence on the performance of private equity funds. It is unclear as to why the private equity returns show no significance related to the SMB and HML variables.

The above results show that 98,6% of the results in the sample of the S&P500 can be explained by the model. However the Fama and French model can only explain the results of the private equity firms for 48,4%. The majority of variation in the private equity seems to be caused by the presence of unobserved determinants, whereas previously identified

15 determinants (mktrf, SMB, HML) are responsible for only 48,4% of the explained variation. These unobserved determinants might be insider information or management bias as discussed earlier in this paper.

To further test and compare these results the Fama and French regression was also done on the 25 industry portfolios provided by Fama and French. These portfolios are constructed at the end of each June, and are formed on size, and book equity to market equity ratio. The portfolios include all NYSE, AMEX, and NASDAQ-stocks for which this data is available. Because of the inclusion of all these stocks, these industry portfolios are a good alternative to the benchmark (S&P500) that was used in the previous test and enables us to test the assumptions found. Since the database with the industry portfolios already contained the returns all that remained to be done was to calculate the excess returns before it was possible to run the regression. The results from the Fama and French regression are shown in Table 3.

Table 3: Industry Portfolios Fama and French Regression

Variables Industry_Small Industry_2 Industry_3 Industry_4 Industry_Big Mktrf 0.282*** 0.309*** 0.305*** 0.326*** 0.327*** (0.0141) (0.0109) (0.0115) (0.0117) (0.00707) Smb 0.334*** 0.243*** 0.149*** 0.0753*** -0.0885*** (0.0229) (0.0177) (0.0187) (0.0190) (0.0115) Hml 0.0791*** 0.0724*** 0.0621*** 0.0695*** 0.0802*** (0.0150) (0.0116) (0.0122) (0.0124) (0.00749) Constant 0.472*** 0.340*** 0.460*** 0.430*** 0.364*** (0.111) (0.0858) (0.0903) (0.0922) (0.0556)

Observations 101 101 101 101 101 R-squared 0.920 0.946 0.927 0.921 0.961 Standard errors in parentheses

*** p<0.01, ** p<0.05, * p<0.1 All variables are statistically significant at the 0.01 level even though only one more observation was observed compared to the S&P500. The R-squared is lower than what was found for the S&P500 but still very high. Most of the variance in the industry portfolios can be explained by the factors in the Fama and French model. Comparing these results to the results found when regressing the Fama and French factors on the private equity excess returns, it is noticed that the mktrf is actually quite similar. The constant found in the industry portfolios is a lot smaller than found with the private equity.

To get an indication of the Sharpe ratio the excess returns of both the S&P500 index and the Cambridge Private Equity List were divided by their standard deviation and summarized the results in the table below. The results of the industry portfolios were added as well. The results can be found in Table 4.

Table 4: Overview of mean Sharpe ratio’s

Variable Obs Mean Min Max Private Equity 100 0.6122811 -3.177512 3.189792 S&P 500 100 0.2108026 -2.863109 2.503935 Industry Small 101 0.2368748 -2.647444 2.449887 Industry 2 101 0.211833 -2.532312 2.230646 Industry 3 101 0.2506405 -2.55451 2.256266 Industry 4 101 0.2452797 -2.971272 2.344931 Industry Big 101 0.2292209 -2.871483 2.135282

The results are with expectations, the Sharpe Ratio for the private equity is far larger than the Sharpe Ratio of the S&P500 indicating a return almost 3x as large based on risk. This is what investors expect since they are incurring more risk than when investing in a more stable option like the stocks in the S&P500. The industry portfolio‟s show a similar return as the S&P500 which is to be expected. The returns for the industry portfolio‟s is actually slightly larger than the return of the S&P500 which could be because the Industry Portfolios are mainly based on the NYSE instead of the S&P500. Also, note that the mean return for the industry portfolios does not follow a linear line as was expected. Looking at their standard deviations it becomes clear that these are indeed correct and become smaller as the industry portfolio becomes larger. The difference in mean returns might be caused by the small sample as there are no other references as to why this could be the case.

Based on earlier research and the expectations, these outcomes are no surprise. More than any other type of investments, Private Equity leaves room for these kinds of returns because of their inaccessibility of information and their influence in the companies in their portfolio.

To research if private equity firms perform better or worse during an economic crisis the same Fama and French regression is used and Sharpe Ratio is calculated as above, using the data from the current credit crisis, 2007 – 2011 (most recent data). The results from this test can be found in Table 5.

Table 5: US Private Equity and S&P500 Fama French Credit Crisis

Variables S&P500 Private Equity Mktrf 1.024*** 0.538*** (0.0356) (0.0950) Smb -0.175 -0.00579 (0.110) (0.408) Hml 0.0476 -0.153 (0.0475) (0.176) Constant -0.314 1.416 (0.274) (1.016)

Observations 17 17 R-squared 0.994 0.733 Standard errors in parentheses

*** p<0.01, ** p<0.05, * p<0.1 Unfortunately only the mktrf appears to be statistically significant. This is probably due to the small amount of observations available when dropping all observations prior to 2007. Because the dataset used consists of quarterly observations, this only leaves us with 17 observations to analyse.

Next the Sharpe ratio was calculated using the same period. Results are shown in Table 6.

Table 6: Overview of mean Sharpe ratio’s Credit Crisis

Variable Obs Mean Min Max Private Equity 17 0.3646657 -3.177512 1.576432 S&P500 17 0.0091784 -2.863109 2.017937 Industry Small 17 0.06777 -2.484016 2.084744 Industry 2 17 0.1542173 -2.532312 1.939223 Industry 3 17 0.2629368 -2.484396 2.256266 Industry 4 17 0.1078149 -2.971272 2.344931 Industry Big 17 0.0051756 -2.871483 2.064694

These results are actually quite surprising, because the sharpe ratio for the private equity index is still larger. The Min – Max does show a larger downward potential and smaller upward potential that the S&P500 and industry portfolio‟s for this given period. But the larger mean is surprising given the illiquidity of the investments of private equity funds, which makes it hard to adjust to economic crises. However, because the variables in the Fama and French regression turned out to be statistically insignificant, this will probably be the same for the variables which the Sharpe ratio is based on, thus making it impossible to draw any real conclusions from this test. The large differences in the Sharpe ratio for the industry portfolio‟s confirm this.

5: Conclusion 5.1 Conclusion This research is conducted in order to provide an answer to the main and sub research questions that were provided in the first chapter. To recall, the main question of this thesis was:

“Does private equity perform better than the S&P500?”

Followed by the subquestion:

“How does private equity perform in times of economic crisis?”

Based on the research conducted in this thesis it can be concluded that private equity firms outperform the Index (S&P500) by a large margin. The results found in the Fama and French regression, based on the complete dataset, gave some interesting insight in the performance of Private Equity funds.

Showing an R-squared of only 48,4% indicates that returns of private equity funds can not be explained completely by a model like Fama and French and there are other factors influencing the returns than the ones included in the Fama and French model. For the S&P500 the R- squared was very high, which was to be expected, since the Fama and French model is respected for being able to explain large parts of the variance in stock markets, better than older models like the CAPM used to be.

The remaining 51,4%, which cannot be explained by the Fama and French model indicates that there are other factors driving private equity funds performance. The large constant found in the results of the Fama and French regression for the private equity returns confirm this. As discussed earlier in this paper, factors like insider information and management bias can play an important role in the performance of private equity funds. Because information is not so easily available about the private companies that are being invested in, and the influence of the funds managers in these companies, performance is not as straightforward as a portfolio of normal S&P500 stocks would be, where investors have little to no influence on the decisions being made at the companies they invested in, and, all investors have the same information since all public companies are obliged to share this information with public investors.

Due to the small dataset it was not possible to draw any conclusions from running the same test during the period of the current credit crisis. The results turned out to be statistically insignificant even at a 10% level and are therefore useless.

5.2 Limitations and future research

5.2.1 Limitations The largest limitation of this research is the small dataset that was used to acquire the data for the analysis. Although the data proved to be sufficient to analyse the performance of private equity funds based on the period 1986 – 2011, there were not enough results to get any statistically significant results about the performance of private equity during the current credit crisis.

Another limitation is the use of just the S&P500 and the industry portfolios as a performance measure. More extensive research could be done using other benchmark indexes like the NYSE, Nasdaq and MSCI Index. Furthermore only data concerning the American private equity market was used whereas it would be better to get a more global view of the market by including also the European and Asian private equity funds.

At last, the availability of data on the performance of private equity funds is a limitation. Data as was used by Ljungvist and Richardson (2003) is not publicly available but would give the best results. Working closely with some of the largest private equity funds would be the only option to conduct such a research and get access to reliable data.

Future research Future research could be done using a much larger dataset. A similar research as has been done by Ljungqvist and Richardson (2003) could be performed using more recent data to analyze the performance of private equity funds in the credit crisis. Based on their dataset it would be possible to give a more precise conclusion about the role of management in private equity funds and their influence on the performance.

Research in another market would be a very good addition as well. Almost all research that has been done on the performance of private equity has been done in the US market, whereas almost no research can be found on the fund performance of private equity firms in Europe or Asia. Since these types of investments are relatively new compared to stock investments it would be interesting to show the differences, if any, between these markets. Furthermore, more research could be done based on the size of these private equity firms to see if larger firms perform better or worse than smaller firms. This future research will depend on the availability of information about private equity fund investments.

6: List of References

Bance, A. (2004). Why and how to invest in private equity. EVCA Investor Relations Committee.

Cochrane, J. H. (2005). The risk and return of venture capital. Journal of Financial Economics, 75(1), 3-52.

Cumming, D., Siegel, D. S., & Wright, M. (2007). Private equity, leveraged buyouts and governance. Journal of Corporate Finance, 13(4), 439-460.

Diller, C., & Kaserer, C. (2009). What Drives Private Equity Returns?- Fund Inflows, Skilled GPs, and/or Risk? European Financial Management, 15(3), 643-675.

Gladstone, D., & Gladstone, L. (2002). Venture capital handbook : an entrepreneur’s guide to raising venture capital.

Gompers, P. A., & Lerner, J. (2000). The Determinants of Corporate Venture Capital Success Organizational Structure , Incentives , and Complementarities (pp. 17-54).

Harris, R. S., Jenkinson, T., & Kaplan, S. N. (2011). Private Equity Performance: What Do We Know? SSRN Electronic Journal.

Hodges, C. W., Taylor, W. R. L., & Yoder, J. A. (1997). Stocks, Bonds, the Sharpe Ratio, and the Investment Horizon. Financial Analyst Journal, 53(6), 74-80.

Huss, M. (2005). Performance Characteristics of Private Equity: An Empirical Comparison of Listed and Unlisted Private Equity Vehicles.

Kaplan, S. N., & Schoar, A. (2005). Private Equity Performance : Returns , Persistence , and Capital Flows, LX(4), 1791-1823.

Ljungqvist, A., & Richardson, M. (2003). The cash flow, return and risk characteristics of private equity. Working Paper No. 9454. Retrieved from http://onlinelibrary.wiley.com/doi/10.1002/cbdv.200490137/abstract

Malkiel, B. G. (2003). The Efficient Market Hypothesis and Its Critics. Journal of Economic Perspective, 17(1), 59-82.

Phalippou, L., & Gottschalg, O. (2007). The Performance of Private Equity Funds. Review of Financial Studies, 22(4), 1747-1776.

Phalippou, Ludovic. (2007). Investing in Private Equity Funds: A Survey. SSRN Electronic Journal, 1-22.

Renneboog, L., & Simons, T. (2005). Public-to-Private Transactions : LBOs , Public-to- Private Transactions : LBOs , MBOs , MBIs and IBOs, (August).

Sahlman, A. (1990). The structure and governance of venture-capital organizations, 27, 473- 521.

Weidig, T., & Mathonet, P.-yves. (2004). The Risk Profiles of Private Equity Private equity is a risky asset , but private equity investments are not necessarily so ., (January).