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Does Private Equity Perform Better Than the S&P500?

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Does Private Equity Perform Better Than the S&P500? 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 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. 3 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
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