Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Deep Dive on Private Equity: Risk, Returns, and Manager Performance (S1 E11)
Discover the hidden complexities of private equity and the factors that can make or break your investment portfolio. Edward Finley guides you through the labyrinth of risk factors inherent in private equity, drawing on the analytical work of the economists L'Her, Jenkinson, Kaplan, and many others to dissect the performance of buyout, venture capital and growth equity strategy under the microscope of risk.
We unravel the myth that larger firms are always the prime targets for buyouts, exposing a surprising tilt toward smaller companies and their associated size premiums. As we navigate the murky waters of measuring value in private equity, where market prices don't exist, we find that buyout almost certainly buys value firms but it's impossible to observe; while venture capital and growth equity likely have the opposite. We also shed light on the impact of leverage in the strategies and its double-edged sword in shaping returns.
Come further into the realm of private equity with me as we evaluate the performance of buyout and venture capital. Through the lens of recent scholarly work by luminaries like Harris, Jenkinson, and Kaplan, we uncover that the modest outperformance of buyout since the turn of the century is really the result of only top quartile managers...and, sadly, there seems to be no way to know which managers will be at the top. In contrast, we discover that the top quartile venture capital managers earn whopping excess return, even more than the already impressive median manager. What's more, it seems like top managers tend to be top managers. So what's the catch? Listen and fined out!!
Our conversation is a clarion call to investors, emphasizing the pitfalls of investing in the private equity landscape. Stay tuned as we pivot from equity to the world of bonds in our next episode, promising to enrich your finance knowledge journey with each step we take together.
Notes - https://1drv.ms/p/s!AqjfuX3WVgp8uXbQAMablbPWeFl6?e=hhPBhc
Thanks for listening! Please be sure to review the podcast or send your comments to me by email at info@not-another-investment-podcast.com. And tell your friends!
Hi, I'm Edward Finley, a Sum-Time Professor at the University of Virginia and a Veteran Wall Street Investor, and you're listening to Not Another Investment Podcast. Here we explore topics and markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast, I'm Edward Finley. Next time we took a deep look at private equity and, in particular, its structure, its form of governance, how it works, what the different stages of private equity investment are and some of the real challenges in measuring risk and return. We ended that episode with a question what risks do we own when we own private equity? The one of the most important papers that helps us answer that question is an analysis that was done just of buyout not of venture capital and growth equity by LaHair and a number of his co-authors called a bottom-up approach to the risk-adjusted performance of the buyout fund market. It's a big name. We're just going to call it bottoms up. What LaHair and his colleagues do is they have access to some very, very good data on limited partnership investors' investments in buyout funds. They've got very good data not only on their investments in the buyout funds but also the portfolio companies themselves.
Speaker 1:Over a very long time horizon, lahair and his co-authors seek to decompose what the risk exposures are in a buyout fund. First, and I think probably most obviously, is market risk. There's going to be some degree to which portfolio companies operate in the broader economy and they're subject to the same macro effects as public equities. They are, after all, both exposure to the productive economy, earning a premium for uncertainty. There's going to be some amount of market risk that's inherent in a company, whether it's a private company or a public company. In addition, public equity markets have a really large influence on the price that a strategic partner will pay to buy the portfolio company from the buyout manager and certainly the price that can be commanded in a public offer or sale of the company. But likewise, public equity market levels will have a huge impact on the price that the buyout manager pays to take the company private, both on the acquisition of the public company, taking it private, on the deaccessioning of the private company. All the levels of public equity markets will have an important impact on what the risk is inherent. The uncertainty is inherent in that investment. Market risk, we think is inherent in all of these strategies. Laharran and his team find that to be true.
Speaker 1:Second question is well, what about the size risk. What about small companies versus large companies and the premium that we saw in the Fama and French research? Well, in buyout I suppose it might not seem like there would be any exposure to small risk, because typically when we read the newspaper about buyout funds, we're reading about deals that are enormous buyout managers that are acquiring public companies for billions of dollars, and so it might seem to us intuitively that buyout really should have no exposure to the size premium. In fact, if anything, maybe the opposite, exposure to large. But LaHarran and his colleagues find that this is exactly wrong. 99.96% of the portfolio companies in their data are smaller than large cap. I love how only academics would be so precise as to say 99.96% instead of all. So there are some there that are not. Which ones are not are probably the ones we're reading about in the headlines. So the headlines are really four hundredths of a percent for basis points of all of the deals that happen. So it's really misleading what the headlines tell us.
Speaker 1:Most all, nearly all, of portfolio companies in buyout are small cap companies and the median portfolio companies. Enterprise value is well below the minimum size to be considered small cap in public markets Well below, in other words, half of portfolio companies are significantly smaller than even small cap. Moreover, the distribution of portfolio companies size is skewed towards the larger small companies. Even though half of them are smaller than small cap, the other half the half that is in small cap are really skewed towards the larger small companies. So 91% of portfolio companies are in the bottom 10% of small cap, and so, to put that all together, what that means is that in buyout, we absolutely do have exposure to the size factor. We own small companies. In fact, we not only own small companies, we own very, very small companies.
Speaker 1:How about venture capital and growth equity funds? Well, here, the Leher paper doesn't talk about it. There's no research to support this, but, intuitively, it should be very clear that in venture capital and growth equity, we are talking about very small companies. Recall when I gave you some of the data as at the end of 2023, the late stage series C companies on their fund raises at the end of 2023, we noted that the median enterprise value is 173 million. That is very, very small. Small cap companies typically are in the range of 250 million to as much as a billion, so that's really small as well, but growth equity should be little different.
Speaker 1:Another factor that could be present here is value. Again, let's start with some intuition. So, whether in buyout, whether we're talking about, you know, leveraged buyout or traditional buyout, in both cases these are public companies who are experiencing some sort of distress, meaning their price is relatively low relative to its book value, and so that is the definition of the academic value factor. So, intuitively, we would imagine that buyout managers will have exposure to the value factor. The problem is and Lahare and his co-authors explain it's very, very difficult to measure this directly, because private companies don't have market prices, and so we can't compute price to book value ratios because there is no regular price, and so we have to kind of just imagine that the factor risk is there, but we can't really observe it and we can't really measure it, so Lahare and his co-authors simply choose to ignore it.
Speaker 1:Next is leverage. Well, in buyout, let's start with Lahare's study. In buyout, whether we're talking about traditional buyout or leveraged buyout, both typically involve adding some debt to the balance sheet of these companies, and Lahare and his team don't differentiate between the two types. They're looking only at buyout and the aggregate, and what they find is that, at acquisition, when the private equity fund acquires the public company, it takes a private. The average portfolio company after acquisition has about twice the level of debt as its equivalently sized public company peer. Twice as much debt. However, by the time that portfolio company is sold to a strategic or taken public again, the debt is only about 30% higher than the equivalently sized public company peer. So we have absolutely companies that are more leveraged than, say, small cap companies would be leveraged. But it changes over time and so Lahare and his team imagine that over the life cycle of a single private equity vintage there is on average about 50% more leverage in those portfolio companies than there would be in a public company peer.
Speaker 1:So leverage just clearly plays a role In venture capital and growth equity. Again, lahare and his team don't study that but using our intuition we know that these companies are at the earliest stage of their life cycle and they can't really use debt very much because they usually don't have sufficient cash flow to service the debt, don't have profits to make it useful to deduct the interest of the debt all the reasons we talked about earlier in why companies access debt versus equity. So we wouldn't expect to find much financial leverage in these companies, but we might expect to find more operating leverage in these companies. That is, smaller companies do more with less, and that kind of leverage makes the company just as fragile as financial leverage would. If you're doing more with less and there's an adverse circumstance that takes place in the economy, it's going to be far more impactful for you as a small company trying to do more with less than it would be for a giant company like Apple to be able to roll with that change in the economic circumstances. So leverage, it would seem, should be present in venture capital and growth equity. It's just that it's very, very difficult to observe and compute it.
Speaker 1:Last but not least, is illiquidity risk. Now here we have to distinguish between the illiquidity of the portfolio company, and it's very intuitive. That's quite high because it's no longer public, it's private. So there's going to be a lot of illiquidity in those companies themselves, and typically, finance theory tells us that if there is difficulty in selling an asset on a market, ie if it's illiquid, that owners of that asset will demand a risk premium for that illiquidity. We also have to take into account, though, that the fund itself is illiquid. The investors in the fund are not permitted to sell their limited partnership interests, they have to have the general partner's permission to do so, and that makes those illiquid. So illiquidity exists in two forms the portfolio company has a significant amount of illiquidity and the limited partnership interest that we invest in in the fund has a sufficiently large amount of illiquidity to take note.
Speaker 1:Many studies have found that there are some returns in buyout that are attributable to illiquidity. Other studies don't find any. Lahare and his team are in that latter category. They can't seem to find any evidence for illiquidity. But we know that the risk is there. We just don't quite know how to observe it and how to measure it. Okay, so let's start with what we observe. Those are the risks we think we own when we own private equity. Let's turn our attention now exclusively to buyout for a moment and evaluate what those risks look like and then how the average manager does in earning returns for those risks. So again, lahare studies vintages dating back to 1986 and goes up through 2008. So this is not very, very up to date.
Speaker 1:What does Lahare and his co-authors find Well? First, they find that the average buyout manager usually delivers excess returns over size and leverage, but that it varies with business cycles. So in their data we can see that the excess return over their risks here we're just focused on leverage and size the excess return over their risks varies by vintage. Here In 1986, it was positive 4.5%, but in 1987 and 1988, it was negative 2.4%, and we see that occur again and again. In 1996, 78 and 9, vintages underperformed by 1.5%, and on just size alone, and 3.3% on size and leverage. In 2006 through 2008, vintages on average underperformed a little more than 3%. So Lahare and his team find that, just like we would have imagined, the excess returns time vary with the vintage years. They also find that the average vintage so let's just say we didn't pay any attention and every year we invested in every buyout manager. So we own every vintage and we own every manager the average vintage delivers a meaningful outperformance over the risk. On average they earn about 1.5% per year over the size and leverage exposure.
Speaker 1:Well, it's difficult to choose vintages ex ante because we can't know which vintage is going to be a good business cycle and which vintage is going to be a bad business cycle, and so, as investors, the data suggests to us that we shouldn't try to pick vintages. We should be regular investors in that risk if we want to own it. It also shows that if the average vintage is producing excess performance over the risk, it also suggests that it might be that there's some skill there. It also might not be skill. Remember when we talked about some of the weaknesses of arbitrage pricing theory? One of them is that these risks are not an exclusive list. More importantly, we just discussed a moment ago how we know that buyout contains value risk. We just can't measure it. And we know that it has illiquidity risk. We just don't know how to measure it. And so if we find that the average vintage earns 1.5% a year more than size and leverage, that might not be skill. That might just be the compensation for illiquidity and or the compensation for value.
Speaker 1:The question that one has to ask, though, is assuming that this data tells us that there's something interesting about owning buyout and I think it does tell us there's something interesting about owning buyout 1.5% in excess of the risks doesn't sound like a whole lot, particularly when you take into consideration the illiquidity. The question that it begs is so Do most private equity managers deliver only that, and are the really good ones delivering a lot more than that in excess return, or not so much in excess return, and for that we have to turn to a different study that was prepared by Harris, jankensen and Kaplan, and this is a 2020 paper, so it's a little bit more up to date. They look at data from 1984 to 2019. And they also don't just look at buyout, they also look at venture capital, and so we can get a better idea. What we find is that top quartile managers, in both buyout and venture capital, earn significantly more than their risk exposures and significantly more than the median manager. So let's take buyout first.
Speaker 1:Top quartile managers in buyout earned, on average, 8% a year excess return compared to the median, and the median is very similar to what Lahare and his team found in buyout about 1% over the risks. So, top quartile managers, that is very, very rich. If you can earn 8% in addition to the return for those risks, that is very, very rich. Now it's interesting Harris and his team find that before 2001, that was a more significant number. That was an 11% excess return over the risks and it diminished somewhat after 2000, down to 7.5%. But nevertheless, I think pigs get fat and hogs get slaughtered. Whether you're earning 8% more or 11% more, top quartile buyout managers are really well worth the effort.
Speaker 1:How about venture capital? Top quartile venture capital managers earned wait for it 19% in excess return compared to their risks. Now if you compare that to the median venture capital manager, the median venture capital manager earned 6% excess return. So first takeaway is that the median manager you have no way of knowing who's good and who's bad, you just get the middle of the road. Venture capital is earning a lot more in return over their risks than buyout 6% versus 1%. The second takeaway is when we're looking at just the top quartile, buyout sounds pretty great. The managers earn 8% more than their risks. But venture capital sounds even better. The top quartile managers earn 19%. So top quartile private equity managers both buyout and venture earn significantly higher excess returns than the median manager, and the excess performance of venture capital is a lot higher than that of buyout. But in both cases it's really well worth the focus.
Speaker 1:The other thing that you take away from this is that both for venture capital and for buyout it's diminished since 2001. I told you the buyout number. It went from 11% before 2001 to 7.5%. In venture capital, it went from 26% excess return to 14%. I would argue that while that's interesting, I'm not entirely sure that we have to adjust our views. We can really rely on the fact that venture capital top performing managers do far better than the median and buyout top performing managers do far better than the median, okay.
Speaker 1:So then the next question, the next sort of logical question, is do you have to find only the top quartile managers to earn those really great returns? And it turns out that you kind of do Second quartile managers barely, or didn't even earn excess returns over their risks. What Harris and his team found, that is, in buyout, the excess return of a second quartile manager was less than 1% a year over their risk, and in venture capital they found that it was a 1% underperformance of their risk. So the data from Harris and team indicate that it's not only important to get the top quartile. It would seem it's crucial, because unless you have sufficient capital to invest in all the quartiles and own all the managers, you're not gonna get that 1% in buyout, you're not gonna get that 6% in venture capital median excess returns. You're likely, much more likely, to have very modest, less than 1% returns in buyout and maybe even underperformance in venture capital. Okay, so that's the takeaway.
Speaker 1:The takeaway is it's super important to be able to identify the top quartile managers. Can we? And here it seems the answer is different depending on whether we're talking about buyout or whether we're talking about venture capital. Let's start with buyout. So what Harris and Jenkins looked at is they looked at all of the managers' previous funds and I ranked them by quartile. So they were either top quartile, second quartile, et cetera, in terms of excess returns over their risk, and then they mapped out the next fund from that manager and they quartiled that. And when they collected all that information then they computed well, what was the probability that a top quartile manager delivered a top quartile fund, a second quartile delivered a top quartile, et cetera.
Speaker 1:So in buyout, can we see what we call in the literature this notion is the notion of persistence, because if we have a top quartile manager whose next fund is more likely to be a top quartile fund, that suggests there's some skill and we wanna just invest in that manager and we can look historically at how they do. And then we can know okay, we want to invest in this manager's next fund because they're good at it. Remember, we don't wanna time vintages, because that time varies significantly and we can't really identify which vintages will be good and which will be bad. We wanna own all vintages, but not all managers. We just want those top quartile managers. So the Harris and his team sought to answer that question, for both buyout and venture. So let's start with buyout.
Speaker 1:The top quartile managers in Harris's study had a 28% chance of their next fund being in the top quartile. Now you don't have to be a statistics scholar to figure out that we're talking about quartile. So there's only four different options. It can be first, second, third or fourth. If it's completely random, the probability of a fund being top quartile is 25% if it's completely random. And Harris and his team found that top quartile managers' next funds were only 28% of the time top quartile.
Speaker 1:It would seem that it isn't really persistent. It would seem that a top quartile manager doesn't necessarily mean you're gonna get the next fund to be top quartile. It's also interesting to note that that's the overall data After 2000,. There was a 22% chance that a top quartile manager's next fund would be top quartile. So with buyout, it seems there's very little evidence to suggest that there's persistence of returns, that there's skill that's replicatable by buyout managers. Just for completeness, the second quartile managers had a 26% chance that their next fund would be in the top quartile Like.
Speaker 1:The reason to look at the second quartile is sort of maybe this is an avus story. You know, we wanna be number one, so we work harder. We don't have to be number one. But the evidence isn't there right. The second quartile funds on the next go round had a 26% chance of being top quartile and the median manager had a 27% chance of their next fund being top quartile. So overall, it would seem Harris's data suggests there's really no evidence of persistence in the returns of buyout managers. So how do we find those top quartile managers? It would seem that how we find them is we have some qualitative insight not a quantitative insight that we can appreciate that a manager is going to do well over time. But that's a very, very difficult thing to do, which is part of what makes investing in buyout a very, very risky enterprise, in addition to all of the other risks that are there. Because, in addition to all of the other risks, what we've seen is that we're very likely, if we don't know what we're buying, we're very likely to earn just what our risk exposures would have been and maybe less.
Speaker 1:How about venture capital. The story is very different in venture capital. So nearly half of top quartile managers had their next fund in the top quartile Half. That's real evidence of persistence. Now it did drop a bit. It went from 49% to 48% after 2000,. But that's really the same number.
Speaker 1:In my opinion, the evidence there suggests that a top quartile venture capital manager is going to be a top quartile venture capital manager and therefore very worthy of investment. How about the Avis question? Is the second quartile manager likewise going to work harder? Second quartile managers were much less likely to have their next fund in the top quartile. It was 29% across the whole sample and it fell to 24% after 2000. And so the takeaway here is it's not enough to be second quartile. Even in venture capital it has to be top quartile in order to earn the kind of excess returns that matter. Interestingly though, the median manager, if I just sort of threw darts at the top half, they had a 39% chance of their next fund being a top quartile fund, both before and after 2000. And so it suggests that if we're not hitting for the stands and we're just instead swinging for doubles, we might actually have a pretty good chance of getting top quartile performance.
Speaker 1:So let's take it all together, then and see if we can't make any sense of this. It would seem that the challenges in understanding investing in private equity are at every turn. One challenge is precisely understanding the kinds of risks that we own, and, as we saw, it's difficult to measure all of them and so creates some challenges. It's very challenging giving the structure and the operation of private equity funds to even compute the normal statistics that we would compute in order to evaluate return for a given level of risk, and we have some solutions there, like public market equivalent, but they're imperfect. They're not entirely telling us the whole story.
Speaker 1:We saw that while the average buyout manager and the average venture capital manager and vintage will earn returns in excess of their risks and buyout, it's pretty modest. In inventory capital it's not. It's pretty robust. But when we looked a little more deeply, what we saw is that really where the great amount of juice comes is in the top quartile, and there, in buyout and inventory capital, it's. It's got to be the top quartile. The top quartile is important.
Speaker 1:The problem is that in buyout, we have no reliable way of evaluating whether a manager is going to be a top quartile manager or not. And so it leaves us a little bit in a quandary. With venture capital, we very well know from the data, we very well know that a top quartile manager is very likely to be a top quartile manager. And so you might think, well, that's great, that's easy, you just invest in top quartile managers.
Speaker 1:But there's the rub, because in the world of venture capital the top quartile managers aren't readily available to investors, even big institutional investors. A very good friend of mine who works at a large public firm that invests in venture capital managers they create what is called a fund of funds Once told me that the top quartile venture capital managers do outstanding work but he can't even get it. Even he can't get access to those funds. And the reason is because those managers recognize that they have skill and they recognize that their skill is replicatable and they don't want to water down that skill by accepting too much capital. So they've significantly restricted. Any large university endowment will tell you the same story Very, very difficult to get access to those managers, and it's built largely on relationship.
Speaker 1:So there's the world of private equity. It's equity, but it's not. It's something different and it isn't really the panacea that sometimes we read about in the press. It's a very tricky thing to evaluate and it's not something that anyone should attempt to do, sort of willy nilly. I'm going to leave it there and look forward to seeing you next time when we come to bonds as an asset class. Thanks for listening and see you soon. You, you, you, you, you oder you, you, you, you, you, you, you, you, you, you, you, you.
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