Fintech investor Pantheon's Andrew Lebus reveals why unlisted eqity can add alpha over the long term.
One of the much touted benefits of investing in private equity was its low correlation to other asset classes, particularly public equities. Its different return profile led many institutional investors to allocate to private equity in the 1990s because of the presumed diversifying effect within portfolios. To some extent this was correct; valuations of private equity investments were, at that point, generally held at cost until an actual realisation event. Specifically, they were not adjusted up or down even in rising or falling equity markets. The theory was that illiquidity made private equity not only “alternative” but also uncorrelated.
In 2007, new accounting standards forced managers to mark-to-market their investments and it soon became apparent that private and public equity were indeed correlated – highly correlated in fact. A tumbling global equity market made private equity valuations fall and the “ah-ha” moment occurred – public equity and private equity are the same corporate assets subject to the same company-specific issues and macroeconomic trends. The historic lack of private equity valuation adjustments had created the false perception of uncorrelated returns, and with this new insight, private equity’s ability to diversify was discredited.
So, if private equity offers few diversification benefits, why should investors bother to include this illiquid asset class in their portfolios?
Over the past 30 years, a number of studies have shown that quality private equity managers have been able to generate excess returns on a risk-adjusted basis. But for an investor looking to allocate to private equity it is important to understand the drivers of this outperformance – is it due to financial engineering and sector-geography exposure? Or does private equity offer value creation, and, if so, how is it generated.
A study* by Pantheon using a unique proprietary dataset of realised deals found the alpha generation is created by improving the operations and management of their portfolio companies, optimising the alignment of management incentives, introducing initiatives to grow revenues and optimise margins, expand overseas and re-investing cash flow at the expense of short-term earnings. It’s an activist ownership model on steroids that public ownership typically can’t deliver. Private equity’s “alpha” is the component of performance that cannot be replicated by simply leveraging a portfolio of publicly traded securities.
The survey also revealed that alpha was delivered throughout the business cycle, which indicates skill rather than luck highlighting the relevance of the private equity asset class, especially for portfolios with a long-term objective. Portfolios such as these will, by construction, invest through multiple business cycles, and can therefore benefit from allocations to an asset class, such as private equity, that can potentially deliver robust risk-adjusted outperformance throughout the cycle.
In the technology sector, for example, the strong growth dynamics resulting from the proliferation of software and technology services across industries, as well as the appealing characteristics of a number of business models in the sector, have driven strong appetite within private equity. Over the past few years, a number of technology-focused buyout/growth funds have been raised as private equity sponsors appear to be more knowledgeable about how particular business models operate and are more comfortable with the pricing environment in a sector where cash rich trade buyers have dominated M&A activity for a long time. In an increasingly expensive pricing environment, it is essential for private equity managers to not only select the best assets in the market at the most advantageous price, but to also showcase their ability to improve the performance of businesses and achieve growth above and beyond that available in public markets.
Applying the same analysis as the one used in the study* to a set of technology buyout transactions yields results that suggest the amount of alpha generated in technology buyouts is even more material compared to the wider sample of transactions used in the study*. A significant part of the returns was driven by (i) the ability of managers to develop businesses and achieve annualised revenue growth above the growth of listed market comparators despite absolute growth for the analysed technology sub-sectors being very robust in public markets; (ii) private equity managers were able to manage the profitability of their portfolio companies better than public peers; and (iii) private equity managers were able to take advantage of multiple re-ratings by repositioning assets and realising value efficiently.
It is suggested that public corporations often suffer from management whose incentives are not sufficiently aligned with those of shareholders. Buyouts, on the other hand, allow the shareholders, who in this case are the partners in a private equity fund, to control and manage the company thereby aligning the interests of owners and management and enforcing value-adding operational improvements that might not occur otherwise.
Both the study* into improved efficiencies delivered by the private equity model and the improved alignment of interest provide both fundamental and economic theory for how value creation might occur. With time and effort an investor will be able to develop a good idea of the alpha that a private equity manager can deliver.
* “Value Creation and the Business Cycle” is available at www.pantheon.com and includes a full description of the sample, method and results of the study.