1.5 Demystifying Illiquid Assets

Question 1

What four questions should an investor allocating to PE ask themselves about the asset class?
1. How much
2. Measurement
3. Fees
4. Risk/diversification

Answer 1

1. How much should we allocate to PE?
2. Against what yardstick should we measure performance?
3. Are the high fees relative to other asset classes, such as public equity, justified?
4. What are the risks of PE? What is the diversification potential?

Question 2

Why are PE returns said to be ‘smoothed’?

Answer 2

Unlike public equity, PE (and other illiquid assets) is not marked to market daily, but rather, prices are estimated using appraisals or self-reported net asset values. This can make PE appear less risky, relative to public equity; both systematic risk and the beta of PE are likely to be higher than returns suggest

Question 3

What is the effect of smoothed PE returns? (makes returns appear … with likely higher… what about betas?)

Answer 3

Makes PE appear less risky relative to public equity (as masks the volatility). Both systematic risk and the beta of PE are likely to be higher than returns suggest.
While regressions of PE returns generally suggest a beta less than one, studies indicate the true beta is closer to 1.2 to 1.5 (so actually higher volatility and lower risk adjusted returns than suggested).

Question 4

What are the 4 ‘factor tilts’ of PE relative to public equities?
1. ER
2. IP
3. S
4. V

Answer 4

1. equity risk (companies with more debt have higher equity risk, more return volatility, and a higher equity beta)
2. illiquidity premium
3. size (typically smaller cap)
4. value (buyout targets typically trade at lower valuation multiples than the overall market)

Question 5

Equity risk: Companies with more debt have higher ___, higher ___ and higher ____

Answer 5

Companies with more debt have higher equity risk, higher return volatility and higher equity beta

Question 6

Why do companies with more debt have higher equity risk?

Answer 6

Higher interest payments to bondholders mean increased risk to the remaining cash flows available to equity holders (i.e. more debt means more financial risk)

Question 7

How has debt levels (debt to equity ratio) of PE firms changed since the 1980s?

Answer 7

PE firms today have 100%–200% debt for every dollar of equity (down from 300%–400% debt-to-equity ratios in the 1980s).

Question 8

What is the beta of PE firms according to regressions of returns (and what is more likely)?

Answer 8

Generally suggests a beta less than one, but actually studies indicate the true beta is closer to 1.2 to 1.5 (disguised by smoothed returns)

Question 9

PE illiquidity premium. Evidence shows that even if a large illiquidity premium exists, it may be offset by ______?This may be exacerbated by

Answer 9

The artificially high PE prices that result from investor preference for smoothed returns.

May be exacerbated by agency issues - the fear of losing end-investors creates an incentive for limited partners (LPs) in PE to reduce short-term risks rather than long-term economic risks

Question 10

Why might LPs be happy with net-of-fees PE returns that are on par with public equity returns (even though they are not being appropriately compensated for PE’s higher equity risk (beta) and illiquidity)?

Answer 10

They have less volatile returns due to smoothing.

Question 11

Why might an LP overpay for PE exposure if they underestimate ____ and attribute returns instead to ____ or _______

Answer 11

If they underestimate the equity beta, and instead attribute returns to illiquidity premium or alpha (instead of to the true equity risk premium).

Question 12

Why might a leveraged small-cap index may be a more appropriate PE benchmark than a large-cap index?

Answer 12

Buyout targets are typically small and have smaller capitalizations

Question 13

Buyout targets are typically small and have smaller capitalizations - what does this mean for an index?

Answer 13

A leveraged small-cap index may be a more appropriate PE benchmark than a large-cap index.

Question 14

Why is PE said to have a ‘small-cap tilt’?

Answer 14

Buyout targets are typically small and have smaller capitalizations

Question 15

Why might PE be said to have a ‘value tilt’? What is the argument against this?

Answer 15

Buyout targets typically trade at lower valuation multiples than the overall market and venture capital targets are typically growth companies, implying higher multiples. This might imply a value tilt, but evidence is mixed - PE used to have a valuation discount relative to public equities, but that discount no longer exists

Question 16

What are the four PE tilts that should increase returns?

Answer 16

1. equity risk tilt - yes should increase returns due to higher equity beta/equity risk premium
2. illiquidity premium - may be offset by LPs overpaying for PE artificially high PE prices that result from investor preference for smoothed returns
3. size tilt - small cap
4. value tilt - possibly not true anymore, as valuations are no longer lower than public equities

Question 17

Why should PE investors should still expect a higher rate of return than for public equity (4 tilts - 2).

Answer 17

While illiquidity premium may be offset by overpayment and value tilt has mixed evidence, investors should still expect a higher rate of return than for public equity due to the small-cap bias (size tilt) and the higher-equity beta (equity risk tilt).

Question 18

Why is a large-cap public equity benchmark not an appropriate basis of comparison for PE? (illiquidity premium and alpha, tilts)

Answer 18

Doesn’t consider size and value tilts - better to use a small-cap index. This also doesn’t consider the equity risk tilt (but can lever). Also no consideration of illiquidity premium.

Question 19

How did returns of PE index (Cambridge, US Buyout) compare against public equity (SP500 and Russel 2000) over 1986 to 2017? (arithmetic average returns). What is not a good comparison when using Russell?

Answer 19

Average annual PE was 9.9% versus 7.5% for SP500 and 7.6% for Russell 2000. Shows outperformance of c. 2.3%.

But when we leverage the small-cap index (remember, PE is leveraged 100%–200% debt to equity, versus about 50% for public equities) by a factor of 1.2 (7.6% return × 1.2 = 9.12%) the premium falls to a mere 0.7% (= 9.9% – 9.12%), rounded

Question 20

When comparing PE index (Cambridge) against unlevered Russell 2000 value index and an unlevered basket of small-cap value stocks what was the result?

Answer 20

PE outperformed the Value R2000 by 1.6%, and underperformed the unlevered basket of small-cap value stocks by a rounded 1.6% (9.9% vs 11.4%).

Question 21

How did returns of PE index (Cambridge, US Buyout) compare against public equity (SP500 and Russel 2000) over 1986 to 2017? (GEOMETRIC average returns).

Answer 21

Geometric average annual PE was 9.8% versus 6.4% for SP500 and 5.5% for Russell 2000. Shows greater outperformance when using geometric average than when using arithmetic average.

Question 22

In what way does a comparison of PE returns to levered and unlevered small and large cap indices show that PE, on average, offers only a small illiquidity premium beyond typical factor tilts of value, size and equity premium?

Answer 22

When comparing against large cap/small cap, levered small cap index, and small cap value index, PE outperformance is reduced (relative to outperformance against large cap unlevered).

Question 23

What are the two problems with IRRs that make it possible for managers to game them?

Answer 23

1. IRRs are not time weighted (they are money weighted). This means that the timing and the size of cash flows influence the IRR - which GPs can influence to game IRR.
2. IRR assumes that all cash flows can be reinvested at the IRR rate (the faulty reinvestment rate assumption problem). This is not the case.

Question 24

What does PME stand for (PE)?

Answer 24

Public market equivalent

Question 25

What is the purpose of the public market equivalent (PME)?

Answer 25

It is a superior relative performance comparison metric that attempts to create a comparison by removing the possibility of gaming that exists with IRR. It assumes cash flows are deployed into a public stock market index (i.e., the benchmark) in the same amounts and at the same times as those of the private equity investment being evaluated

Question 26

PME involves what?

Answer 26

Deploying cash flows into a public equity index at the same times as PE investment so as to remove the possibility of gamed IRR

Question 27

What do studies show about PE returns vs public equities when using a PME method? (i.e. vs SP500, what does this mean and annualised)

Answer 27

Studies find a 1.2 long-run average PME for PE versus the S&P 500. This implies 20% outperformance relative to the S&P 500 over the period deployed, and a 3.1% outperformance net of fees over a six-year investment period.

Question 28

What does EBITDA/EV (an inverted purchase multiple) show about PE’s edge against public equities from 1998? (why edge, what happened to it)

Answer 28

It shows PE had an edge in returns since 1998 due to lower valuations (wide valuation gap between PE and public equity). Around 2002, the PE edge over public equities started to decline, and by 2006, it had disappeared. This implies that PE no longer had an advantage over public equities after 2006.

Question 29

Some studies find that PE has no edge in returns using PME after 2006, while others argue there still has been a slight edge - such as who?

Answer 29

Brown and Kaplan show a slight edge using updated vintages from 2009–2014

Question 30

When comparing PE returns to a leverage, size, and sector-adjusted S&P index from 2005-2014, what does this show?

Answer 30

PE underperforms the index over the period.

Question 31

What are three explanations for the post-2006 decline in PE performance relative to public equities?
1. r
2. l
3. c

Answer 31

1. richening of PE: greater amounts of capital allocated to PE (as enticed by PE’s strong performance as well as spotlight on the endowment model espoused by Yale’s David Swensen). Record amount of dry powder and number of PE firms.
2. lessening leverage: gradual decline in PE debt-to-equity ratios from 3-4x in 1980s, to 1-2x now. This is in part due to regulatory changes.
3. competition for deals is increased

Question 32

Why, despite challenges to PE returns, are investors still optimistic/expect PE to outperform public equities? (lack of/benchmarks/misunderstanding)

Answer 32

1. lack of transparency regarding PE returns
2. use of misspecified benchmarks
3. misunderstanding of PE returns

Question 33

Why might investors be satisfied with zero excess returns relative to public equities (for PE)?

Answer 33

Attractiveness of smoothed returns/lower volatility.

Question 34

What are the four ways PE firms can increase returns?
1. ds
2. oi
3. ot
4. fl

Answer 34

1. deal selection - results in higher starting yields
2. operational improvements - resulting in improved earnings growth rates
3. opportunistic timing of entries and exits into the market, resulting in higher multiples
4. financial leverage

Question 35

Formula for yield-based approach to finding PE net expected real return

Answer 35

(yu+ gu) + [D/E × (ru– kd)] + m – f

Question 36

PE net expected real return formula

Answer 36

See notes

Question 37

Given PE does not pay dividends and therefore doesn’t have a ‘yield’ like public equities, what is used in place to calculate the PE ER in the yield approach? What is the assumed number?

Answer 37

The PE income yield is assumed to be half of the unlevered earnings yield, where the PE unlevered earnings yield is defined as EBIT to EV. This works out to be 2.1% (at least in the example used).

Question 38

In the yield approach to PE ER calculation, what is the assumed growth rate? what is this in comparison to public equities, and why is this different (2)?

Answer 38

A real growth rate of 3% is assumed. For public equities this is assumed to be 1.5%. The PE number is double the public number, because of assumed operational improvements leading to higher profit margins, as well as PE being more likely to be overweight higher growth sectors.

Question 39

In the yield approach to PE ER calculation, what is the assumed cost of debt?

Answer 39

The cost of debt is estimated as the market reference rate plus a spread (33% of the high-yield index OAS over duration-matched Treasuries).

Question 40

In the yield approach to PE ER calculation, what are % fees assumed to be? How does this compare to passive public equity?

Answer 40

PE fees are estimated as 5.7%, based on research. Versus 10bps for passive public equities.

Question 41

In the yield approach to PE ER calculation, what is the PE ER expected to be. What is the equivalent for public equities?

Answer 41

Net ER is expected to be 3.9% versus public equity returns at 3.1%

Question 42

Why is the PE expected return lower than the historical average?

Answer 42

Richening of PE, declining leverage and competition.

Question 43

Why did PE perform well from 2002 to 2005, and especially in the early 1990s,versus now?

Answer 43

Lower PE valuations and a low cost of debt, combined with greater leverage. Less competition.

Question 44

In the yield approach to PE ER calculation, what is the reason for the higher ER of PE to public equities?

Answer 44

Higher equity risk (i.e., a higher equity risk premium).

Question 45

What is the yield-based approach formula to public equities ER?

Answer 45

(ypub+ gpub) + mpub– fpub

i.e. takes out the leverage * (ER - cost of debt) section given they are unlevered

M is assumed to be zero
F is assumed to be 10bps

Question 46

What are the five possible reasons for the difference in yields between public and private equities in the yield based approach?
1. LYD
2. LGD
3. MED
4. FD
5. COD

Answer 46

1. Levered yield differential. (depends on both the unlevered yields and the leverage ratios). This component has declined over the past 15 to 20 years due to lower leverage).
2. Levered growth differential. The constant unlevered growth rates are, for simplification, assumed to be the same for public equity and PE. Thus, any differences in this yield are attributed to declining leverage in PE.
3. Multiple expansion differential. While a small component of the overall yield differential, this is due to the difference between the two expansion factors (i.e., 0.3% for PE and 0.0% for public equities).
4. Fee differential. This reading uses a constant assumption of 5.7% fees for PE and 0.10% fees for public equities; thus, there is a constant –5.6% difference.
5. Cost of debt (for PE). PE interest payments to debtholders reduce returns to PE equity holders. This negative component for PE returns has declined over the years as leverage has declined. For public equity, the return starts with the dividend yield, and thus is already net of interest payments (i.e., dividends are already accounted for).