Reading 1.5

Question 1

Ilmanen (2011) 3 main findings on PE returns

Answer 1

1. A leveraged small-cap public equity index may be a better benchmark for PE performance than large-cap indices. Further, internal rates of return (IRRs) may be misleading when compared against the time-weighted returns used for public market indices.
2. PE’s smoothed returns understate true economic risk and are due to the lack of mark-to-market for illiquid assets.
3. Richening PE valuations may be a headwind for future returns for the asset class, suggesting a slimmer edge over public equity than long-term averages.

Question 2

4 factors that tilt PE returns (net of fees)

Answer 2

1) Equity risk - risk is higher, however some investors are ready to overpay for the return smoothing

2) Illiquidity premium - theoretically yes, but investors averse to price swings accept Net of fee PE returns that are on par with public equity

3) Size - lower cap companies have higher possibility for higher growth numbers

4) Value - theoretically the private buyout targets have lower valuation multiple than public companies, but that is not really the case now

Question 3

Empirical studies show average beta for PE

Answer 3

1.25-1.5

Question 4

How much debt do PE firms take on for every dollar of equity

Answer 4

100-200%

Question 5

Appropriate benchmarks for PE reported returns

Answer 5

Leveraged small cap indices

Question 6

PE historical performance from 1986-2017

Answer 6

The data indicates that PE, on average, has offered limited illiquidity premium beyond the typical factor tilts.

• PE outperformed large-caps by 2.3% based on the arithmetic mean.

• PE outperformed a 1.2x leveraged small-cap index by only 0.7%.

• PE underperformed a basket of small-cap value stocks by 1.6%.

Question 7

What measure is better than IRR for assessing the long term performance of PE?

Answer 7

PME - public market equivalent

Question 8

Long run PME of PE? What does it mean?

Answer 8

1.2 = 20% outperformance of PE

Question 9

After what period is the PME drastically lower? Why is that?

Answer 9

1) After 2006

2) several factors:
- demand for PE is strong (record number of uninvested capital and cash rich corporations)
- endowment model popularity
- strong performance prior to 2006
- FAS 158 was issued
- lower debt levels (leverage)
- cheap debt => bit up prices

Question 10

What is FAS 158

Answer 10

The Federal Accounting Standards Board (FASB) Statement No. 158 (FAS 158) requires employers to recognize a benefit plan’s funded status on their balance sheets for the first time.

Question 11

After which periods is the return on PE less?

Answer 11

After hot years:
- years of cheap financing
- high fundraising activity

Question 12

What is the PME of PE when accounted for size, leverage, sector?

Answer 12

Below 1 since 2006

Question 13

Yield based approach for PE ER estimation

Answer 13

Discounted cash flow

Question 14

How can PE firms use levers to enhance returns

Answer 14

• Higher starting yields via deal selection
• higher earnings growth rates via operational improvements
• multiple expansion via opportunistic timing of entries and exits
• financial leverage

Question 15

What is a multiple expansion

Answer 15

When investor sells an asset for more than he bought it for

Question 16

Net levered PE ER formula

Answer 16

Ypvt + Gpvt - Dpvt + Mpvt - Fpvt

Or See in photos

Question 17

Net levered PE ER formula 6 assumptions

Answer 17

1) yield - 2.1%

2) Growth rate - assumed to be 3% (twice of public equities growth rate)

3) Leverage - post 2008 ratios (109%) are from Pitchbook/Bain, pre - 300% to 150%

4) Cost of Debt - PE’s cost of debt is estimated as real LIBOR plus a spread proxied by 33% of the high-yield
(HY) index OAS over duration-matched Treasuries.

5) Multiple expansion -

6) Fees - 5.7% according to Mckinsey survey

Question 18

Net of Fee Public Equity ER: components and formula

Answer 18

1) where Ypub is the dividend or equity payout yield, Gpub is the long-term expected growth rate (assumed to be 1.5%), Mpub is the multiple expansion (assumed to be 0), and Fpub is the management fee (assumed to be 10 bps) for public equities.

2) Ypub + Gbpub + Mpub + Fpub

Question 19

How is PE net of fee return edge over Public Equity is determined?

Answer 19

Net of Fee PE ER - Net of Fee Public Equity ER

Question 20

Assumptions of the NET OF FEE PUBLIC EQUITY ER

Answer 20

1) Levered yield differential: This differential depends on both unlevered yields and leverage ratios (i.e., D/E). It has experienced a gradual decline due to relative richening of PE’s unlevered yield discussed previously and decreasing PE leverage.

2) Levered growth differential
This differential is driven entirely by PE’s time-varying leverage of PE (since unlevered growth rates are assumed to be constant). The differential has declined due to the declining trend in PE leverage.

3) Multiple expansion differential = PE expected multiple expansion

4) Fee differential - This differential is -5.6% (since fees for PE are assumed to be 5.7% and for public equities to be 10bps).

5) PE payout to debt holders - The PE payout to debt holders reduces returns to PE equity holders. This component exhibits a declining trend due to a gradual decline in rates and PE leverage, but this is more than offset by the decline in other components.

Question 21

State an issue with using the internal rate of return as a measure of performance for private equity investments of individual managers, and state and briefly describe a preferred performance metric.

Answer 21

1) The issue with using IRs for individual managers is that IRs can be gamed.

2) A preferred performance measure is the public market equivalent (PME).

The PME involves comparing capital generated by a private equity fund to that generated by a public market index over the fund’s life, based on similar amounts being invested with the same timings in the two indices.