Reading 1.5 Flashcards
Ilmanen (2011) 3 main findings on PE returns
- 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.
- PE’s smoothed returns understate true economic risk and are due to the lack of mark-to-market for illiquid assets.
- 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.
4 factors that tilt PE returns (net of fees)
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
Empirical studies show average beta for PE
1.25-1.5
How much debt do PE firms take on for every dollar of equity
100-200%
Appropriate benchmarks for PE reported returns
Leveraged small cap indices
PE historical performance from 1986-2017
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%.
What measure is better than IRR for assessing the long term performance of PE?
PME - public market equivalent
Long run PME of PE? What does it mean?
1.2 = 20% outperformance of PE
After what period is the PME drastically lower? Why is that?
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
What is FAS 158
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.
After which periods is the return on PE less?
After hot years:
- years of cheap financing
- high fundraising activity
What is the PME of PE when accounted for size, leverage, sector?
Below 1 since 2006
Yield based approach for PE ER estimation
Discounted cash flow
How can PE firms use levers to enhance returns
- Higher starting yields via deal selection
- higher earnings growth rates via operational improvements
- multiple expansion via opportunistic timing of entries and exits
- financial leverage
What is a multiple expansion
When investor sells an asset for more than he bought it for
Net levered PE ER formula
Ypvt + Gpvt - Dpvt + Mpvt - Fpvt
Or See in photos
Net levered PE ER formula 6 assumptions
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
Net of Fee Public Equity ER: components and formula
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
How is PE net of fee return edge over Public Equity is determined?
Net of Fee PE ER - Net of Fee Public Equity ER
Assumptions of the NET OF FEE PUBLIC EQUITY ER
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.
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.
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.
