Replicating Private Equity With Value Investing, Homemade Leverage, And Hold-To-Maturity Accounting
Harvard Business School – Finance Unit
December 20, 2015
Private equity funds tend to select relatively small firms with low EBITDA multiples. Publicly traded equities with these characteristics have high risk-adjusted returns after controlling for common factors typically associated with value stocks. Hold-to-maturity accounting of portfolio net asset value eliminates the majority of measured risk. A passive portfolio of small, low EBITDA multiple stocks with modest amounts of leverage and hold-to-maturity accounting of net asset value produces an unconditional return distribution that is highly consistent with that of the pre-fee aggregate private equity index. The passive replicating strategy represents an economically large improvement in risk- and liquidity-adjusted returns over direct allocations to private equity funds, which charge average fees of 6% per year.
Replicating Private Equity With Value Investing, Homemade Leverage, And Hold-To-Maturity Accounting – Introduction
The professional and active management of private equity investments is widely believed to have many unique advantages over passive portfolios of publicly traded equities. Specialized knowledge (Leland and Pyle (1977)), monitoring (Diamond (1984)), and access to credit markets (Ivashina and Kovner (2011)) are a few ways in which intermediated investing may provide advantages over a non-intermediated strategy. To the extent that these are material advantages in equity investing, the pre-fee returns on an aggregate private equity index are expected to outperform a passively managed portfolio comprised of otherwise similar public investments. This paper investigates whether an outside investor can replicate the risks and returns of a diversified private equity allocation with passive investments in public equities using similar investment selection, leverage, and the calculation of portfolio net asset value under a hold-tomaturity accounting scheme.
The Cambridge Associates Private Equity Index is used as a proxy for the returns earned by limited partners who have diversified allocations to private equity investments. Over the period 1986 to 2014, the mean excess return on the private equity index, before fees, is 18% per year with an annualized volatility of 17% and a market beta of only 0.7.
The literature on the cross section of expected stock returns suggests that a portfolio of low beta value stocks represent a promising starting point for matching the attractive risk and return properties of private equity. There is strong empirical evidence that value firms earn high stock returns (Stattman (1980), Rosenberg, Reid, and Lanstein (1985), Fama and French (1992)). These papers empirically link realized excess equity returns to a firm’s ratio of book equity, BE, to market equity, ME. Interestingly, I find that the operating cash flow (EBITDA) multiple is a more powerful variable than BE/ME for sourcing a value premium in stocks, producing a larger spread in returns and driving out the statistical significance of BE/ME in Fama-MacBeth (1973) return regressions. There is also strong empirical evidence that low beta firms earn relatively high returns with risks that continue to be low (see Baker, Bradley, and Talliaferro (2014) for a recent review). Low risk firms are likely to be able to support higher leverage, both at the individual firm level and at the level of an outside investor’s portfolio.
In the spirit of Modigliani and Miller (1958), an outside investor interested in the levered equity return of a firm that has chosen too little leverage can manufacture a return levered to the investor’s desired level on their own using a brokerage margin account. A modest amount of portfolio leverage through a brokerage margin account is highly efficient because the debt is essentially riskfree due to over-collateralization and high frequency marking-to-market, allowing for borrowing rates close to the riskfree rate. This so-called homemade leverage will not manufacture the incentive and tax effects that increased leverage at the firm-level may produce, but can significantly alter the risk and return properties of the underlying equity. A prototypical private equity transaction increases a firm’s leverage, measured as the ratio of market debt to firm value, from around 30 percent to 70 percent (Axelson, Jenkinson, Strömberg, and Weisbach (2013)). An outside investor would need to select a portfolio of comparable pre-transaction stocks and invest slightly more than two times their equity capital in this portfolio to match the post-transaction levered equity return, which is expected to essentially double the underlying market beta of the underlying stock.
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