Replication can illuminate private equity’s nascent risks

The riskiness of private equity funds has long been a source of divisive debate in buy-side circles.     

The way one investment manager puts it, the strategy entails buying increasingly expensive, risky companies and loading them with growing amounts of debt: “I think it’s the stupidest, riskiest possible thing you could be doing. People are going to get whacked by this stuff. It’s going to be a disaster.”

There are plenty of reasons to be wary. Almost 40% of private equity deals in 2018 were leveraged seven times or greater, according to data from LPC, which tracks the syndicated loan market.

Ninety-two percent of businesses owned by the top 16 private equity firms are rated several notches below investment grade, Moody’s reports, and almost a fifth of those companies are on the rater’s distressed debt list.

An academic study released this year found 10-year bankruptcy rates for large US leveraged buyouts were around 20% compared with 2% for equivalent public market companies.

The industry’s returns, though, tell a different story.

Cambridge Associates’ benchmark index of US private equity has had just 18 down quarters out of more than a hundred from 1994 to mid-2019. Buyout funds have beaten returns from public equities in all regions, over one, five, 10 and 20-year horizons. Volatility has ranged at about three to four-fifths the levels seen in public stocks.

Detractors say this is only because funds mark assets to model rather than to market, which serves to reduce volatility.

Benchmark indexes

To help make sense of the conflicting assertions, investors today have a growing array of benchmarks against which to cross-check reported returns.

These indexes have been constructed mostly for investors that want private equity-type exposures via investing in liquid public-market stocks. Some take the view that private equity returns result from leveraged investment in cheap, small companies – essentially a bet on the value and size factors well known in public stocks. Others track and match the changing sector exposures taken by private equity managers.

Because they mark values to market, these newer indexes are much more volatile than the mark-to-model returns stated by funds.

The volatility of DSC Quantitative Group’s private equity replication index – one of the longest standing – is around 20% annualised. That’s more than double the historical volatility of the Cambridge Associates index, which tracks returns as reported.

Arguably, the greater volatility exposes a latent risk in private equity funds, should circumstances conspire against them.

It’s hard to say if that might happen – or when. A conventional default cycle could wipe out equity in a sizeable chunk of private equity funds’ portfolio companies. In 2001, default rates reached 17% on US companies rated in line with nine-tenths of companies held by the biggest funds today. In 2008, defaults peaked at 20%.

Equally, a drawn-out recession in which central banks kept rates low could create a cohort of privately owned zombie companies: unsellable and generating too little cash to pay dividends and pay down debt.

Private equity’s defenders say funds would not be forced sellers in such beggarly markets. A downturn would create opportunities for private equity as well as causing losses, they argue. Firms would be able to buy and revive struggling companies.

That may be true. But with the contrast in volatility of replication indexes and reported returns, the debate about whether that is the case or not is likely to fizz.