Private Equity Goes Public: Examining the Risk and Return Characteristics of Buyout Funds

Abstract

This paper analyzes the risk and return characteristics of buyout funds from two different perspectives and extends on previous studies by Harris and colleagues (2014) and Stafford (2017). Traditional performance metrics show a clear outperformance of buyout funds relative to public markets, however, these disregard much of the risk in buyout funds. Using a sample of 755 U.S. public-to-private LBOs, we show that buyout investors tilt toward small companies with low EBITDA multiples and modest profitability. These preferences suggest that the risk inherent in buyout funds is more akin to a portfolio of small value stocks. We construct a portfolio that mimics the following passive components of the private equity investment process; (1) asset selection criteria, (2) long holdings periods, (3) infrequent and conservative estimates of net asset values, and (4) use of leverage. This private equity mimicking portfolio generates an absolute return that is similar to the one of the Cambridge Associates U.S. Buyout Fund Index, before fees, implying a considerable outperformance, net-of-fees. With a CAPM beta of 2.07, the systematic risk exposure of the PE-mimicking portfolio seems more reasonable compared to the beta estimates ranging from 0.29 to 0.77 for the aggregate buyout index. A comparison of portfolio performance, using both mark-to-market and hold-to-maturity accounting, shows that the difference in measured risk between the aggregate buyout index and the private equity mimicking portfolio can be attributed to artificial return-smoothing resulting from infrequent and conservative estimates of portfolio net asset values. The findings bring into question the value added by active fund management, the existence of a liquidity premium, and the justification of the annual fees paid by LPs, estimated at more than 5%.