By Donna Marie Howe, CFA
Last week when we met, one of my friends (Jim Purnell, CRO at Kenmar Group) and I started a discussion about the nature of Private Equity investing. My opinion is that it can be a diversification to equity portfolios, if structured appropriately. He feels rather that it is more a variant on standard equity and thus does not provide robust diversification. However he does feel it is – or should be - a higher returning type of equity
Part of our difference of opinion relates to the use of valuation models. Private Equity, as a class, has a wider range of modeling choices than public companies. That means the spread between an EBITDA-style idiosyncratic model, and an index reference model, such as a Beta or factor model is likely to be wider in a private company than in a public company.
In academia, the primary model referenced is the Fama-French three factor Beta model. Further, there is the Miller-Modigliani theory that says that the value of the firm is irrelevant to its capital structure. It’s with the assumptions embedded in these model and theories that we disagree. To quickly review, Fama-French basically splits “classic” beta into three by adding a small market cap factor (SMB) and a book –to-market value factor (HML).
My friend’s basic view is that a business valuation is primarily driven by changes in the capital structure. So the LBO process may create value by moving the capital structure to a more optimal point (by adding leverage) or it may create “alpha” above the Fama French factors. Additionally, of course, it could change the composition of the company and thereby change the Fama French risk loadings for that company. Finally, Fama French could be misspecified and there could be some other missing risk factor that PE is “loading” on which is perceived in a Fama French model as “alpha.” Jim is generally skeptical that PE funds are creating very much alpha if properly calculated along these lines…and perhaps none after fees. Further, if this framework were applied using something like market implied forward pricing, he is further skeptical that many standard PE attributes (say the “J” curve) would hold. He thinks they are primarily the result of accounting valuation rules that apply multiplies to the most recent cash flows - or if you will, a case of model risk looking like added-value.
My perspective on PE has to do more with new businesses that often have new products or services. They are on the transition from venture capital to publicly traded company, once the business model is proven. This is different than the type of company that is already established, but has management challenges. The already established firm might be a family company where the third or fourth generation is no interested, or where historic advantages has reduced or disappeared.
So on one hand we have a company that cannot initially execute the optimal capital structure due to perceived risk issues, and on the other we have a firm where the optimal capital structure may be changing.
To use my friend’s example, suppose there is a widget manufacturer in upstate NY. This manufacturer – a small public firm - has stable SMB and HML factors, as it is an established firm and has a traditional business model. Theoretically, an LBO would not change the value of the firm, and so the liquidity premium required by investors would be small, approaching zero. This leaves the only way the LBO would add value would be if the restructuring of ABC Widgets could be done more efficiently (fewer principal agent costs) as a privately held firm rather than public.
This restructuring may change the Fama French factor relations, but if so, they should converge near the beginning of the restructuring, discounted for any uncertainty in execution of the restructuring plan. The valuations of the company over time will likely follow a "J-curve” as the execution discount reduces as the plan bears fruit. So there would be a break in the factor inputs early on with a discrete upward jump in valuation.
If this were the only type of PE investment, then I would agree that it is not a diversification to “typical” equity portfolios. Even in this case, the assumption of a zero liquidity premium is likely to not hold. There are incentives for operating on a less expensive capital base and implications for leverage changes. If the leverage increase is greater than or equal to the cost of the liquidity premium, then the Fama-French factors will change again.
Regardless, if you look for PE companies with stable SMB and HML factors, you can indeed build a portfolio of PE investments that mimics a regular equity portfolio.
However, let’s look at an investment of another sort. Rather than ABC Widgets, let’s look at ABC Biotech or Happy P3 Systems. Both of these firms have recently been founded and both have new products and services offering non-traditional business models. In this early stage, the HML, the book to market factor, is quite likely negative. These firms are perceived by the market as having the most potential, since they are in new areas and/or have a new twist to their business model. They also, however, have a perception that they have a significantly higher probability to fail in the market (think biotech here or any SME). This higher probability of default also translates into higher funding costs, a higher required liquidity premium, reduced collateral terms, etc. Over time, the successful PE firms show that the business model is a success – or not. Regardless of the level of success, the HML will start to stabilize. I do agree that this HML factor impacts the valuation of the firm, but I think it’s more idiosyncratic than systemic. As well, in my experience it follows a more extreme version of the “j curve” until the HML figure flips from negative to positive. The switch here can attract additional investors and a spurt of autocorrelation (aka trending) can occur. After the HML factor shows a higher market price than book is the optimal time for the PE investor to exit and the company to go public.
As this type of PE firm is pooled with others of the same type, and the portfolio is ramped up, valuations across the J-curve smooth to a degree. The SMB factor continues wide due to the higher average probability to default during ramp-up, with the HML factor initially negative but trending in a positive direction. Despite the tail risk of the PE fund exit, the HML will stay strongly positive in the latter years even as the SMB starts to come in. All of those considerations will bring correlations to the overall stock market down, while keeping volatility somewhere in the same neighborhood. So in my opinion, this type of Private Equity investment is a diversifying asset.
My friend thinks differently. He believes the third-party valuation method, and the “lower of cost or market” valuation processes both smooth returns and create the initial dip in valuation. This process, by only marking larger declines in deterioration or profit, create a profile that appears to behave very differently from stock returns - creating low correlations and volatility on a quarterly return basis. (The same will hold true for real estate fund). This lower correlation and lower volatility (prices won’t change) will create a perception of increased risk-adjusted return – or alpha. However, by the time the PE fund has been liquidated after a decade the total return may or may not have appreciably beaten their equity market benchmark. He points to results that appear to be very dependent on macroeconomic conditions, for example the venture capital launches in ‘99 and LBOs in early ’08 severely underperformed compared to venture capital launches in ‘95 or LBOs in ‘02).He concludes with an opinion that the Fama French risk factors associated with the widget factory or other brick-n-mortar activities are invariant to an LBO. What does change, he says, is "process and management" improvements post LBO (or post event fund attacks). These marginal management process changes plus changes in capital structure is where the LBO should add value and where risk factors may marginally change.
What do you think?
Donna Marie Howe, CFA is a risk management and finance professional with more than 25 years industry experience in the financial services sector. With the ability to combine high-level quantitative skills with qualitative management excellence she has held a variety of senior risk management roles in some of the world’s largest banks including Deutsche Bank, UBS, ABN-AMRO, and Santander. Acting as a force for change to improve standards of practice, she has broad experience across both the buy-side (retail banking, commercial banking, insurance, hedge funds) as well as sell-side. Her product expertise includes liquidity management, client analytics, derivatives use, clearing and prime brokerage and incentives management. Well-known within the North American risk community she served for 10 years on the Board of the Global Association of Risk Professionals (GARP). Currently she is providing consulting services in governance, data, and enterprise risk management including Basel III, Dodd-Frank Act and CCAR while completing her PhD in International Economics & Finance at Brandeis University.
Interactions with senior regulators on capital adequacy and risk governance range from Large Bank OCC to SEC and FRB, as well as international regulators including the ECB and Banco de Espana. Current projects include design of a forward-looking model for operational risks with greater predictive capability and establishing a framework for systemic risk assessment of the health-care and pharmaceutical industry.