Private Equity Replication with Leveraged Small-Cap Value Stocks

Private Equity Replication with Leveraged Small-Cap Value Stocks

August 6, 2015 Value Investing
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Of the major asset classes, private equity has recently had the best absolute returns.  According to Cambridge Associates, the 25-year return on private equity was 13.5%, relative to 9.75% for the Russell 2000. Academic studies, surveyed recently by Steven Kaplan and Berk Sensoy, have consistently found that private equity outperforms the public markets by 3-4% per year.

Based on historical performance, private equity is an interesting asset class, however, we must consider some of the major drawbacks:

  • High fees
  • High complexity
  • Poor liquidity
  • Poor transparency

Ouch.

Private equity scores pretty poorly on a lot of metrics that are important to investors. Ideally, one could replicate the success of the Barbarians at the Gates, but without the major drawbacks. But how?

We think we have found an answer.

Understanding Private Equity

The biggest difference between private equity and the typical public equity portfolio is that private equity firms are more aggressive in their use of debt. In 2014, the typical private equity investment had $49M in equity ($252B total / 1995 deals = $126mm EV * 39% =$49.3mm), transacted at ~9.7x EBITDA, and was financed with 61% net debt to enterprise value (5.9x EBITDA from WSJ).

What happens when we look at a portfolio of publicly-traded stocks with similar characteristics? 

In a new paper, “Leveraged Small Value Equities,” by Brian Chingono and Dan Rasmussen, the authors study the performance of public companies that had comparable levels of leverage (as measured by net debt to enterprise value) to private equity investments.  Brian and Dan find that small-cap value companies that have high levels of debt perform similar to LBO deals. A strategy that invests in portfolios of these companies can produce returns comparable to the gross returns of private equity (and best private equity on a net-basis). Unlike leveraged ETFs and other similar products, this strategy does not use margin lending or options to obtain leverage, but rather, invests in public companies that have high levels of debt on their balance sheets. 

How the Authors Replicate Private Equity

This private equity replication method uses a multi-factor ranking system to find companies in the public markets that are similar to private equity deals on five key quantitative metrics: size, leverage, value, and capital allocation strategies (debt reduction and asset turnover).

The table below summarizes the returns of the top quartile of stocks in their ranking system during the 1989 to 2014 period where return information is also available for private equity. Please note that they are comparing gross-of-fee returns to net-of-fee returns, and Kaplan and Sensoy estimate private equity fees at 3-4% per year on average. However, even if we add back 4% per year to the PE index, we are comparing 24.70% to 19%. Of course, there is a vast difference in volatility (we’ll discuss this later).

Top Quartile Leveraged Small Value Stocks and Private Equity Returns: 1989-2013

Top Quartile Leveraged Small-Cap Value (Gross) Private Equity (Net)
Average Annual Returns 24.70%  15.00%
Annual Std. Deviation (based on yearly returns) 51.10% 13.90%
Annual Return / Annual Std. Deviation 0.48 1.08

Note, these figures are not available in the paper, but the authors provided this information upon request. The private equity returns are from the Cambridge Associates Private Equity Index. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

A multifactor regression of the top quartile-ranked leveraged small value stocks against the three Fama-French factors, momentum and the Pastor-Stambaugh liquidity factor shows a risk-adjusted return (alpha) of 12.3% per year, which is statistically significant.  The strategy has a high market beta and positive betas to the size (SMB) and value (HML) factors. Moreover, as expected for a value strategy that benefits from reversion to the mean, the beta to momentum (MOM) is negative. Finally, the beta to liquidity risk (LIQ) is not statistically significant so there is no evidence that exposure to market-wide liquidity shocks is a driver of the strategy’s returns.

Top Quartile Leveraged Small Value Multifactor Regression Results: 1968 – 2013

Alpha MKT-RF SMB HML MOM LQD
Top Quartile Portfolios 12.33% 1.41 1.09 0.77 -1.11 -0.34
(t-statistic) 2.81 8.29 4.24 3.42 -4.78 -1.34

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The Drawbacks to Private Equity Replication

There is, however, a significant challenge in implementing this strategy: leveraged small-cap value stocks exhibit a stomach churning level of volatility, nearly three times as high as private equity’s reported volatility.  The strategy’s maximum drawdown from August 2007 to March 2009 was 78%, relative to 59% for the broader Russell 2000 index.

Private equity appears to have a significantly higher Sharpe Ratio than the equivalent strategy in public markets.  There are, however, reasons to be skeptical that private equity as an asset class truly has a Sharpe Ratio of 1 and that the volatility reported by private equity firms is less than that of small leveraged stocks that are publicly traded.

Yale’s David Swensen notes in Pioneering Portfolio Management:

           “The inability to determine a true market price for private assets forces one to use appraisal-based prices that typically lead to artificial smoothing of the returns.”

Swensen’s thesis has been backed up by recent research by Kyle Welch at Harvard Business School that found that opaque and inconsistent accounting practices in private equity result in systematically deflated estimates of risk in the space.

Regardless, the volatility associated with leveraged small-cap value stocks is a significant risk to investors, who have a tendency to buy high and sell low.  But for a buy-and-hold investor, the returns could be worth the price of the volatility.  Since 1964, the private equity replication strategy has had a positive return in 91% of rolling 3-year periods and would have beaten private equity in 60% of rolling 3-year periods.  Over a longer period, the strategy also has an edge relative to the Fama-French Small Value Index (note that the private equity index is net of fees).

Rolling Win Rates of Leveraged Small Value (1987 to 2014)

3-Yr Rolling 5-Yr Rolling 10-Yr Rolling
Leveraged Small-Cap Value vs. Private Equity 60% 70% 72%
Leveraged Small-Cap Value vs. Fama-French Small-Cap Value 56% 52% 64%

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

And, as to whether this strategy is likely to continue to beat private equity, valuations are cheaper for leveraged public companies than for LBO deals transacted in private markets.  Below, the authors shared data with us that compares the median private equity buyout multiples from Pitchbook to the mean purchase multiple of the top 25 companies in their ranking system:

public versus private multiples

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Asset Allocation Implications

For decades, private equity has been the cornerstone of the Endowment Model, popularized by Yale’s CIO, David Swensen. As of 2014, Yale allocated a staggering 33% of its endowment to private equity. However, Swensen correctly notes that private equity exposure is generally unattainable to the average investor because of limitations in terms of accessing the top private equity managers. As a result, his recommended retail portfolios contain 0% private equity.

We believe that the private equity approach developed by Brian and Dan offers great promise as a way for retail and professional investors to access private equity-like returns without many of the headaches. Instead of trusting in private equity managers, with high-fees and low-liquidity, investors can follow a systematic and repeatable strategy that does not suffer from error-prone human judgment.

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Please remember that past performance is not an indicator of future results. Please read our full disclaimer. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.

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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.


  • Andrew M.

    Great article! If PE returns are smoothed won’t they have greater autocorrelation? If so, isnt there a way to gross up the vol by adjusting for the auto correlation? Also, won’t the fee structure of the carried interest also smooth the fluctuations as the carry gets bigger with bigger returns and then if reruns fall the carry gets smaller with it so it helps offset some of the vol?

  • There are a lot of techniques one could use and the concepts you mentioned are a great start.

    Bottomline: PE is WAY more volatile than the returns reported.

  • Steve

    Reading the summary made me think of the warnings to be careful with PE ratios, as a heavily leveraged company can look cheap. So now I’m thinking, maybe that’s actually at least a part of why low PE works?

    “The strategy’s maximum drawdown from August 2007 to March 2009 was 78%”

    ….WOW!!! Trend filter, anyone?!!

    On the plus side, that 90% positive rolling 3 year performance strikes me as quite impressive.

    For a part of your portfolio, this could make sense. What should we call someone who made it their core portfolio?

  • Tom Rinaldi

    Wes keep in mind private equity reported volatility is false. Private equity uses accountants to value their investments between marks to market / financing rounds. In bad markets no marks to market are made. For instance at the bottom of the financial crisis Stanford offered 30 cents on the dollar for a piece of harvards endowment pe holdings. They didn’t accept, nor did they mark the investment at that only bid.

  • Tom Rinaldi

    Ah I see below you know this already. Such a scam.

  • Marc Dutil

    Well if no transaction had occurred, there is no point to mark it at that bid. There are lots of bids in the public market that are below market price.

    I still agree that PE volatility must be interpreted carefully. There is an interesting paper (which I unfortunately cannot find back) that estimated PE funds return volatility based on terminal wealth, which makes sense if your investment is locked in for the life of the fund (and that is your investment period). The conclusion was that according to the author’s methodology of estimating volatility, PE returns were slightly more volatile that the S&P 500 returns.

    In the end, you should be looking at numbers that really matters to your investment profile (liquidity needs, investment horizon).

  • Tom Rinaldi

    My point Mark is that the Stanford bid is more relevant than the private equity firms own accountants estimate. That would be like marking public equity with the analysts DCF valuation. The public market analogy falls over because their are constant transactions so there would be no reason to use bids that dont transact. In this case, the Stanford bid makes sense….down 70% in a public market that was down over 50%.

  • Ciaran Youd

    Trend strategies will mean that you miss out on the rapid recovery. After playing around with this model all day I have sussed out that fundamental based hedges work extremely well (eps momentum, interest rates or even cpi changes). Returns are lower but so is the drawdown.