New Developments in Long-Term Asset Management
Second Annual Conference
May 19-20, 2017
Replicating Private Equity with Value Investing, Homemade Leverage,
and Hold-to-Maturity Accounting
Erik Stafford of Harvard Business School 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, holding periods, leverage, and the calculation of portfolio net asset value under a hold-to-maturity accounting scheme. [Download the paper]
Other Conference Papers
Institutional Investors and Information Acquisition, Matthijs Breugem and Adrian Buss
The Relevance of Broker Networks for Information Diffusion in the Stock Market, Marco Di Maggio, Francesco A. Franzoni, Amir Kermani, and Carlo Sommavilla
Asset Insulators, Gabriel Chodorow-Reich, Andra C. Ghent, and Valentin Haddad
Do Institutional Incentives Distort Asset Prices? Anton Lines
Chasing Private Information, Marcin T. Kacperczyk and Emiliano Pagnotta
ETF Arbitrage under Liquidity Mismatch, Kevin Pan and Yao Zeng
Efficiently Inefficient Markets for Assets and Asset Management, Nicolae Gârleanu and Lasse Heje Pedersen
< 2016 Conference Papers>
A selection model finds that, over the period 1984-2014, private equity investors tended to target relatively small firms and firms that would generally be characterized as "value" stocks. The value stock characteristic most reliably associated with buyout is the EBITDA valuation multiple (enterprise value divided by earnings before interest taxes and depreciation).
Stafford shows that this selection criteria produces a large spread in realized stock returns over the sample period, such that a simple unlevered strategy that buys all stocks with low EBITDA multiples has a higher mean return than the aggregate private equity index net of fees. He argues that long holding periods are required for private equity investors to implement their operating and financing strategies, but that an investor managing a portfolio of minority interests of public value stocks has more flexibility in choosing the holding period.
This is shown to have economic consequences for two primary reasons: First, the value stock investment strategy realizes lower mean returns as the holding period lengthens, presumably because once value stocks realize high returns, and are no longer value stocks, they no longer earn a value premium. Second, long holding periods can significantly distort measured risks when portfolio values are conservatively marked. Comparing risks of identical portfolios under two accounting schemes for portfolios value — mark-to-market and hold-to-maturity — Stafford demonstrates that popular measures of portfolio risk like beta, volatility, and worst drawdown (current price level relative to previous maximum price level) shrink significantly as the holding period is extended from one month, to one year, to multi-year periods.
Finally, Stafford applies portfolio leverage through a brokerage margin account to the unlevered replicating portfolio of public stocks to match the doubling of leverage typically found on corporate balance sheets during leveraged buyouts. As predicted by all standard theories in finance, this application doubles the measured risks of the unlevered replicating portfolio under the mark-to-market accounting scheme, but produces measured risks that are roughly one-fourth this large for the hold-to-maturity accounting scheme, roughly matching the measured risks of the aggregate private equity index returns.
The private equity investment process essentially combines a value stock investment strategy, leverage, long holding periods, conservative portfolio marking, and active investment management. Stafford shows how a passive portfolio strategy can effectively mimic each of these elements except for the activism and can be well-marked to accurately measure portfolio risks relative to common investment benchmarks. The EBITDA multiple is a highly effective variable for sourcing a value premium over this sample period. Consequently, buy-and-hold portfolios comprised of firms with characteristics similar to those chosen by private equity funds earn high risk-adjusted returns, exceeding the mean private equity return — estimated to average 3.5 to 5 percent per year before fees — when target portfolio leverage is chosen to match the levered returns accruing inside private equity funds. The measured risks of replicating portfolios are high under traditional market-value based net asset value reporting. Using a hold-to-maturity accounting scheme, to mimic the discretion available to private equity fund managers, effectively eliminates the majority of measured risks for the replicating portfolios during this sample period. Stafford's results indicate that sophisticated institutional investors appear to overpay significantly for the active portfolio management services associated with private equity investments.