Slide 1

Report
Estimating Private Equity Returns
from Limited Partner Cash Flows
Andrew Ang, Bingxu Chen, Will Goetzmann, Ludovic Phalippou
Q-Group, Apr 2014
Liquidating Harvard:
A Cautionary Example
“Liquidating Harvard” Columbia Case available from
http://www8.gsb.columbia.edu/caseworks/node/236/Liquidating%2BHarvard
Harvard Endowment
● Harvard
was an early adopter of the “endowment” model based
on diversification concepts extended to illiquid assets (thanks to
Swensen, Leibowitz, and others)
Harvard Endowment Asset Allocation June 30, 2008
Liquid
Semi-Liquid
Illiquid
Total
27%
35%
39%
Dev Mkt Equity, Liquid Commodities, Govt Bonds
Emg Mkt Equity, High-Yield Bonds, Hedge Funds
Private Equity, Timber/Land, Real Estate
100%
5
“Returns” on Illiquid Assets
● Illiquid
asset “returns” are not returns
● Harvard
University President Faust, on the 22% loss between July 1
and October 31, 2008:
“Yet even the sobering figures is unlikely to capture the full extent of actual
losses for this period, because it does not reflect fully updated valuations in
certain managed asset classes, mostly notably private equity and real
estate.”
● Returns
of illiquid alternatives are biased upwards, and their risk
estimates are biased downwards
6
Infrequent Trading
● Infrequent
trading biases volatility and beta estimates downwards.
Quarterly Sampling
3.5
3
2.5
2
1.5
1
0.5
0
7
Infrequent Trading
● Infrequent
trading biases volatility and beta estimates downwards.
Daily Sampling
3.5
3
2.5
2
1.5
1
0.5
0
8
Infrequent Trading
● Infrequent
trading biases volatility and beta estimates downwards.
Daily vs Quarterly Sampling
3.5
3
2.5
2
1.5
1
0.5
Quarterly Sampling vol = 0.23
Daily Sampling vol = 0.28
0
9
Sample Selection Bias
● Selection
biases the average return upwards, systematic risk
downwards, and idiosyncratic volatility downwards.
Excess
Return
True
Excess Market
10
Sample Selection Bias
● Selection
biases the average return upwards, systematic risk
downwards, and idiosyncratic volatility downwards.
Excess
Return
True
Fitted
Excess Market
11
Building a Private Equity
Return Index
“Estimating Private Equity Returns from Limited Partner Cash Flows”
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2356553
Current Approaches
Based on
● NAVs
● Deal-level
● IRRs
● Multiples
Do not represent returns, and not based on the actual cash flows
received by LPs
13
Private Equity Returns
● Based
on cashflows to LPs
– What you actually “eat”
– Data from Prequin and proprietary datasets
● Decompose
into market and other factors, and the private
equity-specific return (PE “alpha” or “premium”)
● Can
be updated in “real time” to create a private equity return
index
14
How Does It Work?
● Suppose
the private equity total return, g, follows
gt  5%  1.5rmt  ft
– rmt is the market return
– f is the return specific to PE
– Risk-free return is zero
15
How Does It Work?
● Consider
the cashflows of four funds, living between times t=0 to
t=4
0
1
2
3
4
Market
PE
PE
Return rmt factor ft return gt Fund 1 Fund 2 Fund 3 Fund 4
-100
-100
5.6% -7.5% 5.9% 105.9
0
-100
-100
10.0% -2.5% 17.5%
-100 124.4 117.5
0
-8.2% 2.5% -4.8%
95.2
-100 111.9
12.8% 7.5% 31.7%
131.7
IRR
1%
12%
23%
6%
16
How Does It Work?
● According
to a NPV condition,
PV(Investments) = PV(Distributions)
Fund 1: 100 
100
105.9
95.2


,
(1  g1 )(1  g 2 ) (1  g1 ) (1  g1 )(1  g 2 )(1  g3 )
Fund 2: 100 
124.4
,
(1  g1 )(1  g 2 )
100
117.5
131.7
Fund 3: 100 


,
(1  g 2 )(1  g3 ) (1  g 2 ) (1  g 2 )(1  g3 )(1  g 4 )
111.9
Fund 4: 100 
.
(1  g 2 )(1  g3 )
● With
four funds, there are four unknowns—can solve using a
non-linear root solver
17
How Does It Work?
● If
the private equity return, g, were constant then there would be
four funds/equations with one unknown resulting in an overidentified system
if g is persistent (not iid), then we also require fewer
funds/equations
● Similarly,
● Identification
is achieved by having funds with different
cashflows at different start dates, and different end dates
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Model
● Total
private equity return:
gt     ' Ft  ft
● Private
equity-specific component is allowed to be persistent:
ft   ft 1   f  t
● NPV
condition for distributions, D, and invested capital, I:
PVi ( D)
log( PME )  log
PVi ( I )
N ( 12  2 ,  2 )
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Private Equity Total Return Index vs. US Index Funds
Index Values
20
10
9
8
7
6
5
4
3
2
1
0.9
Mar
1993
Dec
1993
Dec
1994
Dec
1995
Vanguard Small Cap Index Inv
Dec
1996
Dec
1997
Dec
1998
Dec
1999
Vanguard 500 Index Inv
Dec
2000
Dec
2001
Time
Dec
2002
Dec
2003
Dec
2004
Dec
2005
Dec
2006
Dec
2007
Dec
2008
Dec
2009
Sep
2010
PE total return
20
Comparison with Industry Indexes
● Our
cash flow-implied returns are more volatile, with lower
autocorrelations than industry indexes
21
Decomposition of Private Equity Return Index into Passive and Premium Components
Index Values
20
10
9
8
7
6
5
4
3
2
1
0.9
Mar
1993
Dec
1993
Dec
1994
PE total return
Dec
1995
Dec
1996
Dec
1997
PE Premium
Dec
1998
Dec
1999
Dec
2000
Dec
2001
Time
Dec
2002
Dec
2003
Dec
2004
Dec
2005
Dec
2006
Dec
2007
Dec
2008
Dec
2009
Sep
2010
PE Passive
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Private Equity Premium
Return Values
3.0%
2.8%
2.6%
2.4%
2.2%
2.0%
1.8%
1.6%
1.4%
1.2%
1.0%
0.8%
0.6%
0.4%
0.2%
0.0%
-0.2%
-0.4%
-0.6%
-0.8%
-1.0%
-1.2%
-1.4%
-1.6%
-1.8%
-2.0%
-2.2%
-2.4%
-2.6%
-2.8%
-3.0%
Jun
1993
Dec
1994
Dec
1995
Dec
1996
Dec
1997
Dec
1998
Dec
1999
Dec
2000
Dec
2001
Time
Dec
2002
Dec
2003
Dec
2004
Dec
2005
Dec
2006
Dec
2007
Dec
2008
Dec Sep
2009 2010
PE Premium
23
24
Alphas
Model
CAPM
3 factors (FF)
4 factors (PS)
EW CAPM
EW FF
EW PS
βmarket
1.41a
0.24
1.49a
0.23
1.41a
0.21
1.42a
0.18
1.47a
0.20
1.40a
0.22
βsize
βvalue
βilliquidity
0.41
0.31
0.41
0.26
0.09
0.27
0.03
0.23
0.36
0.27
0.40
0.25
0.33
0.30
-0.11
0.21
-0.19
0.25
0.26
0.27
In-sample
Alpha
0.05a
0.01
0.04a
0.01
0.00
0.02
-0.04a
0.01
-0.04a
0.01
-0.05a
0.02
Persistence
of Alpha
0.40
0.19
0.43
0.19
0.48
0.19
0.45
0.19
0.47
0.19
0.47
0.19
25
PE Returns vs IRRs (Corr = -0.03)
0.8
0.4
0.6
0.3
0.2
0.2
0.1
0.0
1993
-0.2
1995
1997
1999
2001
2003
2005
2007
0.0
IRRs
PE Returns
0.4
-0.1
-0.4
-0.6
-0.2
-0.8
-0.3
PE Returns (LH)
IRRs (RH)
PE Returns vs Multiples (Corr = 0.04)
0.8
3.0
0.6
2.5
2.0
0.2
0.0
1993
-0.2
1.5
1995
1997
1999
2001
2003
2005
2007
Multiples
PE Returns
0.4
1.0
-0.4
0.5
-0.6
-0.8
0.0
PE Returns (LH)
Multiples (RH)
26
0.8
1.6
0.6
1.4
0.4
1.2
0.2
1.0
0.0
1993
-0.2
0.8
1995
1997
1999
2001
2003
2005
2007
0.6
-0.4
0.4
-0.6
0.2
-0.8
0.0
PE Returns (LH)
PMEs
PE Returns
PE Returns vs PMEs (Corr = 0.14)
PMEs (RH)
27
Pro-Cyclical Investing in Private Equity
28
Private Equity Returns Over the Business Cycle
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Private Equity Returns
● Reported
● IRRs
returns on PE are not returns!
and multiples are not returns!
● Develop
a time series of private equity values representing the
returns to an investor (LP), not a fund, and not a manager (GP)
● Decompose
private equity returns into passively replicable
returns, and the unique return to private equity (“alpha” or
“premium”)
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