Demystifying private equity

US public pension funds, on average, have around 9.4 per cent allocated to private equity but for many public funds monitoring the firms that manage these investments – including the transparency of underlying investments, fees, performance and benchmarking – as well justifying these investments to boards and stakeholders, takes up more than 10 per cent of their time.

Broadly speaking, one of the problems is gauging whether private equity firms are doing what they say they are doing and how to use comparable metrics to assess private equity investments with the other investments in a portfolio. Now, with the help of some new academic analysis from Chicago Booth and Harvard, investors can gain a greater insight into what private equity firms say and think they do.

Steve Kaplan, the Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business, along with his colleagues from Harvard, Paul Gompers and Vladimir Mukharlyamov, examine “what private equity firms say they do”.

The authors survey 79 private equity investors with combined assets of more than $750 billion about their practices in firm valuation, capital structure, governance, and value creation.

The research finds some differences between the practices of the private equity firms and the LPs which invest in the funds.

One of the findings is that private equity investors believe that absolute, not relative performance is most important to their LP investors.

“The focus on absolute performance is notable given the intense focus on relative performance or alphas for public market investments,” the paper says. “There are two possible explanations for this. First, LPs, particularly pension funds, may focus on absolute returns because their liabilities are absolute. Alternatively, the chief investment officers of the LPs choose a private equity allocation based on relative performance, but the professionals who make the investment decisions care about absolute performance or performance relative to other PE firms. We believe that the advent of greater dissemination of risk-based performance benchmarks like PMEs is likely to affect the view of limited partners and potentially trickle back down to the private equity general partners.”

Public market equivalents (PMEs) try to deconstruct alpha indirectly by comparing it with the return of a related public market benchmark. They try to evaluate the value of a private equity investment by assessing its opportunity cost against investing in other available vehicles or investments.

The authors also find that private equity investors anticipate adding value to portfolio companies, with a greater focus on increasing growth than on reducing costs.

They also explore the difference between firms and how the actions that private equity managers say they take group into specific firm strategies which are related to firm founder characteristics.

The paper looks at exploratory analyses to consider how financial, governance and operational engineering practices vary within PE firms.

“The analyses suggest that different firms take very different strategies. For example, some focus much more heavily on operational engineering while others rely heavily on replacing incumbent management. These investment strategies are strongly influenced by the career histories of the private equity firm founders. It will be interesting (and, with these data, possible) to see which of these strategies, if any, exhibit superior performance in the future.:”

Steve Kaplan will address delegates at the Fiduciary Investors Symposium at the University of Chicago Booth School of Business

He is the Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business, and co-founded the entrepreneurship program at Booth.