Through good times and bad

Are private equity’s superior returns purely down to higher risks? That’s the question Partners Group sets out to address in its latest research piece. And it’s a timely one: if the asset class is inherently more risky, investors might decide to steer well clear in the kind of difficult macroeconomic climate that many developed countries are facing this year and beyond.

But the answer, according to Partners, is no. Far from being a riskier bet than public markets, private equity has actually outperformed public indices not only in good times but also in bad, the group found. Overall, its figures suggest an outperformance of 5 percent in North America and 9 percent in Europe since 2000, on an annualised basis.

But the difference is particularly marked in difficult economic times: in the three years after the internet bubble burst, outperformance was 6 percent in North America and 20 percent in Europe, while in the downturn that followed the financial crisis (Q3 2007 to Q1 2009) private equity investments beat public market indices by 19 percent in both North America and Europe. That’s quite a gap.

Then there’s the issue of volatility, another element commonly associated with risk: is the value of private equity investments more volatile than comparable investments in public equities? Again, Partners’ research suggests not: even if you correct for auto-correlation (the fact that in private equity, one quarter’s returns tend to depend on previous quarters’ returns, which sometimes happens because they haven’t been revalued), the asset class still seems to show less volatility than public equities.

Partners also considered one final risk measure: the maximum drawdown, or the biggest peak to trough decline. Again, private equity compares favourably, showing a smaller fall in both of the crisis periods mentioned above.

It’s worth pointing out that however good this sort of analysis may be, its greatest weakness is always the underlying performance data it relies upon – which, like most data related to private equity performance, comes with a health warning attached. For public markets, the relevant information is readily available and transparent; for private companies, it is inevitably incomplete and imperfect, and possibly involves a degree of self-selection bias (since the firms that would skew the results negatively are less likely to contribute). So there’s a danger it could present the asset class in an unduly flattering light – although an outperformance of this magnitude gives a decent margin for error.

The broader question is, however: if private equity’s outperformance isn’t due to greater risk-taking, where does it come from? Partners devotes the rest of its report to answering this, and its conclusions are compelling (if not earth-shattering): private equity invests in better companies to start with, thanks to the level of due diligence that feeds into its selection process; it can adopt a longer-term strategic horizon than public companies, because it doesn’t need to keep one eye on the next earnings call; and it has a governance model that better aligns the interest of owners and managers while allowing the former to engage more directly with the latter.

The benefit of all this, Partners suggests, is that private equity is better placed to make tangible operational improvements to the businesses it owns. Indeed, the report’s summary proclaims that “almost 75 percent of expected value creation is generated by direct operational improvements within portfolio companies” – 38 percent from revenue growth, thanks to private equity investors’ focus on long-term, sustainable growth, and about 37 percent from EBITDA margin improvement, thanks to their focus on improving cost structures. Even the other two levers of value creation – multiple expansion and cash flow, responsible for 4 percent and 21 percent respectively – can both be related back to operational improvement, it argues (for instance, companies that are elevated to a market-leading position tend to sell for a higher multiple).

Drilling down deeper into the report, it soon becomes clear that these figures have their limitations; rather than being in any way representative of the industry as a whole, they were actually derived by examining Partners’ own deal opportunities in the preceding two years, and working out to what extent each lever was expected to contribute to value creation. And since we imagine deal teams rarely go into an investment meeting suggesting that they’re going to rely on multiple expansion (even if they are), we’re not entirely sure how scientific or indeed useful this approach is.

Nonetheless, this study is an admirable attempt to address some myths and prejudices about private equity with hard numbers, and for that Partners is to be saluted; it’s what the industry needs to be doing at the moment. The next step is to come up with similarly insightful quantitative historical data about operational value creation post-investment, because that’s the best way of convincing critics that private equity might not be so bad after all.