There is a growing body of opinion that says that private equity performance correlates closely with the performance of the public equity markets. As a result, institutional investors are asking themselves why they need invest in this asset class when they already have a significant exposure to public equity markets in their portfolio. Additionally, confidence in public equity markets has reached a very low level, further encouraging investors to query their need for private equity exposure alongside their existing public equity commitments.
Any attempt to quantify correlation between assets classes is tricky though. And this is made doubly difficult when trying to evaluate an asset class (private equity) where performance data can be hard to obtain and/or qualify. Much like others considering private/public correlation therefore, rather than trying to argue a case with numbers, I will try to comment on variable qualitative aspects in private equity investing which have to be taken into consideration when comparing it with public equity markets.
Are the two markets comparable?
It is important not to oversimplify private equity as an asset class. The long-term nature of private equity makes only a limited comparison with public equity markets possible, as two fundamental differences exist between them. First, private equity investing occurs as a time-consuming, negotiated process and second, private equity managers are in a position to exert an active, long-term influence on companies, normally for a period of up to five years from investment to divestment. It is precisely these important elements that are not available to public equity market investors. In the public equity market, the investment manager is typically only a passive observer. Movements in equity prices are subject, amongst other things, to sometimes extremely irrational factors. And price movements happen quickly – the time horizon is very short-term. In contrast, the private equity manager expects to, and can, exert an active influence on companies’ operation and consequent performance over a prolonged period.
Unsurprisingly therefore, if one looks for evidence of correlation between publicly traded and private equity owned companies one can soon find contradictions. There are numerous examples of how private equity backed companies have been successfully managed and then sold despite the fact that public equity prices have gone down significantly. One can also find instances where the opposite has occurred, with private companies going bankrupt on account of funding problems or mismanagement for example, although public markets went up in value in the same period.
The three stages to private equity investing
In order to attempt to assess the correlation between private equity and the public equity markets, private equity investing must be divided into roughly three stages.
1. Acquisition of a company: Depending on which corporate phase the company is in when it is acquired and how large the company is (from small, early stage to a large, mature company in a buyout), several key performance and valuation figures deriving from the public equity market (e.g. P/E ratios, EBITDA multiples) are relevant when determining the purchase price of the company. In this regard it can be said there is correlation between private and public companies. Usually, a specific correlation is created in the event of a major corporate purchase that usually occurs in the buyout, as opposed to the venture capital, area.
Different benchmarks apply to start-up financing or smaller buyouts – in the broadest sense, it is the negotiating skill of the private equity manager that here determines whether the acquisition is cheap or expensive. The situation in the public equity markets at the time has only a limited and relatively intangible influence on these kinds of transactions.
2. Transformation period: This is the period between the purchase and sale of the company by the private equity manager, and is on average a period that lasts around five years. For private equity investing both the macro economic and micro economic outlook must be considered. What will happen in the next five years on the macro economic level? At the moment various corporate scandals, such as Enron, WorldCom, Tyco, etc. and the prospect of military conflict in the Middle East are having a negative impact on the global economic situation – but in private equity we talk about a transformation period of around five years and this should allow for one (or more) economic upturn, even if it is only on a fragmented basis in individual countries. More generally speaking, smooth and consistent economic growth favors private equity investing (although in some cases economic downturns can encourage specific private equity actions – see below).
It is at the micro level that the power of private equity, and its remoteness from public market performance and sentiment, is most evident. Because here performance is determined by what the fund managers actually do during the transformation process. This is the area that has the lowest correlation with the public markets, in some cases, even a negative one. For instance, it is general experience that corporate restructuring by a private equity investor is easier in a difficult economic environment when public markets are down.
In most of the cases it is during the transformation process on the micro level that the essential success or failure of the investment is fashioned. If the private equity management is weak then the investments will likely be weak as well (unless everyone gets a free ride on a boom such as occurred with the Internet and technology bubbles of the late 90s). And if the fund management is first-class then it can fashion success out of virtually every investment and often achieve a level of return for investors in the private equity fund that is well above public equity market returns. However, the transformation process requires considerable hard work – one reason why successful private equity managers receive top salaries and profit shares (and another area where correlation with public equity markets can be minimal!).
3. Exit – sale of the investment: only around 20 per cent of all exits in private equity are carried out via the stock market (IPOs). The remainders are by trade sales or secondaries to other financial investors. As is the case when acquiring a company, market sentiment plays a major role in IPOs and large corporate transactions and there’s no doubt that achieving an attractive sale price is far more of a challenge in stressed economic times.
But with the majority of trade sales, there are numerous other, very important, factors than the public equity market situation that play a role in determining the exit price. The vendor’s negotiating skills, selling experience, reputation and having the right network of contacts are all factors which have nothing to do with public equity market movements but are vital in the sale process. Additionally, it is the strategy applied during the transformation period that provides the platform for selling the company. For example, attractive returns can be achieved via trade sales if a mid cap company is modeled from a small cap using a combined acquisition and consolidation strategy. A successful such strategy can move the company into a more attractive EBITDA-multiple category and generating premiums as a result of “multiple arbitrage”. There have been a number of these types of profitable trade sales by experienced private equity managers in the past two years notwithstanding the very difficult economic situation.
Besides these three stages to the private equity investment process, there is another area where private equity correlates poorly with public equity markets and that is to do with transparency. Whilst public equity investment managers have access to extensive information sources and receive countless research reports on public companies, private equity and private companies are far more opaque. Private equity firms can exploit this very opacity to create compelling investment opportunities: whilst public markets thrive on clear information channels, private equity markets prefer to avoid the obvious and eschew such channels.
If all this suggests that the private equity fund manager can insulate his/her fund from public equity market upheaval then a quick look back at the late 1990s should dispel that notion. Since the second half of 2000, stock prices, valuations for corporate acquisitions and start-up financing have fallen severely, in some cases to such an extent that it’s not longer any fun for an entrepreneur to be in business. The Internet bubble has burst and the private equity industry in particular has borne its share of the pain. It is a fair estimation that anyone who has invested in private equity funds active in the Internet and technology sectors in the late 90s will not see much of their money back. That said, the experienced managers are mostly able to draw support from a long track record and investments in other sectors to produce what is still an acceptable return overall. Many young and inexperienced private equity managers though (mostly first-time fund managers) will be eliminated as part of a process of consolidation.
Towards a conclusion
Reviewing the life cycle of a private equity fund it’s clear that correlation with public equity markets varies significantly during this period. To summarise:
At entry and exit: Depending on the type and size of transactions the entry and exit valuation in a private equity transaction is partially (to a higher and lesser extend) correlated with the public equity markets. But in all such transactions it is several very important other factors (e.g. negotiating skills, selling experience of the PE managers) that are crucial to the success of a deal. In smaller transactions, public equity market factors play virtually no role at all.
During the transformation stage: This corporate development phase (micro level) provides for the least correlation with public equity markets. Here, experience of the private equity fund managers in building company value is the most important component in achieving success. The transformation process takes a number of years and is far more relevant to the overall success of an investment than achieving the right entry and exit prices. During the transformation period a favourable macro economic situation – steady growth – is desirable in general, but it is important to mention that some corporate actions are easier to push through during stressed economic situations – thus, correlation with public private equity markets can sometimes be negative.
Markus Ableitinger joined RMF in 2000 and is responsible for European private equity investment management. He was previously Investment Director for an expansion and buyout fund managed by INVESCO Central and Eastern European Asset Management.
RMF Investment Group is a provider of alternative investment solutions in Europe, specialising in Hedge Funds, Leveraged Finance, Private Equity and Convertible Bonds. As of June 2002 RMF had $9.5bn under management, of which $400m is allocated to private equity fund investing. The group has recently been taken over by global alternative investment firm Man Group. The firm's private equity investment arm was set up in 1999. It concentrates on private equity investments in Western Europe, Israel and the US across the range of investing stages.