Scholars find buyout funds produce alpha

An alpha component responsible for nearly 5% of performance helps buyout funds outperform public markets, according to a recent study carried out by HEC Paris and London Business School.

The debate as to whether or not alpha exists in private equity – or if it is simply leveraged beta – has taken a new turn in light of alpha-confirming research revealed this week by two European business schools and renowned private equity scholars.

“There’s more to do and further things to be found out, but I do think it’s an important step ahead,” said Oliver Gottschalg, a prominent private equity scholar at Paris’ HEC School of Management and one of the study’s lead researchers. “It demonstrates very clearly that for a typical sample of a large and experienced investor … [buyout] funds generate real outperformance and that outperformance is not attributable to just leverage and market riding.”

It demonstrates… [buyout] funds generate real outperformance and that outperformance is not attributable to just leverage and market riding.

Oliver Gottschalg

The core research examined 20 fully or mostly realised European funds whose vintage years were pre-2001 and studied their 455 underlying portfolio companies in great detail. Net of fees and carry, the funds’ performance was evaluated in relation to four factors: public market comparables, the differential of specific industry sectors, the effect of leverage and “residual intrinsic value generation”, or alpha.

A fund considered to be “alpha”, one of five statistical measurements used in modern portfolio theory, means its returns exceeded its risk and the investment outperformed benchmarks, while beta refers to performance relative to the broader market.

With anonymous fund data provided by fund of funds Pantheon Ventures, scholars from London Business School and HEC in Paris found that, net fees and carry, a unique alpha component contributed to 4.47 percent of a fund’s internal rate of return, representing roughly 23 percent of a buyout fund’s total return. Sponsored by the British Venture Capital Association, the research also found that of the average 19.6 percent IRR delivered by funds studied, a little more than 6 percent was due to sector differentiation and about 7.71 percent was due to leverage. This 7.71 percent figure attributed to leverage translates to 39 percent of weighted average buyout fund performance.

Sophisticated investors really have to … make sure they understand where the value is being created by the managers.

Helen Steers

The data highlights that institutional investors must understand exactly where and how managers create value, said Helen Steers, head of Pantheon’s European primary investment team. “In recent cycles a lot of people have benefitted from the rising-tide-lifting-all-boats-type syndrome,” she said. “Sophisticated investors really have to drill through this and make sure they understand where the value is being created by the managers. My personal belief is we’re going to see much greater dispersion of returns going forward.”

Gottschalg said there was no “cherry picking” for the sample, nor was there an attempt to exclude funds that invested during the frothy buyout environments of 2006 and 2007. “It is a data set where the fund’s vintage years end in 2001 but the investment activity ends in late July 2009. So it does capture investment and activity until very, very recently,” he said.

Asked whether funds of more recent vintage years would be expected to produce similar results, Gottschalg acknowledged they may have different characteristics or challenges given where they are in their investment periods or broader macroeconomic cycles.  “It’s just too early to tell,” he cautioned.  “I’ll be delighted to run the numbers in a few years’ time and update the figures,” he said, “but I’m not in the business of making prophecies based on a crystal ball and frankly I do not know what’s going to happen in a couple of years.”