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.
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.
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.”