Study: Alpha is ‘counter-cyclical’

Private equity generates no alpha in boom years, but outperforms public markets by nearly 16% during downturns, according to recently released research.

Private equity investments post the strongest performance – delivering the most “alpha” – during downturns, according to research unveiled today in Frankfurt, Germany.

An analysis of 4000 realised investments between 1977 and 2009 showed that during boom years, private equity investments delivered no alpha: i.e. they did not outperform comparative publicly listed stocks when the impact of leverage was stripped out. The research was conducted by Oliver Gottschalg of Paris’ HEC School of Management and Golding Capital Partners, a Munich head-quartered private equity fund of funds manager.

Furthermore, the research found that during times of downturn, private equity investments outperformed public stocks by a substantial 15.5 percent.

The research categorised boom years as being those in which markets rose by at least 15 percent per year. Downturns were defined as those in which markets fell by at least 5 percent over the year. During times of more moderate or stable public market growth, the amount of alpha returned ranged from 5.1 percent to 10.6 percent.

Critics have suggested that the outperformance claimed by many private equity funds is dependent primarily on leverage, rather than genuine value creation at the portfolio company level. According to the recent study, the overall amount of alpha returned by the private equity investments studied was 7.1 percent on average.

“This points to a very attractive feature of private equity,” said Gottschalg. “Private equity firms seem to ‘protect’ value during downturns.”

“This is consistent with what many people see as the advantages of the private equity governance structure,” he said, adding that this is most likely the first time a study had examined the generation of alpha across various stages of the economic cycle with this large a sample size.

Gottschalg recently teamed with fund of funds Pantheon Ventures on a related study, which 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.