Research on PE fund performance plays into the family office direct investment narrative

Berkshire Hathaway’s Warren Buffett once remarked: “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” 

For years, private equity firms have argued the opposite –  that their diversification away from small-cap buyouts would deliver the goods thanks to their skill in managing different companies and strategies.

Private equity does not always outperform the public equity markets. The major change that PE firms make to portfolio companies is the addition of debt, not magical operational transformation

Blackstone chief executive Stephen Schwarzman said this month he was “incredibly proud” of the role his firm plays in society by delivering generous returns to investors.

According to a study by Cambridge Associates, the US private equity industry has beaten many indices, most years, by delivering an annualised return of 13.4% over five years, 10.3% over ten and 11.9% over twenty.

Family offices are happy enough with this. But they often feel a little uneasy, questioning private equity cost structures and a lack of disclosure.  They are wary of differing rates of distribution, which can be a “guessing game” according to PitchBook, which says 10% of funds can keep clients waiting 3.5 years for their first payout.

Family offices might be even less enthusiastic about private equity funds when they look at some recent research on the sector. And it will play into their direct investment narrative, which continues to gain momentum.  

Dan Rasmussen, Brian Chingono and Nick Schmitz of Verdad say private equity firms built their reputation by leveraging up on the purchase of cheap small-cap stocks. As they became larger they had to diversify, thus reducing their returns, while continuing to rely on leverage to boost returns.

When Rasmussen worked at Bain Capital he found the cheapest 25% of its deals produced 60% of its returns, with the help of leverage. 

Bain later argued he was too junior and failed to access data on all its funds, but Rasmussen, the son of a prominent class-action lawyer, was not going to give up in a hurry. 

He went on to apply his research skills at Harvard and Stanford, once using them to write a book called  “America Uprising: the Untold Story of America’s Largest Slave Revolt” describing the massacre of 100 slaves in Louisiana in the early 19th Century.

A research paper by Rasmussen, with his colleague Brian Chingono, showed that cheap leveraged US small-cap value stocks returned an annualised 25%, between 1965 and 2013, beating the average by 11.7 percentage points. 

They were convinced that success for private equity was established through leverage as opposed to achieving corporate efficiency. They may indeed achieve efficiency but Rasmussen and his colleagues at Verdad said it was leverage and cheap purchases that really mattered.  

In a 2018 article in American Affairs, Rasmussen warmed to his theme: “Private equity does not always outperform the public equity markets. The major change that PE firms make to portfolio companies is the addition of debt, not magical operational transformation. And the valuation marks which suggest that the volatility of private equity is lower than that of public equity are based on the subjective opinions of the PE firms themselves—hardly an unbiased source.” 

Professional investors from the Abu Dhabi Investment Authority and Canada Pension Plan Investment board subsequently analysed 906 private equity funds for the Financial Analysts Journal, and also found their performance profited from leveraged small-cap bets.

Over the years, private equity funds have applied leverage to new disciplines such as large caps, venture capital, infrastructure, real estate. And they have often performed well during a period of low interest rates.

But the battle to find cheap small-cap value opportunities has become fierce. In a bid to prove its point, Verdad has used a different route by buying leveraged small-cap value stocks in the US, Europe and Japanese stock market to create a virtual private equity portfolio.

According to Verdad: “While private equity firms are paying more than 10 times Ebitda for acquisitions, and 5-6 times for debt, our average purchase price is less than 6 times Ebitda and our average debt levels are 3 – 4 times.”

It uses computer models to identify a range of companies with buyout characteristics. Leverage is an important part of the mix because its repayment boosts net assets and reduces the risk of bankruptcy. Verdad has found machine learning useful in analysing future corporate debt exposures, particularly in stripping out prospects which are too risky.

Verdad’s performance can be volatile, given its leverage and market exposure to the unloved small-cap value stocks. It calls its recent returns “lousy” as a result of a bad period for small, value and leverage stocks. 

According to its second-quarter update, as large-cap growth forged ahead, the Verdad Leveraged Company Fund lost 16.1% over twelve months, against a loss of 6.2% from the Russell 2000 value index. But it has gained 13.7% over three years, compared to 9.8% from the index. It gained a cumulative 88% in 2016 and 2017 and still retains its top decile ranking compared to its small-cap value peers.  None of its companies have gone bust. 

In the update, it said small-cap stocks were exceedingly cheap, while spreads on high yield debt were relatively excessive. And the outlook for the value style of investing has improved in the third quarter.

Verdad added: “We believe we’ve built a Ferrari. But we’ve been driving it down a bumpy gravel road of late.” 

It would be interesting to find out what goes on under the bonnet of leveraged private equity firms, particularly during periods of turbulence, but the chances are we shall never know.