Tim Melvin: The Case for Private Equity Replication

https://dailyalts.com/wp-content/uploads/2019/10/52e5d4454852ac14ea898579ce203e7c1d22dfe0545074407d2a79d1_640.jpg

A way around the barriers to investment in the private equity space for retail investors

Private equity replication represents a unique opportunity for investors to avoid the high costs of PE investment. Forbes Magazine recently ran a story about the high barriers to entry for private equity investors.

To access the bigger, more successful funds, you need millions of dollars to invest.

Even to invest in a smaller fund, one still must be a reasonably wealthy individual. It also helps to be able to afford a good lawyer to go over the terms of the deal. The regulators will tell you this all done to keep the individual investor form taking on too much risk.

The problem is that private equity has been the best performing asset class for decades now, and many believe that will continue to be the case in the future. The author of the Forbes piece, Frank Holmes, cites a study that shows that showed that a hypothetical $10,000 investment in a fund that tracks the S&P 500 would have grown to $76,123 over the 30 years through 2017 while the same $10,000, invested in private equity, would have grown to an average $211,071, or 2.5 times greater than the S&P 500 returns.

Mr. Holme’s answer to that is to make access to private equity more available to smaller investors. While agreeing in general with the concept, I am a little uncomfortable with what Wall Street might offer to individuals to gain private equity exposure. It is likely the products will be complex with prospectuses written by lawyers to confuse lawyers and fees that are high and mostly hidden. One of the reasons these funds are so restricted by regulatory agencies is that they are extraordinarily complex and expensive, and I don’t think that translates well to the general public.

Private Equity Replication Solves the Dilemma

I think a better alternative to opening access to private equity funds is to teach individuals how to replicate what private equity funds do with their investor’s money. Two studies have been done in recent years to figure out how to do that, and both have discovered strategies that would allow individual investors to capture private equity-like returns with the fees and complexity of investing in the funds themselves.

Erik Stafford of Harvard did the first. His study found that “Private equity funds tend to select relatively small firms with low EBITDA multiples. Publicly traded equities with these characteristics have high risk-adjusted returns after controlling for common factors typically associated with value stocks. Hold-to-maturity accounting of portfolio net asset value eliminates the majority of measured risk.

A passive portfolio of small, low EBITDA multiple stocks with modest amounts of leverage and hold-to-maturity accounting of net asset value produces an unconditional return distribution that is highly consistent with that of the pre-fee aggregate private equity index. The passive replicating strategy represents an economically large improvement in risk- and liquidity-adjusted returns over direct allocations to private equity funds, which charge average fees of 6% per year.”

The only problem with Mr. Stafford’s study is that “hold to maturity accounting” ignores the possibility, if not the probability of margin calls in a market meltdown.

I have replicated much of his work and found that his conclusions are correct.

How to Replicate the Returns of Private Equity Companies

You can replicate private equity returns, but you would need to find some way of hedging against full-on bear markets. The other choice is to be willing to meet margin calls to make it work in a real-world setting.

Brian Chingono, then of the University of Chicago – Booth School of Business and Dan Rassmussen of Verdad Capital, also did a study of using value and debt to recreate private equity returns.

They took a different path and looked for undervalued companies that leverage on the balance sheet. They found that “We develop a ranking system for creating annual portfolios of leveraged small-value stocks in the United States. This ranking system prioritizes smaller, cheaper, and more leveraged stocks. These companies are already paying down debt and exhibit improving asset turnover.

Annual portfolios of the top 25 stocks in this system had a 25.1% average annual return between 1965 and 2013. At a standard deviation of 39.4%, the Sharpe Ratio of these annual portfolio returns is 0.51. These portfolios have a CAPM alpha of 9.6% and a CAPM beta of 1.66. The portfolio’s average risk-adjusted return o is 13.1% per year after controlling for the 3 Fama-French factors, momentum, and liquidity.

Additional Insight on PE Replication

Finally, I also ran my tests on the strategy. As a result, I found it works extraordinarily well if you use simple tools like Altman Z-scores and Piotroski F-scores. These tools further help screen out most credit and financial statement risk. In my test, I also restricted myself screens to companies that were reducing debt year over year.

We can also replicate PE exposure to real estate, infrastructure, energy, and private credit markets. This strategy uses REITs, MLP’s, Business Development Companies, and Closed-End funds.

We will explore some of those in the weeks and months ahead.

Related: Are Community Banks an Alternative Investment?]

 

Free Industry News

Subscribe to our free newsletter for updates and news about alternatives investments.

  • This field is for validation purposes and should be left unchanged.


Shape

Latest Alternative Investment News

https://dailyalts.com/wp-content/uploads/2020/07/153327650_b2c927a955_o.jpg
Artificial Intelligence: How CrowdSmart’s Predictive AI Improves VC Investments
July 7, 2020     Artificial Intelligence, News

CrowdSmart’s Cyrus is a software-as-a-service (SaaS) platform that uses AI and collective intelligence to better predict the likely result of an investment. Speaking to Barron’s in a panel interview, Polese…

https://dailyalts.com/wp-content/uploads/2020/07/forest-climbing-park-931256_640.jpg
Venture Capital: SaaS Data Protector OwnBackUp Gains $50M Funding
July 7, 2020     News, Venture Capital

OwnBackup is a cloud-to-cloud backup and restore vendor that provides automated, daily backups of SaaS and PaaS data, as well as data compare and restore tools for disaster recovery. Its…

https://dailyalts.com/wp-content/uploads/2020/07/photographer-407068_640.jpg
Digital Assets: Now Book Any of 700,000 Expedia Hotels Through Crypto Friendly Travala.com
July 7, 2020     Digital Assets, News

Travala.com is a blockchain-based, crypto friendly travel booking platform with access to over 2 million hotels in 230 countries. In a partnership with Expedia Partner Solutions announced Monday, more than…

https://dailyalts.com/wp-content/uploads/2020/07/PD00902_-_US_payments_acacia_apple_pay_photobreak.jpg
FinTech: Digital Payment Company Square To Give Banks A Run for their Deposits – Analyst
July 7, 2020     FinTech, News

San Francisco-based Square Inc (NYSE: SQ), a digital payment processor led by Jack Dorsey, benefited Monday from a highly bullish report by SunTrust analyst Andrew Jeffrey. The stock touched an…