Caveat Emptor - Private Equity

Private equity firms paid an average of over 10.5x EV/EBITDA and employed leverage of 5.8x Debt/EBITDA on average in the first half of 2016. These are some of the highest prices since the financial crisis.

What returns should private equity LPs expect from these pricy buyouts and these huge debt loads? We decided to run a backtest* to find out how companies with similar financials performed in the public markets.

Using Portfolio123, a commercial backtesting software, we looked at how a portfolio of all companies trading at >10x EV/EBITDA with >5x Net Debt/EBITDA would have performed from 1999–2016 with quarterly rebalancing. The results are as follows (before fees). The red line represents the screen of companies trading at >10x EV/EBITDA with >5x Net Debt/EBITDA, and the blue line represents the Russell 2000 small cap benchmark.

Figure 1: Backtest of >10x EV/EBITDA and >5x Net Debt/ EBITDA

Source: Portfolio123

As you can see, investors are likely to lose money when selecting companies trading at >10x EV/EBITDA with >5x Net Debt/EBITDA. As shown by the backtest, those  stocks have underperformed over the past 17 years and investors who are buying into these types of buyouts are investing in a selection of companies with low expected returns.

Contrast this with a screen that shows the performance of all companies trading at <7x EV/EBITDA and >30% Net Debt/EV, which is the rough universe of leveraged small value equities that we target in the public market. The red line represents the screen of companies trading at <7x EV/EBITDA with >30% Net Debt/EV, and the blue line represents the Russell 2000 small cap benchmark.

Figure 2: Performance of <7x EV/EBITDA and >30% Net Debt/EV companies

Source: Portfolio123

As shown by the backtest, this strategy performs significantly better than the Russell 2000, albeit with greater max drawdown.

We believe that the characteristics of the private equity asset class have taken a significant turn for the worse. From a quantitative perspective, we also believe there is a world of difference between the cheap LBOs of the pre 2005 era and the expensive LBOs of the pre and post crisis era.

Our view is that investors should not blindly invest in private equity expecting historical private equity returns. It appears that private equity historically outperformed the public markets because buying cheap leveraged companies was and is an excellent way to generate above market returns. Buying assets at >10x EV/EBITDA with >5x Net Debt/EBITDA is a recipe for high risk and low rewards.