Why Replicate Private Equity?
Actively-managed mutual funds have consistently disappointed investors: 70% of actively managed funds have failed to beat the index and just 2.3% have delivered excess returns of more than 2.5% — and those are pre-fee numbers.
Surveying these statistics, Eugene Fama and Ken French concluded that skill in mutual funds was extremely rare, if it existed at all. Fama and French wrote in their famous paper on mutual fund statistics that “On a practical level, our results on long-term performance say that true alpha (α) in net returns to investors is negative for most if not all active funds, including funds with strongly positive α estimates for their entire histories.”
But in sharp contrast to these disappointing numbers, private equity (PE) firms have beaten the market in dramatic fashion. Over the past 5 and 10 year periods, PE firms have outperformed the S&P 500 by 3.3% and 3.75%, on average and after fees.
Figure 1: Private Equity Performance vs. Broad Benchmarks
Source: Cambridge Associates
Assuming annual private equity management fees of 6%, this means gross outperformance of 9–10%. These performance numbers are far superior to those we see from mutual funds. Public equity investors who want to beat the markets over the long term should be devoting all of their time to slavishly researching the drivers of private equity outperformance — those drivers are singular in consistently beating public equity markets.
Our goal at Verdad is to identify the key drivers of this success and replicate it. We aim to do so at much lower fees and with increased liquidity compared with traditional private equity managers.
There are four possible explanations for this outperformance: private equity investors are more skilled than mutual fund investors, private equity firms are superior operationally, private equity firms are harnessing an illiquidity premium, or private equity firms are advantaged in the type of companies they are buying and the structure of those investments. We believe that the first three of these suppositions are empirically invalid:
Active skill is extremely rare in mutual funds, making it unlikely that all the private equity fund managers have enough skill to explain such massive delta.
The only empirical difference between firms pre- and post-LBO is a massive increase in debt. There is no evidence of massive changes in growth or margins that would be required to explain a difference in performance of such magnitude.
To earn an illiquidity premium, investors need to be able to buy illiquid assets at a discount. Private equity markets are now more expensive than public markets. Furthermore, private real estate investments have underperformed public REITS, in contrast with the outperformance of private equity to public equity. This is an indication that the illiquidity premium is a myth, like ether, that attempts to explain a gap in performance that the theorist is otherwise unable to explain.
That leaves the structural explanation. Investments made by private equity firms differ from those of mutual funds in three principle ways. Unlike mutual funds, private equity firms invest in companies that are small and cheap. They then use leverage to boost returns. These core distinctions in investment strategy (size, value, and leverage) present the most plausible explanation for the dramatically superior performance of private equity.
Fama and French estimate a value premium of 2.8%, a size premium of 1.6% per month, leaving roughly 5.6% to be explained by the judicious use of leverage. Leverage adds to these returns both by amplifying unleveraged returns and through the excess returns driven by deleveraging.
This is, in sum, the Verdad strategy. Guided by proven, structural drivers of success, we rely on algorithms to systematically invest in companies that are small, cheap, and leveraged. We offer our investors exposure to the core drivers of the wildly successful PE industry, one that is, for the average, small-cap investor virtually unparalleled in its construct. Our research proves that this strategy would have worked historically, significantly outperforming both public markets and the private equity index.
Note, however, that we are arguing for exposure to the factors that drove the success of private equity, not private equity itself. Why? Because private equity has strayed from those factors. And because most private equity investors attribute their success to individual skill, either in choosing investments or running businesses, or both. They have drifted from the core commitment to leveraged, small-value stocks that drove the industry’s success — excess money flooding in has led to higher prices for bigger companies with lower debt as a percentage of enterprise value — in short, to lower yielding deals.
Figure 2: Yield Convergence between Private Equity and Public Markets
Source: Verdad research
To beat the markets and produce returns that exceed broad low-cost index funds, we need to adopt the structural elements of successful private equity firms that, using leverage to boost size and value premiums, have delivered historically exceptional returns. There is simply no other proven methodology for producing significant outperformance than the volatile cocktail of leverage, size, and value.