Podcast transcript: How academic research can measure and predict PE performance

27 min approx | 10 June 2021

Winna Brown

Hi everyone. I’m excited to be joined today by Greg Brown, Research Director at The Institute for Private Capital (IPC) and Finance Professor at the University of North Carolina (UNC) Kenan-Flagler Business School. Greg and his team undertake academic research to help us, as the public, better understand the role of private capital in the global economy. Greg, thanks so much for joining us today.

Greg Brown

Well, thank you for having me. This is really exciting.

Winna

Yeah. Well, Greg, please describe your role, as well as the focus and objectives of the Institute for Private Capital.

Greg

Let me start out by just giving a little bit of background on the Institute for Private Capital. So, we’re a nonprofit, multi-university research initiative and we’re headquartered here at the University of North Carolina. But IPC actually involves most of the leading scholars in private capital. We have an academic network that stretches across more than 40 different universities. Our mission is to, as you said, improve the public understanding of the role of private capital in the global economy, and we really do this in a variety of ways. The primary way is really by providing unbiased and independent research that’s conducted by our network of academic affiliates. Our relationships are also with private-sector companies, and IPC is really able to do exclusive data agreements with private companies to get data that we can use for academic research. It’s really an important part of what we do because it’s so difficult to do research in private markets. The data isn’t available through regulatory disclosures, and so we’re able to provide this data to PhD researchers who actually work at their own institutions and with their PhD students to conduct the research. Another way we carry out our mission is by really kind of building a community where academics and industry practitioners interact around the research. We have more than 35 member institutions that are part of IPC; EY is one of those. We’re really thankful for your support. And these institutional supporters really play a critical role in helping us make sure that the research that we’re doing is actually useful for practitioners and policymakers. We host a bunch of events each year, where researchers and practitioners interact. These events are really valuable for the entire institute. So, the feedback that we get in discussion is really important. It helps us understand the problems the industry is grappling with, and, oftentimes, we end up in lively debates that are a lot of fun. My personal role as co-founder and research director really has two facets. The first one is I’m essentially the coordinator of the research activity. So, I helped bring together academic researchers and the data that they need to do their work, and my other role is as an actual researcher. So, I’m involved in several of our research projects, especially in the private equity area.

Winna

Maybe you can explain a little bit more of the importance that the role of academic research actually plays in the world of private equity.

Greg

Before IPC was founded, researchers just really didn’t have access to the data that they needed to do rigorous, unbiased research. As we know, data is difficult to get in private markets. There were very different opinions about even very basic things like what returns were in the private equity space. Some of the estimates on the high end were more than a thousand basis points higher than the lower-end estimates in terms of what historical performance had been, and so there was really just not much information that folks had in terms of the fundamental understanding of the asset class. So, what we sought to do was go out and get research-quality data. We realized we had to partner with people in industry that had access to that data, and that was really the only way we were going to be able to have research that would be objective and unbiased, and available to the broader community. So, I think that it’s really important to point out that the research that IPC does, it all enters the public domain, so we don’t do sponsored research. All of our research is unbiased and independent, and none of the faculty affiliated with IPC are paid to do the research; they’re sponsored by their home academic institutions. And because of this, we’re able to very credibly weigh in on what some of the most important questions are that private capital investors face.

Winna

Just pulling on one of the areas that you mentioned, one of the things that defines private equity is the private nature of the industry. There’s almost like this lack of transparency that makes getting high-quality information really difficult, yet, at the same time, it’s critical, hence, the importance of what you and your team are doing. As some of the IPC materials were noting, private capital, as it’s defined more broadly, accounts for the vast majority of capital in the world, yet research on public companies seems to always vastly outnumber research into private businesses and industries like private equity. So, what are some of the key questions that you and other academics are seeking to answer, and, specifically, is there already some good research out there that maybe, you know, people in the public aren’t really aware of yet?

Greg

The way that we’ve gone about trying to get data and work with industry folks is to try to find that win-win, where, essentially, we bring a lot of analytical firepower to the table, but we’re short on data. There’s a lot of companies out there that, through the course of their business, have collected data, but they just don’t have the bandwidth or expertise to do the rigorous statistical analysis that we do. So, what we have done is partner with industry people, find folks where there’s this kind of natural synergy, this natural win-win and partner up on doing research, and we’ve been super-productive in generating now over 50 different research projects that have come out of the Institute for Private Capital, and these are informed by the academic community, but we also have an industry advisory board. And in fact, we worked with them recently to help identify some topics from the body of research that are sort of front of mind for most investors and pull together something that we think of as sort of IPC research’s greatest hits, and the topics are pretty wide-ranging: everything from PE’s role in portfolios to what predicts future returns.

Winna

Okay, well, let’s dive in into some of those greatest hits. Obviously, one of the first things that investors always want to know about is returns. So, what’s interesting is that, despite the adoption of alternative investments by the majority of most sophisticated investors in the world, in fact, I actually once read a stat that about 90% of US pensions are invested in PE. So, that’s a great example. There’s still this debate, if you will, in the public sphere as to whether or not private equity and other types of alternatives actually have a place in investors’ portfolios and whether they really improve returns. So, having said all of this, what do we actually know about whether private-asset investments improve the performance of diversified portfolios, and in what ways do you think it alters the risk profiles of these portfolios? Are they making them more risky?

Greg

One of our research projects took the data that we have access to and then did a large historical simulation exercise, where we went back and said, starting back in the 80s, what if you took just a 60/40 portfolio that was all public? So, 60% public equity, 40% public debt, and then you said, let’s take 20% of the equity portfolio and devote it to private funds. And we’re going to do this with actual cash flows. It’s a completely realistic simulation because we have fund-by-fund level cash flows. And so, we have this for several thousand funds, essentially the entire universe of institutional quality funds. We said, again, realistically, we’re just going to make commitments to 10 funds per vintage year, and we’re going to roll that all the way forward up to the present. So, we have a long history through multiple cycles, and we’re gonna do this a thousand different times. So, we’re going to simulate a thousand different realistic portfolios, randomly allocating. So, it doesn’t require that the investor have skill. And then we see what the characteristics of those portfolios. And what we found was that, in just about every scenario, the portfolios with private fund investments have superior returns on a risk-adjusted basis. This is true for buyout funds, it’s true for venture capital funds, it’s true for real estate private equity funds, as well as all of these types together. And the other interesting thing is that there’s this very pronounced risk-return pecking order as well. It’s one of my favorite projects of my whole career, to be honest, because it’s just such a really nice clean result. So, what you see is that you add real estate private equity, you get a little bit more return, and they’re sort of on the low-risk end of the spectrum. If you add in buyouts, you get even more return – a little bit higher risk; if you had venture capital, even more return, but even higher risk. But all of these are better risk-adjusted outcomes. So, in every case, the Sharpe ratio, the ratio of performance to risk, is better when you include private funds in a diversified portfolio.

Winna

So, what you’re saying is your research found that this additional return, if you will, for private capital comes from diversification into assets that are less correlated with the rest of LP’s portfolios, and some perhaps comes from the out-performance versus the indices? Is that right?

Greg

So, we’ve done a really detailed analysis using the most state-of-the-art risk adjustment at both the market and industry level, and despite what some rather vocal people claim, we find that private equity outperforms, and that relative performance varies quite a bit by vintage year. But, remarkably, private equity has outperformed public markets for 21 of 27 vintage years from 1987 to 2014. So, I mean, we don’t know if that record will continue or not – there’s no way to tell the future, and we also sort of don’t know a lot about recent vintages just because they’re still in their investment phase and they’re kind of young. But, if we look at the long historical record, private equity has really reliably outperformed the public markets.

Winna

If that is the case and your research demonstrates that and proves that, why is there so much debate in the public sphere?

Greg

It’s not that there’s this 50- or 100-year history of looking at returns; it’s not like it’s easy for anyone to do it. And so, I think that people are able to sort of cherry-pick data. They’re able to look at the data sets they want or the time periods that they want, they’re able to do different types of benchmark comparisons, and, you know, if you go around hard enough looking for something, you can always find a vintage year or a benchmark or something that lets you say that private equity hasn’t performed as well. I think the other issue is that there’s no doubt that a lot of people have done extremely well for themselves in the private equity industry, and so, some of this may be just, why is it that these people have been so successful and have such great financial gains and we see still positive returns, but more modest benefits to the kind of broader investment community.

Winna

Well, I don’t know that I want to unpack the reasons behind that because I imagine that would be pretty controversial. But let’s kind of unpack why we think private equity perhaps does so well, and it’s a bit of a joke, if you will, within PE that every manager is top quartile, but it kind of gets to this critical underlying point that you’re not just taking all your assets and dumping them into an index and hoping to replicate the returns of the S&P. They’re actually consciously investing in active management. And so, investors believe, for a good reason, that manager selection is a critical part of investing in PE. So, from the work you’ve done, how important would you say that manager selection and, maybe more broadly, what are some of the best predictors that a particular fund or particular vintage will do well?

Greg

This is really complicated question. There’s a lot of different facets to this question, and I think you can think of them as moving from the market-wide macro type of factors all the way down to very specific, you know, manager or even deal partner-type issues. So, let’s unpack those kind of sequentially. So, the first one is market-wide factors. We know that the private equity industry is very cyclical. And so, you would think like, oh, I can figure out when there’s a market peak that this is followed by vintage years that tend to not perform very well. We know that things, like valuation ratios or quite cyclical and easy to observe, for the most part. But it turns out that it’s hard to take advantage of these kind of market-wide timing opportunities. And the reason for that is, when you make an investment in a private fund, you’re just making a commitment to that fund. You’re not actually putting the money to work. The GPs get to pick when the money goes to work. And that could be over a much longer period, over typically a five-year period. And so, even if you commit in exactly the right vintage years in terms of understanding when the best opportunities are, that doesn’t necessarily mean that the GP is going to put all the money to work at the exact right time. So, what we see is that, even commitment strategies that take very different views in terms of when the right time to invest is, that the cash flows coming in out of those strategies look pretty similar, right? They sort of line up more broadly with what the trends are because GPs are, in general, seeing what opportunities are by industry or, you know, as the market permits. So, as a practical matter, these kind of big macro issues, very difficult for investors to take advantage of these opportunities. Now, when we look at industry conditions, here things get, I think a little bit more subtle, there’s a little bit more opportunity for investors to take advantage of timing. So, what we know is that, for example, dry powder predicts underperformance of new funds, okay? So, to the extent that you can understand what’s happening with industry-level opportunities, that may help you figure out what sectors to allocate to at different times again. So, some opportunity there. But really, I think it’s the deal-level analysis and fund-level analysis where there’s the most opportunity. So, we know that, when we look at EBITDA multiples, those are an indication of what future performance is going to be for particular industries and for particular companies even. We also know that deal partners seem to have skill. And so, there’s a literature that shows that there’s persistence in private equity firm performance. So, GPs who were successful in one fund are likely to be successful in the next fund. But that tendency has eroded somewhat over time. It was quite a strong result back in the 80s and 90s. It sort of got a little bit weaker in the 00s. And then it is really not significant anymore. But what’s interesting is that, if instead of following the GP, you follow the deal partner, as they might set up their own firm or move to a different firm, that persistence is still there. There still seems to be skill for doing deals, and a good LP, if it can do that analysis, is able to take advantage of that persistent skill. So, another thing we’ve been able to do with our analysis is look at what are the determinants of performance are over the life of a fund. So, for example, we can say, okay a fund that is 5 years old, what is going to determine the performance of that fund for its remaining life? It turns out that those are different things than what might predict performance from day one or performance at year 10. And so, we’ve been able to collect a large number of characteristics, market characteristics and fund characteristics, to try to understand what predicts performance at different points in a funds’ life. And there’s some really interesting things here because some things change radically over the life of a fund. So, dry powder is another great example of that. So, when there’s a lot of dry powder early in a fund’s life, that’s a bad thing for the fund’s future performance, and you can think of it as they’re having to compete for deals more than they would if there wasn’t as much dry powder. But then, when you move toward the end of a fund’s life, a lot of dry powder is a good thing for a fund because then it’s able to sell into that high demand. So, being able to unpack kind of what matters at different stages of a fund’s life has been one of the things that our recent research has focused on.

Winna

One point I wouldn’t mind just kind of following up on, you mentioned of late, it’s the deal partner that seems to drive returns more so than the fund or other predictors. Why do you think that is? Do you think it comes down to the skill of that person identifying a target and an asset and the ability to either negotiate a good deal and almost have that eye to the future of where there can be value created? Is that the key, is that the talent we’re looking to harness, if you will?

Greg

I think there’s a lot of different ways that private equity funds could add value. Some of them are simple things in some sense, such as, you know, levering up, taking more risk, financial engineering, things that I think most people currently view as sort of a commodity type of approach toward investing. One of the really important differences between private equity and public equity is that private equity comes in and actively manages the company to a large degree, right? So, they have the ability to make decisions and often hard decisions or decisions that would be more difficult for a CEO of a public company to make, and that ability to make meaningful direct contributions to the operations of a company clearly has value in some context. It may not have value for every company, but clearly there are some companies where that has value. And that’s well documented in the research now. We were able to look at specific companies, see what the specific impact is on those companies and associate that with business plans that the private equity firms had coming in, and the, as the private equity firm, and the deal partner in particular, executes against that plan, they were generating value, and the closer that the changes in operations are to that original plan, the greater the value creation. It’s really interesting to look at, you know, exactly what’s happening with the operations of the company vs. sort of buying and selling companies or financial engineering or other things that you might think of as being either kind of historical performance drivers for private equity or the way that people approach public market investing.

Winna

We’ve certainly spoken a lot about operational improvement and value creation on, you know, different episodes of the podcast. One thing we haven’t done specifically though is, tie it like your research has to the deal partner and that moment where they have identified the target and have crystallized, if you will, the investment thesis and where that value can come from. So that’s actually, that’s really super-interesting, and it’d be interesting to see how that evolves over the coming years, you know, as deal partners are followed to your point. So then, just continue on a little bit about value creation and operational efficiency because I mean, I think what we’re saying is that it is key, it really is key because it impacts investor returns; but then it also influences, I guess, the impact that PE has on the companies in which it invests and, more broadly, the economy as a whole. And of course, this has been subject to great debate. So, in your view, what effects do you think private equity investments have on the broader economy? And I’m, you know, thinking about things like employment and productivity and capital investment, in light of the conversation we just had around value creation.

Greg

At a high level, there’s really two competing hypotheses. The first one is the idea that the size of the pie is fixed, and private equity is just good at grabbing a larger slice of that pie. The alternative is that PE somehow grows the size of the pie. So, the evidence that I just mentioned, it really suggests that, at the company level at least, there are efficiency gains that make businesses better off, and this is growing the size of the pie. But the research suggests that not only do individual businesses benefit, but there are actually positive spillovers to the broader economy. So I have a paper with a former PhD student, and so, we examined a really large sample of countries and industries over a long period, 25 years, and we looked to see what happens to other companies in a particular country, in a particular industry, after private equity investments occur. There is sort of what are the spillovers to the other companies competing in that same country, in that same industry. And so, what we find is really interesting. We find that there’s actually statistically significant positive spillovers to the broader economy, and the most important one of those is an increase in productivity. So, what it seems private equity does, is they come in, they kind of tighten things up, maybe right the ship if it’s a struggling company, make new investments, do things that make the company that they’ve acquired more competitive, and then the other companies in the industry are, in some sense, forced to respond to that and make their businesses more competitive as well. The result of that is that overall productivity increases in that industry, in that country for the years following a private equity investment. Now, that’s really important in a long run, but that might be perceived as bad by the competing companies in the short run because, you know, they’re kind of having to scramble to catch up and get more competitive, but, in the long run, that’s really good for the economy because the primary determinant of the standard of living of an economy is productivity. It’s GDP per capita, and productivity growth is what drives GDP per capita. So, there’s clearly this long-run positive impact that comes from increases in productivity. There’s other studies that have shown this in the US. So, there’s researchers from Chicago and Harvard who have gone into the census data and, at a very granular level, looked at what happens for individual operating units inside of businesses and shown that there is a clear increase in productivity on average from private equity.

Winna

That’s certainly something that we as practitioners who support the private equity sector have always believed, but it’s great to hear that the research supports this. Question though. Have you ever compared the results of that research against the impact publicly listed companies have in the country? Is there a comparison between the two? Do they, you know, directionally both positively impact GDP?

Greg

What these studies tend to do is have a control group, and that control group is most commonly a comparable public company. So, you know, we would say, okay, here’s a restaurant business, in this particular state, or this particular country, okay, let’s pick, and it’s backed by private equity. Let’s pick as similar a company as we can that’s not private equity backed and then look at the difference between those. And so, these comparisons typically are looking at what’s happened to companies that are backed by private equity, or in the case of this spillover literature, companies that are now facing competition from private equity vs. other companies. And so, it’s as close as we can get to an apples-to-apples comparison, it’s never perfect, but that’s why we like large data sets so we can say something with some statistical reliability. So, it’s a challenge to know what all of the effects are. They’re probably not all positive, and there’s going to be winners and losers. There’s certainly some companies that do better than others. There’s sort of, you can find anecdotes where it looks like things have gone bad with private equity no doubt. But it’s also often hard to know what the counterfactual is there. Like what would have happened absent investment by private equity? Would that company still have gone bankrupt or still had to lay people off or still been forced to offshore jobs? So, I think that it’s a difficult empirical exercise to always know, you know, what would have happened without a particular action because you can’t do these perfect controlled experiments the way you can in, you know, biology or chemistry or physics.

Winna

I’ve really appreciated the time that we’ve had and the discussion. I’ve learned a heck of a lot, and I know our audience will feel the same. I really want to thank you for your time, but before I let you go, I am curious, it seems like you and your team have already pretty much focused on many of the big questions the world has about private capital. What are some of the discussion areas that you and the academic community anticipate focusing on in the coming years?

Greg

We have a long list of things that we want to research. There is no shortage of topics where we need to learn more. A lot of this is actually driven by conversations we have with industry partners, and these are people like yourself, they’re large limited partners who are members of the Institute for Private Capital. I would say that two things that we’re hearing the most about right now and have active projects underway addressing the first one is sort of understanding more about how private assets fit into the broader portfolio management process. As you mentioned earlier, most institutional portfolios now have exposure to private funds or illiquid assets of some sort, but really the theory and the mechanics that we have for understanding how to do portfolio analysis, asset allocation, things like that, they’re not built very well for private investments, because you can’t observe returns all the time. It’s hard to understand what the risk factors are, how they correlate with other things. So, you know, what is the exact diversification benefit that you get or really trying to dig in more to understand okay, how do we do portfolio optimization with private investments? That’s like topic number one right now. The other thing we’re really interested in is sort of the other end of the spectrum, from very broad portfolio stuff all the way down into what’s happening at individual companies. We are increasingly getting more and more granular data on portfolio companies and what drives that performance. And so, we really want to understand, okay, what has been the historical drivers of performance and then especially how has this changed over time. Like in the data that we have now, we’re observing some very significant trends post GFC and the types of investments that are being made by buyout funds, for example. Much more of a shift toward growth, toward software, services in general. How is that affecting performance? Is it the same types of things that drive performance? What predicts returns? Has that changed over time? So, really understanding the evolution of the private equity industry at the deal level is a big topic of current research.

Winna

I do hope that you’ll come back onto the podcast and share the findings of that research once you get to the other side.

Greg

Absolutely, it’d be my pleasure to, and thanks again for having me.

Winna

Oh, thank you, really appreciate the conversation.