Last year was a tough year in the quoted equity markets, with many indices falling by up to a fifth in value. These declines have not been confined to the public markets; in the world of private equity, investors have seen many of their holdings fall sharply in value over the same period. This has caused surprise among some private equity investors (particularly the newer entrants to the asset class), who believed that investing in an alternative asset such as private equity should diversify their portfolios, allowing them to achieve uncorrelated returns.
A degree of correlation between public and private equity market returns is to be expected. After all, privately-held companies operate in the same economic environment as do publicly-quoted ones, so are subject to the same trading conditions, interest rates and regulatory regimes. Moreover, the sale of corporate assets controlled by private equity firms is often dependent on public markets to absorb them via flotation. Finally, the original purchase, intermediate valuation and ultimate sale of private equity-backed companies (particularly buy-outs) are normally priced according to benchmarks, such as earnings multiples, derived from the public markets. In short, there are more similarities between public and private equities than differences, and certainly more similarities than many private equity practitioners often assert.
The natural correlation between public and private equities is masked, to some extent, by the inefficient valuation of the latter. It is extremely difficult to assess private equity performance accurately at regular intervals. In public markets, a combination of readily available data, armies of analysts, and volumes of buy and sell orders allows regular assessments of a company’s position and potential to be reflected in its share price. None of these resources exist in private markets, where assets are typically held by a private equity manager, out of sight, for three to five years.
It is only at exit that the returns of privately-held assets are crystallised. Until then they will usually be valued, typically only twice a year, using subjective judgements, lacking the rigour and frequency of the quoted markets’ ‘acid test’. At the point of exit, cash flows from the transaction are back-calculated at a constant rate to determine annualised performance (the internal rate-of-return, or IRR). So, if a company owned by a private equity firm is sold after four years and generates three times its original cost in gains, it produces an IRR of 32% in retrospect. It is a nonsense to assume that the value was created evenly over the four year period. It could have been generated mostly when the asset was purchased (by establishing a new enterprise, or buying at a discount), or mostly at the exit (by selling at a premium), or at any time in between, primarily through increased earnings.
The inefficiency of interim valuations in private equity is compounded by a tendency, especially in venture capital, for managers to value unrealised investments at cost. This approach is enshrined in valuation guidelines such as the BVCA’s. On this basis, investments are often not written up until a third party, arms-length transaction is completed, which may not occur until exit. This delay in the recognition of value, compared to the highly responsive public markets, adds to the impression that private and public markets are not correlated.
Conversely, at interim points during the holding period, the value of the asset could easily be below original cost and bear no relation to the ultimate, positive result on exit. Such a pattern could occur if a private equity firm pursued an operationally-intensive strategy at a portfolio company, one producing volatile financial results such as a cash-consuming, rapid roll-out of a new technology or franchise, or a difficult turnaround of an ailing, established firm.
It is an often-quoted axiom of private equity that ‘lemons ripen before plums,’ which is to say that failure is likely to become apparent earlier in the holding period of investments than success. In venture investing, success will usually be achieved only at the end of a frequently lengthy process of development, whereas failure occurs at one of many hurdles along the way.
In buyout investing, no amount of due diligence provides the certainty of information that ownership allows; nasty surprises sometimes emerge in the early days after a private equity manager takes charge. Also, the inability of portfolio company executives to adapt to the cash flow-intensive requirements of a highly-leveraged business is likely to be obvious before long.
If poor performance often occurs earlier and is reflected rapidly in valuations, and good performance usually emerges later and is frequently not recorded until exit, then the larger the proportion of bad investments in a portfolio, the more correlated it will appear to be with the highly responsive public market. Therefore, in bad times, when more companies fail, the correlation with public markets seems more pronounced than in good times.
Many longstanding investors in private equity use public equity indices to benchmark its performance. While understandable since investing in public markets is normally the alternative use of capital devoted to private equity, such choices implicitly acknowledge a correlation between public and private markets. A typical approach is to mark private equity performance targets to the market eg, S&P 500 index plus 500 basis points – hardly a non-correlation strategy.
However, beyond the anticipation of correlation that is explicit in such targets is the expectation of a margin of out-performance. Indeed, since private equity returns to investors are net of fees and, typically, a 20% carried interest, achieving 500 basis points in out-performance actually requires gross out-performance versus public markets of around 1200 basis points per annum, as fees and carry can easily consume in the region of 700 basis points.
Despite private equity’s natural correlation with quoted equity, its best managers can provide diversification by adding real value in ways traditional public companies generally do not, thereby outperforming the quoted indices. Firstly they can create groundbreaking companies from scratch and generate earnings where none existed before, by definition providing diversification to investors, since there are no quoted equivalents to these new enterprises. Secondly they can buy companies and influence them to improve their earnings and prospects. This can involve focusing corporate strategy, slimming down assets, reducing operating costs, establishing new sales channels or negotiating non-dilutive acquisitions. Thirdly they can bring both extra scrutiny and more imagination to the companies they control than a public company’s diffused set of shareholders can supply. Also, much of the hard work of strengthening and streamlining companies is better done away from the public markets, which distract management through short-term demands and frown on the incentive levels that private equity firms routinely grant to their executives.
On the other hand, lesser private equity houses are unable to provide real diversification from the public markets. To generate results, they may rely on multiple arbitrage which correlates with the market or leverage which magnifies returns but does not diversify the underlying assets.
Similarly, at the height of the recent bull market, public market appetite for IT companies was so strong that venture capitalists were able to float investee companies almost immediately, without having developed them much at all. Any stock that they were unable to sell on exit was therefore almost completely correlated with the public market. Whether in ventures or buyouts, poor private equity practice is likely to produce higher correlation with the public markets, since it involves surfing the wave rather than creating value.
Private equity’s ability to diversify investment portfolios remains genuine, but nonetheless its results are often correlated with those of the public markets, even if the private returns out-perform their quoted equivalents. The correlation can often appear lower because of the ‘efficiency gap’ between pricing in the public and private markets. The bull markets of the late 1990s further blurred the distinctions between public and private markets, leading to enhanced recent correlation between them. However, when private equity firms apply well-crafted strategies that actually create value, and behave sanely in pricing and doing deals, their funds should deliver diversification to institutional portfolios. The best firms – disciplined operators with uncommon access to new technologies, or special restructuring skills – should also deliver out-performance versus quoted markets, meriting a place in institutions’ strategic asset allocation.
John Barber and Laurence Zage are a director and an associate, respectively, of Helix Associates in London. Barber is also non-executive chairman of Altius Associates

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