Now “Private Equity Replication”?

By now, regular readers are familiar with the argument that hedge fund indices can be replicated remarkably well with traditional betas since they are highly diversified.  The large and growing number of constituents in these indices means that the idiosyncratic risk that is a hallmark of hedge funds has been diversified away, leaving only a few common factors.  Proponents of hedge funds are quick to point out that this statistical axiom isn’t an indictment of hedge funds as much as it is an argument against excessive diversification.  Single-manager funds, they say, are much more difficult to replicate using traditional betas (let alone “exotic betas”).  With the hedge fund industry so large, expecting the sum total of all the world’s hedge funds to produce excess returns is like expecting the sum total of all mutual funds to beat the market.

Now it seems that the same argument is being used in the private equity industry.  In this article Jos van Gisbergen of 58 billion Euro Dutch asset manager Mn Services says that private equity returns can be replicated by a levered investment in public equities.   Van Gisbergen cites several studies including one my Citigroup that says the average “top quartile” LBO fund has a 36.6% annualized return over 10 years vs. 38% for “Pan-European and UK leveraged mid-cap value portfolios” (interestingly, Citigroup included balance sheet leverage, not just fund leverage, their calculation).

While this may be true, it begs several questions.  The first and most obvious is, How closely do the leverage portfolios and LBO funds track to each other? After all, you can beat just about anything with a leveraged equity position over the long term.

However, private equity does have a significant correlation to public equity.  But even if the top LBO funds are a dead ringer for levered public equities, what does this tell us about any individual LBO fund? Unfortunately, not much.  Like their hedge fund cousins, the idiosyncratic risk in private equity may be diversified away, leading to the potentially erroneous conclusion that all LBO funds can be replicated by levering up equities.

This may not be the only point of similarity between hedge funds and private equity funds.  Van Gisbergen proposes another way to replicate private equity returns – using activist hedge fund returns. Reports Thomson Investment News:

“‘But private equity funds are not the only asset class allowing investors to have an influence on management,’ argues Jos van Gisbergen. As a case in point, van Gisbergen refers to activist shareholder models by hedge funds.”

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  1. Walt French
    June 24, 2008 at 8:26 am

    A second valuable use of an index is to see how much of any single fund’s idiosyncratic risk actually has any return associated with it. Just as comparing an equity mutual fund to an index lets one see whether the fund’s idiosyncratic returns have a positive or (the typical case) negative average return (net of fees).

    So, a PE fund that actually is adding value to a levered equity strategy in similar stocks should WELCOME the comparison. Those who make bad bets, or wring out huge expenses from their investors are the ones you’ll hear squawking the loudest about how irrelevant the replication is.

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