Can Private Equity Returns Be Achieved By Quants?

by Corey Philip
January 23, 2018

Private equity and venture capital perks my ears, and turns the heads of anyone who has caught 15 minutes of shark tank.  The 2 are different however.  Venture capital invests in small high risk business, with often unproven business models, while generally leaving the current management team (entrepreneurs) in place.  Private equity deals in larger established companies.  Large private equity firms with billions in cash, like Mitt Romney’s Bain Capital, look to take over existing businesses on a rapid growth track, and then implement better management further accelerating the growth.

Since Sharktank launched, right after the recession, this form of investing has became mainstream.  Everyone wants a piece of the pie.  But I’ve long since thought the returns going forward are going to be abysmal, relative to the past results achieved.

I recently wrote the following 2 pieces, on why venture capital works for the sharks but probably won’t for you, and how Mark Cuban’s portfolio has performed relative to a passive index.

Here’s the thing, everyone knows that small, young, high risk companies have produced returns in excess of market beta.  Because of this, the valuations for such companies is increased dramatically.  They’re inflated to a point where they’re overpriced relative to the returns they can achieve.

Anyways, back to private equity.  The theory goes, that private equity firms identify opportunities in companies that are set to thrive, by using their ‘skill’ (in identifying oppurtunities).  They fund millions into market research by Harvard MBA’s to pull this off.

Then once they identify the opportunities and buy a controlling interest in the companies, they implement management and growth strategies to raise the value of the company.  Sounds legit.

But in an awesome episode on Meb Faber’s podcast, Dan Rasmussen discussed how his research has found that there isn’t much, if any, alpha added by these private equity firms.  He looks towards quantifiable characteristics of common private equity investment in public markets.  Private equity targets are usually:

  • Micro – small cap companies.
  • Highly leveraged (lots of debt)
  • Are generating cash flow and paying down these debts.

He’s found that investing in these types of companies historically would generate private equity like returns thus negating the argument that private equity firms and their teams of Harvard MBA’s, really ‘add value’ or have any ‘expertise’.

Other key takeaways:

  • Private equity valuations are currently 10x higher than they were in the early 80s when many of the big name private equity guys made the bulk of their weath.
  • Private equity as a market has not out performed the S&P 500 since 2010
  • Japan is an interesting place. Their culture really looks down on bankruptcy, as such their companies are really low risk.  In the 08/09 crash, when the S&P 500 dropped about 55%, Japanese Small caps only dropped about 30&.

Here’s the episode.  There’s lots more greatness in it!

Episode #90: Dan Rasmussen, Verdad, “The Crown Jewel Of The Alternative Universe Is Private Equity”

About the author

Corey Philip

Corey Philip is a small business owner / investor with a focus on home service businesses.

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