Introduction
At Dixon Midland, we have spent over twenty-five years buying and selling private companies in the lower middle market. We worked closely with our management teams to invest in profitable growth, and we helped them navigate the myriad of business and human challenges that confront organizations big and small. We were successful in our endeavors, but our success required an enormous amount of hard work battling in the trenches of small business. Now, as public equity investors, we ask ourselves a new question. Can we replicate the success and hard work of private equity investing in public markets? The answer is yes. According to research by Harvard Business School, private equity investing can be fully replicated in the public markets with simple stock selection filters and prudent use of leverage. We look forward to implementing these concepts within our long-short public equity strategy for years to come.
Replicating Private Equity with Public Stocks
Successful private equity investing has historically been viewed as a combination of four primary activities: buying good assets at fair prices, using leverage to finance these purchases, operating businesses well, and selling businesses at high prices. In his paper “Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting,” Erik Stafford suggests the selection of small, value-oriented firms with strong earnings and the use of leverage are the two dominant success factors for private equity investors. This finding is at odds with widely held beliefs that private equity success is primarily attributable to superior management skills or better alignment of shareholder interests with management teams. Stafford’s research also has an interesting corollary that private equity performance can be closely replicated using public equity factor models that produce higher returns with lower fees and expenses, and significantly better liquidity. In short, these replicating factor models are superior in every way to private equity as an asset class. Of course, individual funds and individual GPs can significantly outperform or underperform.
Empirical Findings
To support his conclusions, Stafford’s analysis finds that public equity strategies using size-, value-, and quality-based asset selection along with traditional brokerage loans can outperform direct investments in private equity buyout funds. Specifically, the replicating public equity portfolio delivers a higher internal rate of return compared to the typical after-fee returns of private equity funds (14.8% versus 11.4%). These results assume a 2% fee on the replicating portfolio, compared to 4.4% fixed fees plus carry on the private equity funds. This analysis suggests that investors could achieve similar or better returns without the illiquidity, high fees, and complexity of traditional private equity investments.
Moreover, Stafford finds that the frequently cited public market equivalent (PME) analysis, which compares private equity returns to public market benchmarks, may overstate private equity performance. When adjusted for the leverage, size, and value characteristics of buyout portfolios, much of the alpha attributed to private equity investing disappears.
Stafford does not spend much time discussing the much-maligned smoothing of returns found across private equity funds. This ”volatility laundering” is a benefit for institutional private equity investors who receive a portfolio smoothing effect and at least the appearance of portfolio diversification.
Finally, we also note that public market investing allows investors to be “always in,” while private investing can involve extended periods of time between investments when investor capital is not fully deployed.
Conclusion
Stafford concludes that replicating private equity buyout strategies through public equities and brokerage leverage is a viable alternative to direct private equity investing. By focusing on size-, value-, and quality-based asset selection and using leverage to enhance returns, public market investors can mimic the risk-return profile of private equity buyouts without the associated fees and illiquidity. His findings challenge the traditional view that private equity funds derive their performance from superior management and operational improvements, instead pointing to asset selection and leverage as the primary drivers of success.
Stafford’s paper raises important questions about the true value-add of private equity managers and suggests that sophisticated public market strategies could offer a more efficient and liquid way to achieve similar investment outcomes. As private markets become increasingly expensive, we believe Stafford’s findings will continue to hold.
Link to white paper
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