Thoughts on private equity implied returns… not convinced

Although we do not invest in private equity we, nevertheless, have a view on prospective returns for the asset class and its position in a portfolio.

Private equity (PE) as an investment seems to have become increasingly popular over the last ten to twenty years. This seems to be not only because PE funds are extremely lucrative for their managers and for the major banks, as PE has also been increasing in popularity as David Swensen (former Yale Endowment Fund CIO) and the “Endowment Model” have gained notoriety.

The Endowment Model is best described in Swensen’s book “Pioneering Portfolio Management” (2000), encouraging investors to seek out and harvest the risk premia in, amongst other things, private equity.

Whilst “owner/principal PE” i.e. private equity investments in businesses owned and run by the principal has obvious and demonstrable benefits, we are less convinced of the attractiveness of “agency PE funds” i.e. funds of private equity investments run by a manager/bank.

Here’s why:

  • Firstly, there is now a very big body of research largely from the US, where the asset class has been around for longer and the data collected has been over a much longer period, which strongly suggests that PE returns are highly correlated to listed small cap public equity returns.

Back in 2009 the Brandes Institute published a paper titled “Is US Small Cap a viable alternative to US Private Equity?”; the results and conclusions of which have been repeated and replicated in multiple studies in the following years.

It concluded, “… based on long-term performance, small cap has been a viable alternative to private equity in seeking compelling returns”.

Of course, PE is less-liquid, more opaque and the search costs involved in finding and accessing good and persistently performing funds (when the average PE fund delivers returns no better than public equity returns) should also be borne in mind.

In addition, as Professor Ludovic Phalippou (Said Business School, University of Oxford), probably the leading researcher in the performance and risk characteristics of PE funds, has shown, the generally accepted method for performance calculation in PE funds systematically overstates PE fund returns.

As shown in his paper “The Performance of Private Equity Funds” (2009) “… a large part of performance is driven by inflated accounting valuation of ongoing investments and we find a bias toward better performing funds in the data. We find an average net-of-fees fund performance of 3% per year below that of the S&P 500. Adjusting for risk brings the underperformance to 6% per year.”

For those particularly interested, Phalippou has proposed an alternative, more rigorous method to the traditional “internal rate of return” calculation favoured by PE funds – see “A New Method to Estimate Risk and Return of Non-traded Assets from Cash Flows: The Case of Private Equity Funds” (2012).

So, the case that (a) PE fund returns are overstated and (b) PE returns are highly correlated with small cap returns, in our view, is strong and very compelling.

  • Secondly, at the risk of attracting a wave of abuse, it seems to us that a large part of the PE model seems to be buy a company, swap its equity for debt and leverage the balance sheet. Increasing the balance sheet leverage increases the return on equity and, all other things considered, that lifts earnings and thus lifts the price for re-sale. Simple – more debt = better.

In fact, that looks pretty evident in the data. The following chart shows net credit market debt issuance in the private non-financial sector (as a % of GDP) versus the US Small Cap Equity Index implied 10 year annualised return.


The chart is very striking. In the period from 1980 – 1990 there does not seem to be much going on, this changes abruptly after.

Starting around 1990, the correlation between small cap equity implied returns and net debt issuance is extremely strong.

As PE returns have a large debt component and are highly correlated with small cap returns and since small cap returns are highly correlated with small cap valuation, what we see is a debt/small cap valuation/PE synchronisation over the last twenty-five years.

The next chart shows the valuation of US small cap that corresponds to the implied returns in the first chart. Right now, small cap valuation, with net debt issuance running at 4% of GDP, is within a whisper of the highest levels ever and on par with 2000 and 2008… and we know about the PE investment returns for funds entered at those points (Preqin has the data, for a fee).

PE investments made at the top of the valuation cycle at high levels of net debt issuance are never, looking back, a good idea.


The same high valuation/low implied return position is evident in European small cap.

So, implied US small cap returns look unappealing, less than 6%, suggesting very unattractive returns for US PE. Although at least with a small cap stock portfolio it can be liquidated at will, something that cannot be said of a PE Fund.

The next time you consider PE, think if you might not be better off in a cheaper, highly liquid, transparent small cap ETF instead.



Emerging markets… is it time to go back in?

Following our recent blog note on the level of implied returns in the major developed markets, a look at emerging market equities might be appropriate, especially after a sustained period of underperformance. Could it be time to buy back into the dream? What does valuation imply for long run returns?

To recap:

  • The MSCI Emerging Markets Equity (EME) Index (local currency) has returned 10.8% annualised since March 2009 and 2.7% annualised in the last five years.
  • The MSCI EAFE (developed non-US) Equity Index (local currency) has returned 12.9% and 9.5% respectively.
  • The MSCI US Equity Market Index (local currency) has returned 18.2% and 14.3%.

The underperformance of emerging markets in the last five years is striking. 7 – 12% annualised underperformance versus developed non-US equities and the US Index.

The underperformance is clear when you look at the relative price/book ratio for the MSCI Emerging Markets Index versus the MSCI World Index. Emerging markets have gone from a 16% premium to a 35% discount since 2010.

Call us old-fashioned, but we still adhere to the view that emerging markets, with their relative institutional, social, political and economic frailties should trade at a discount. So, at least we are back on the right side of the axis and about half way to the relative valuation at the trough after the Asian crisis in the 1990s.


The question then becomes “Is the current discount sufficient to deliver an attractive, relative implied return premium for emerging markets versus developed markets?”

Here is the relative valuation of emerging market equities versus the EAFE Index (developed non-US markets) and the UK Equity Index:

  • EME at a 14% discount versus EAFE from a near 40% premium in 2010.
  • EME at a 21% discount versus the UK from a near 20% premium in 2010.



As we showed in a previous blog piece on expected market returns, the arithmetic of equity returns is very simple – implied returns are a function of four simple numbers:

  1. The starting valuation ratio.
  2. The ending valuation ratio.
  3. The growth rate in earnings per share over the holding period.
  4. The dividend yield.

Of course, returns can be made to look as attractive as you want if you make outlandish, non-evidence based and obviously biased forecasts for variables 2, 3 and 4 (assuming that we can agree on an appropriate measure of valuation to start from). All one must do is make up a sales story and fix the numbers to fit.

We prefer to let the data speak and on that basis we make the following assumptions:

  1. The starting valuation is the current MSCI Index price/book ratio.
  2. The ending valuation is the long run trailing median price/book ratio i.e. we assume that ten years forward the P/B ratio has reverted back simply to its run trailing median level. What could be more conservative?
  3. The growth rate of earnings per share (and the per share bit is important, especially in emerging markets where vast amounts of equity dilution takes place from net new issuance necessary to finance the growth in earnings) is assumed to be the long run trailing annualised rate of earnings per share.
  4. The dividend yield is what it is and easily observable.

Now, we can turn to calculating the implied ten year holding period annualised return for EAFE, EME and UK equity indices on the basis of those parameters (it should be noted that earnings per share growth, for example, is staggeringly stable across markets over long time spans).

  • The first chart shows the annualised implied return for emerging equities less the annualised implied return for EAFE (developed non-US equities) at monthly points over the last fifteen years.

A number of thoughts spring to mind: (a) investors in the 2007 – 12 period were actually prepared to accept a meaningfully lower implied annualised return in EME equities than in EAFE equities; they believed in the dream of perpetual motion in emerging markets that is at odds with all of the historical data set with the cross sectional correlation between equity returns and growth being negative; (b) investors today seem willing to accept a 1.5% annualised return premium in emerging markets.


  • The second chart shows the annualised implied return for emerging equities less the annualised implied return for UK equities at monthly points over the last fifteen years.

Again, UK investors appeared happy to forgo 3% annualised return in 2008 – 10 to chase the emerging markets growth dream and are happy to accept a 1.8% premium today to move from UK equities to the emerging markets.


Of course, besides valuation and long run expected returns under conservative, empirically-validated assumptions, there are other considerations:

  • Emerging markets have a higher downmarket beta than developed markets. That is to say, when the US market falls sharply the emerging markets fall far more substantially. Emerging markets offer no downmarket diversification at all.
  • We also need to consider other identifiable known factors in returns since, at the end of October, emerging markets had negative absolute momentum and negative relative momentum (versus the UK, US or EAFE). We would want to see positive absolute and relative momentum before we commit to emerging markets.

So, all things considered, the modest implied return premium in emerging markets, the greater drawdown beta, and the negative absolute and relative momentum versus the developed markets all suggest to us that there will come a better opportunity to move back into emerging markets. As Aristotle said “patience is bitter, but its fruit is sweet”.



What is the expected market return?

Often we get asked what our view is of expected returns and, although our investment process is not conditional upon a set of expected asset class returns, we thought it might be interesting to see what a passive balanced portfolio might be expected to return over the course of the next ten years.

We have set an investment horizon of ten years simply because over this time period there is a clear and statistically significant relationship between valuation and returns that is not seen at short horizon dates, certainly not at a one year horizon.

Our analysis is just to give a baseline for what the expected passive return on a balanced portfolio might look like over the next decade.

Starting with Equities: the total return you earn over any period is comprised of capital gain (growth in earnings and the change in the Price/Earnings ratio) and income (dividends).

Without showing some lengthy arithmetic, take it from us (for those of a more nerdy nature we can provide details of the equations and a spreadsheet should you wish) that the Expected Equity index Return (ER) can be closely approximated (from The Gordon Growth Model) as,

ER = (1 + g) * (End PE ratio/Start PE ratio) ^ (1/t) – 1 + Dividend Yield * (Start PE ratio/ End PE ratio + 1)/2

Capital gain and Income are separated.


g = the growth rate of earnings per share over our time horizon, in our case ten years

End PE ratio = the Price/Earnings ratio at the 10 year horizon date, we use the Price/Trailing 10 year average reported earnings

Start PE ratio = the Price/Earnings ratio today, we use the Price/Trailing 10 year average reported earnings

t = the time horizon, in our case this is ten years

Dividend Yield = today’s dividend yield

Now, you might say “if I knew the PE ratio in ten years’ time and I knew how much earnings per share would grow over the next ten years I would be a genius with perfect foresight and life would be easy!”. In fact, you would be correct in thinking that, so we obviously need to make some assumptions/forecasts.

As anyone who has spent time in our company knows, we don’t like forecasts and we have next to no time for forecasters.

(For a fantastic demolition of the futility of forecasting and the witchcraft of forecasters see the following wonderful papers by Dr. Kesten Green and Professor J Scott Armstrong, University of South Australia: “Simple versus Complex Forecasting: The Evidence” and “The Seer-sucker Theory: The Value of Experts in Forecasting

So, rather than forecast the inputs, let’s set them at “normalized” or long run trend levels,

We assume earnings per share growth is at its long run trailing rate over the next ten years, we assume the PE ratio in ten years simply reverts back to its long run historical median level. No forecasts to manipulate, no exaggerated claims, just more of the same we saw over the last 5 decades and more…

Moreover, we proxy expected inflation, needed to convert nominal into real returns, with trailing 3 year average inflation.

So, taking those inputs, we calculate the implied ten year annualized return for the equity indices in the US, UK, Germany and Japan and plot them with real cash yields and real ten year bond yields in each case to give you an “implied return curve”:

In all cases the real implied cash and bond returns are pretty much zero – that is what QE does for you (it drives them to zero to force you out along the curve seeking returns in equities, it drives the curve to the horizontal axis as it has done in the US).

The implied real equity index return in the USA is a measly 2.5%. It is far more attractive elsewhere but we should never forget the down-market sensitivity of non-US markets to the US.


What of a balanced portfolio? Well if we look at a 50/50 Equity/Bonds mix in each case, and a weighted average for a portfolio of all four markets, this is what we get:

A US balanced portfolio has an implied return of 2% – the standard annualized return assumption for most big US pension funds is 7-8% – with the implied real return below 5% in all cases. Interestingly, a weighted average (using equity index weights) is just 2.5%


Of course, it is possible to get more, but that implies that earnings per share growth  (from the starting point of record profit margins) exceeds its long run, and highly stable, trend growth rate and/or valuation multiples go significantly higher.

That would be the best case scenario and, like everyone we like to hope for the best, but a prudent investor always plans for the worst (the event that earnings per share growth is slower than trend or the valuation multiple falls below the long run median level at any point over the next ten years) and that is exactly how we approach portfolio construction.

In the best case our fund should produce solid returns and in the worst case it should substantially lessen portfolio drawdown.



The Dr. Fox lecture

As investors in our Fund and regular readers of our blogs well understand, we are firm believers in the “elegance of simplicity”. In accordance with Occam’s Razor, why make things more complex if the complexity adds little or no incremental marginal value and only means that there are more things that can, and will, go wrong?

We have had people say to us, ‘if you added a few bells and whistles, your strategy would be even more appealing’, ‘it all seems too simple’ or ‘why if things can be made so simple and understandable do others not do the same?’.

To that end, we thought you might find the following brief clip – “The Dr. Fox Lecture” – extremely illuminating. Just 5 minutes of your time will show you just how the desire for complexity and opacity is a trap for the foolish.

Back in 1970, a group of psychologists wanted to test the response of intelligent people to the machinations of a so-called “expert”, the fabled “Dr. Fox”. As you will see from the lecture clip, an actor was put in place to deliver a highly complicated lecture full of opaque jargon, contradictions and made up facts. He appeared smart, well informed and a master of his topic, in fact an expert. Unfortunately, what the audience did not know is that he was delivering a lecture of meaningless nonsense wrapped in pseudo-scientific jargon.

Despite the dense, complicated and absurd content, the audience ratings for the lecture were fantastic. The audience lapped up the complexity and pseudo-science; they couldn’t get enough of it.

That study, and others that have followed, shows that people actually value complexity, even when they cannot untangle it and do not understand it. In short complexity creates exclusivity (there are only so many of us smart enough to understand, of course) and exclusivity creates desirability (as an advertising and marketing executive well understands).

So, the next time you see a portfolio manager with a complex, multi-faceted, opaque portfolio with lots of moving parts just think of the fabulous Dr. Fox.



China’s threat in two charts

If, in fact, China is growing at the reported 7% target rate, it certainly is not evident in these charts.

Things which are produced have to be moved to market. The first chart shows Chinese Rail Freight Volumes (% year/year).


The second chart shows the Volume of Freight per Kilometre Travelled.


Rail freight in China is falling at the fastest rate (year/year) in over twenty-five years.

This certainly does not look like an economy hitting its targets and running at an enviable (even within emerging markets) 7% growth rate.

It looks like an economy that has slowed alarmingly since the second half of 2014. In fact, it looks like an economy going off the rails (excuse the pun).