Ludovic Phalippou

Private Equity Performance and Liquidity Risk

Private equity has traditionally been thought to provide diversi…cation bene…ts. However, these benefi…ts may be lower than anticipated. We …find that private equity suffers from signifi…cant exposure to the same liquidity risk factor as public equity and other alternative asset classes. The unconditional liquidity risk premium is close to 3% annually and, in a four-factor model, the inclusion of this liquidity risk premium reduces alpha to zero. In addition, we provide evidence that the link between private equity returns and overall market liquidity occurs via a funding liquidity channel.

A New Method to Estimate Risk and Return of Non-traded Assets from Cash Flows: The Case of Private Equity Funds

We develop a new methodology to estimate abnormal performance and risk exposure of nontraded assets from cash flows. Our methodology extends the standard internal rate of return approach to a dynamic setting. The small-sample properties are validated using a simulation study. We apply the method to a sample of 958 private equity funds. For venture capital funds, we find a high market beta and underperformance before and after fees. For buyout funds, we find a relatively low market beta and no evidence for outperformance. We find that self-reported net asset values significantly overstate fund values for mature and inactive funds.

Where is the value premium

The value premium is driven by 7 percent of the stock market. The 93 percent of market capitalization held most by institutional investors is value premium free. In contrast, in stocks held most by individual investors, the value premium, even when the stocks are value weighted, reaches a staggering 185 bps per month. In addition, the value premium is a long-side anomaly. It is a value premium puzzle, not a growth discount puzzle. The premise of this article is that if the value premium is a result of both pricing errors and limited arbitrage, then the value premium should be concentrated in stocks that are both held by relatively less sophisticated investors and expensive to arbitrage. Such a concentration is suggested in the literature but has not been quantified. In this article, I show that, indeed, at least 93 percent of market capitalization is free of a value premium. Using institutional ownership (IO) as a parsimonious way to classify stocks by their mispricing likelihood, I show that the value premium monotonically decreases from a high 185 bps for low-IO stocks to a negligible 13 bps for high-IO stocks. This result also holds when returns are value weighted and, importantly, is driven mainly by the long side. Low-IO value stocks are those with the most abnormal returns. The anomaly is a value premium, not a growth discount, as is sometimes argued. Another way to express this important point is that over the last 20 years (on an equally weighted basis), only 15 percent of the value premium came from the short side. Even if one could not short growth stocks, one could short the S&P 500 Index and be long on value stocks, which would have generated 85 percent of the unconstrained value premium. The extreme concentration of the value premium has important practical implications. First, arbitrageurs can expect to face substantial costs when trying to arbitrage the value premium, and those focusing on the stocks most held by institutional investors (the larger, more liquid stocks) will have difficulties generating arbitrage profits. The value premium concentrates where arbitrageurs usually do not go. This reason is also why studies have found that value and growth mutual funds perform the same. Second, studies that select a subsample of stocks that, for instance, either have at least two to five analysts following the stocks or are traded on the NYSE end up with a sample that is almost free of the value anomaly. Such a fact is important to bear in mind when interpreting the results found in such samples.

Investing in Private Equity Funds: A Survey

This literature review covers the issues faced by private equity fund investors. It explores what has currently been established in the literature and what has yet to be investigated. In particular, it reveals the many important questions to be answered by future research. This literature survey shows that the average investor has obtained poor returns from investments in private equity funds, potentially because of excessive fees. Overall, investors need to gain familiarity with actual risk, past return, and specific features of private equity funds. Increased familiarity will improve the sustainability of this industry that plays such a central role in the economy.

Giants at the Gate: Investment Returns and Diseconomies of Scale in Private Equity

We examine the determinants of private equity returns using a newly constructed database of 7,500investments worldwide over forty years. The median investment IRR (PME) is 21% (1.3), gross offees. One in ten investments goes bankrupt, whereas one in four has an IRR above 50%. Only one ineight investments is held for less than 2 years, but such investments have the highest returns. Thescale of private equity firms is a significant driver of returns: investments held at times of a highnumber of simultaneous investments underperform substantially. The median IRR is 36% in thelowest scale decile and 16% in the highest. Results survive robustness tests. Diseconomies of scaleare linked to firm structure: independent firms, less hierarchical firms, and those with managers ofsimilar professional backgrounds exhibit smaller diseconomies of scale.

Private Equity Funds’ Performance, Risk and Selection

As an asset class, private equity has generally enjoyed very favorable coverage in the financial media. Academic studies indicate, however, that private equity’s performance is not as robust as the media suggest. In addition, investing in private equity carries unique risks.

Why is the Evidence on Private Equity Performance So Confusing

Private equity industry associations announce aggregate performance every quarter. Typically these returns are largely above those of public equity markets over long horizons. These numbers are widely disseminated and commented on by the press and have probably played a role in the strong increase in allocation to private equity over the last decade. In contrast, academic studies find returns that are closer to those of public equity (on aggregate). This paper argues that in theory these two results are not necessarily inconsistent. The methodology used in practice can, hypothetically, generate these large returns while the true underlying return may be close to that of the public equity.

A New Approach to Regulating Private Equity

Much of the historic controversy around private equity has focused on the relationship between private equity managers and the companies they control. Yet there is little evidence to support the notion that private equity managers, on average, harm the companies they control. Meanwhile, a different aspect of private equity has received too little attention: the relationship between private equity managers and their investors. The private equity market shows signs of the “price shrouding” that economists have described in consumer markets. This is counter-intuitive for anyone who automatically assumes that “sophisticated investors” write optimal contracts. It is also potentially troubling for regulators and policymakers, because they use the “sophisticated investor” assumption as a building block in the way they organise financial markets. We propose two explanations for why price shrouding may affect even “sophisticated investors” and suggest some remedies. Although this discussion is framed purely in terms of private equity, we believe it is relevant to other complex investments that are popular with “sophisticated investors”.

Can Recent Risk-Based Theories Explain the Value Premium?

This paper shows that some of the most prominent risk-based theories offered as explanation for the value premium are at odds with data. The models proposed by Fama and French (1993), Lettau and Ludvingson (2001), Campbell and Vuolteenaho (2004), and Yogo (2005) can capture the cross section of returns of portfolios sorted on book-to-market ratio and size, but not of portfolios sorted on book-to-market ratio and institutional ownership. These models generate economically large pricing errors in all the institutional ownership quintiles and each statistical test indicates that these pricing errors are significant. More generally, these results show that a minor alteration of the test assets can lead to a dramatically different answer regarding the validity of a given asset pricing model.

An Evaluation of the Potential for GPFG to Achieve above Average Returns from Investments in Private Equity and Recommendations Regarding Benchmarking

This report reviews the evidence on risk, return and fees of private equity funds. It looks at the benefits and costs of being a large investor in private equity, at fund selection. Finally, it discusses how to benchmark investments in private equity.