Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting

Erik   Stafford

Working Paper | HBS Working Paper Series | 2015

Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting

Abstract

Private equity funds tend to select relatively small firms with low EBITDA multiples. Publicly traded equities with these characteristics have high risk-adjusted returns after controlling for common factors typically associated with value stocks. Hold-to-maturity accounting of portfolio net asset value eliminates the majority of measured risk. A passive portfolio of small, low EBITDA multiple stocks with modest amounts of leverage and hold-to-maturity accounting of net asset value produces an unconditional return distribution that is highly consistent with that of the pre-fee aggregate private equity index. The passive replicating strategy represents an economically large improvement in risk- and liquidity-adjusted returns over direct allocations to private equity funds, which charge average fees of 6% per year.

Keywords: private equity; value investing; endowments; investment management; Asset Pricing; United States;

Language: English

Format: Print

43 pages

Read Now

Citation:

Stafford, Erik. "Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting." Harvard Business School Working Paper, No. 16-081, January 2016.

We decompose bank activities into passive and active components and evaluate the performance of the active components of the bank business model by controlling for passive maturity transformation strategies that can be executed in the capital market. Over the period 1960–2016, we find that (1) unlevered bank assets underperform passive portfolios of maturity-matched U.S. Treasury bonds; (2) the cost of bank deposits exceeds the cost of bank debt; (3) bank equities have CAPM betas near one, while passive maturity transformation strategies have CAPM betas near zero; and (4) portfolios of bank equities consistently underperform portfolios designed to passively mimic their economic exposures. The very strong investment performance of passive maturity transformation strategies over this period may mask the underperformance of the specialized bank activities.

Traditional risk factor models indicate that hedge funds capture pre-fee alphas of 6% to 10% per annum over the period from 1996 to 2012. At the same time, the hedge fund return series is not reliably distinguishable from the returns of mechanical S&P 500 put-writing strategies. We show that the high excess returns to hedge funds and put-writing are consistent with an equilibrium in which a small subset of investors specialize in bearing downside market risks. Required rates of return in such an equilibrium can dramatically exceed those suggested by traditional models, affecting inference about the attractiveness of these investments.

Faculty & Research

Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting

Abstract

Citation:

About the Author

More from the Author