Study: resilient PE model designed to outperform

Private equity performance outstrips that of public markets, especially during times of financial crisis. This Partners Group finding challenges commonly held views that the asset class is too much of a risky business.

Consistently outperforming public markets, private equity also fares better during financial crises, according to recent research from investment manager Partners Group looking at annualised buyout performance for the US and Europe measured against the relevant MSCI.

Since 2000, private equity returns in these two regions have outperformed relative public market indices, on average, by 5 percent in North America and 9 percent in Europe a year, according to its data. 

Through this central finding, the report refutes commonly held views that private equity is a high-risk investment model and would fare especially badly during times of financial crisis, according to Partners. 

However, the report shows that during the financial crisis of 2000 to 2003, private equity investments outperformed the public markets by 6.3 percent in North America and 20 percent per year in Europe. The difference was even more substantial in the US during the financial downturn between 2007 to 2009, where private equity exceeded the public markets by 18.8 percent in the US and 19.1 percent per year in Europe.

The relative success of the private equity model derives from a number of factors, according to the Partners Group analysis. 

Importantly, the investment selection process for a private equity firm is fundamentally more advantageous. The study shows that when looking at the average expected value creation of investment opportunities, 75 percent is directly linked to operational improvements in portfolio companies. 

Often controlling majority stakes and boardroom positions, private equity firms are able to make effective operational improvements and scrutinise management performance leading to value creation for portfolio companies. 

Revenue growth and earnings before interest, taxes, depreciation and amortisation accounts for 38 and 37 percent of value creation respectively, Partners says. Where public market investments don’t offer extensive prior inside knowledge of a business, private equity firms carry out intricate due diligence processes before an investment, which allows firms to assess the predicted growth and EBITDA before investing. 

Private equity firms can therefore individually select companies with compelling business models, high entry barriers for new competitors, above-average profitability, high cash conversion rates and good management. 

The Partners Group findings therefore show that the outperformance experienced by private equity is directly linked to its unique business model where firms have higher levels of knowledge and influence on their investments. 

Private equity has outperformed public markets in other regions too. Last year, Private Equity International reported on Cambridge Associates findings that revealed that non-US developed market and emerging market private equity and venture capital had outperformed their corresponding public markets in the first quarter of 2011.

During 2011 Australian private equity investments also outperformed the country’s stock market and other key asset benchmarks over a number of different time periods, according to figures from the Australian Private Equity & Venture Capital Association (AVCAL), reported by PEI’s sister publication PE Asia in November. 

AVCAL together with Cambridge Associates developed the CA Australia Index to measure the performance of Australian private equity and venture capital. For the quarter ended in June, the CA Australia Index had annualised returns of 8.59 percent, 2.42 percent, 4.23 percent and 7.81 percent over one, three, five and 10 years respectively.