Presentation - March, Jeff Hooke Managing Director, Focus Securities

Transcription

1 CFA Society - Atlanta Presentation - March, 2011 Jeff Hooke Managing Director, Focus Securities Author, Security Analysis on Wall Street

2 Topics for Today 1. Background and Private Equity Underperformance 2. Why Institutions Still Invest in PE 3. Replicating Top Decile LBO Fund Returns with Publicly l Traded d Stocks 2

3 PE Industry Equity Commitments LBO - $500 B VC - $140 B Mezzanine and Other - $160 B Total $800 B 3

4 LBO Funds With $500B of equity commitments, possible asset purchases of $2 Trillion 6,000 existing portfolio companies 2,000 have been held longer than five years LBO funds have a tendency to sell good deals first. Boost IRRs 4

5 LBO Fund Performance After fees, average LBO fund underperforms S&P 500 by 1-2% yearly Cash in, Cash out IRR Kaplan and Schoar (2005), Phalippou and Gottschalg (2009) PE industry has never refuted the studies, focusing instead on top quartile returns 5

6 Likely Reasons for PE Underperformance Fund mgt. fees, portfolio monitoring fees, and transaction fees equal 3-4% per year Gross overperformance of plus 1-2% thus becomes minus 1-2% underperformance Funds gaming the portfolio, selling winners early and holding losers longer Pressure on fund mgrs. to invest, and buying firms at 30% control premiums 6

7 Some Factors that Promote PE Results, but Insufficient i Much more money to study an individual stock, vs. a public fund with 100s of stocks LBO fund has complete access to target co. mgt, projections and inside information LBOs have fewer mgt agency issues vs. publicly held firms These factors don t seem to be enough 7

8 Reasons Why Institutions Still Invest in Private Equity 8

9 Institutional Disbelief re PE Underperformance When I first researched PE returns (2006) and discussed with big investors disbelief!! Investors' reluctance to admit mistakes, lack of verifying PE fund claims, and PE industry PR Most said, so what? we're able to select top quartile funds," but 40% chance of repeating. In 2011, some recognition by institutions that LBO funds under perform on avg (NY Times, Fin. Times, Private Banker, the Deal, Calpers). 9

10 Continuing PE Popularity Among Institutions? i Many institutional types were asked the question: why invest, given the results? Their responses: We can pick top quartile funds Our various funds have beaten averages LBO funds have a magic formula; public stock managers don t Academic studies must be flawed 10

11 2011 LBO Fund Results Many investments made in time period have yet to be harvested Prospective returns quoted to date rely heavily on LBO funds own valuations of portfolio companies Institutional LPs often lack (or won t pay for) third party expertise to verify claims Time will tell 11

12 Replicating Top Decile LBO Fund Returns with the Use of Publicly Traded Securities 12

13 Origin of LBO Fund Replicating i Software Hooke and a colleague set out to determine if a synthetic LBO fund, using only publicly-traded securities, could beat LBO fund returns (a similar concept was tried by Groh and Gottschalg in 2007) Initial objective is an academic study, rather than a commercial application 13

14 Developing a Database During , we created a database comprised of hundreds of public LBO transactions as no such database existed Financial, operating, industry and pricing attributes are placed in the database LBOs of private firms and public company divisions i i are excluded d due to limited it info 14

15 Studying the Database The public LBO data is analyzed to identify variables that are typical of public LBOs Hypothetical portfolios are constructed on the basis of information gathered in earlier periods (no gaming), g) and reset every year The portfolios incorporate a set of about 30 inclusion criteria, based on a proprietary analysis of buyouts of public companies 15

16 Software Highlights - Back Testing The annual return of stock selection software (1.5% fees) beats S&P 500 (no fees) by 7.8% on average over a 17 year period, ). On average, 6% of selections acquired each year, providing 2% of excess return In 2008 and 2009, we used real money to produce an excess return of 9%. Favorable Sharpe ratio relative to S&P 500, indicating low volatility despite the high return 16

17 Model Beats Value Funds The model beats mid and small cap value on a back tested basis The premium performance over value funds with 10 year plus track records, : Software beat Delafield by 6.8% annually T. Rowe Price Mid Cap Value 6.0% Franklin Balance Sheet 8.4% Vanguard Select Value 9.1% 17

18 Synthetic LBO Fund On a back tested basis ( obviously no future guarantees), the concept offers top-decile-pefund returns, but with Lower fees Liquidity of public markets Transparency in portfolio pricing Diversification by industry and market cap 18

19 Model Portfolio IRRs - Backtesting Average Annual Returns Over 17 Years Portfolio (1.5% fees) 20.32% S&P 500 (no fees) Difference

20 Synthetic LBO Portfolio IRRs Years Above S&P Years Below S&P Total Years 17 Portfolio Years with Negative IRR (1998 and 2002) 2 S&P 500 Years with Negative IRR (2000 and 2001) 2 20

21 Optional Features Apply additional external leverage to the model portfolio to more closely l match LBO funds leverage. A 25% additional leverage factor adds about 4% to the portfolio IRR. Select portfolio every three months with new 10-Q releases, or turnover every day/week, instead of yearly. 21

22 Institutional Investors Intrigued, But Hesitant We met with numerous family offices, small institutions institutional investment consultants, and hedge funds. Many were intrigued, but unsure where the software fits into the investment t product universe. Not a value strategy, not an M&A selection strategy, not a PE fund. Hesitant to try something untested in the real world. Institutional guidelines ( historical track record), lack of brand name, family office risk aversion, other stock selection software, and private equity commitments (that contradict the synthetic LBO thesis) prevented sponsorship. 22

23 Replicating PE and Hedge Fund Returns Some ETF firms have developed a hedge fund replication product - $2 B in assets A handful are looking at PE replication 23

24 Thank you. Questions, comments? 24