Do Buyout Funds Outperform?

Do Buyout Funds Outperform? A unique approach to comparing private equity results with public equity markets By Jason Malinowski

2 Do Buyout Funds Outperform? Investors traditionally have included private equity as a component of their asset allocation because they expect it to outperform public equities. Academic studies have yielded mixed results on whether private equity has historically outperformed public equities after accounting for fees, risk and unrealized investments. Based on a unique approach to comparing these different asset types, a BlackRock analysis of performance of US buyout funds relative to public equities shows a favorable comparison. After adjusting for financial leverage and biases in market capitalization and industry factors contributing to private equity s higher perceived risk a performance comparison of US leveraged buyout funds to public equities from 1995 2009 reveals that buyout funds have, on average, historically outperformed public equities by approximately 3% to 5% per year. This outperformance can largely be attributed to the operational value achieved by buyout fund managers. The Public Market Equivalent measure Many earlier studies comparing private and public equity performance failed to account for the difference in return metrics used to measure results for these different investment classes. The reason we chose the PME is that most comparisons of US buyout funds and public equities are complicated by the common acceptance of two different return approaches money-weighted return metrics (e.g., internal rate of return [IRR], total value to paid-in-capital [TVPI]) for private equity and time-weighted metrics for public equity. By contrast, the PME measure has the advantage of allowing for calculation of money-weighted return metrics for public equity by mimicking the timing and size of cash flows associated with a private equity investment. In practice, drawdowns are reflected as investments into a public equity index and distributions are reflected as redemptions from the index, while the timing of cash flows is preserved. Changes in valuation over the life of the mimicking portfolio are based on performance of the respective public equity index. For purposes of this analysis, drawdowns and distributions are assumed to occur at the end of each quarter. TVPI and IRR metrics for US buyout funds by vintage year are presented in Figures 1a and 1b. Similar metrics for the S&P 500 are also presented based on the previously described PME approach. As cash flow patterns for US buyout funds differ by vintage year, this requires a separate S&P 500 PME calculation that reflects the cash flows of each US buyout benchmark s respective vintage year. To avoid this shortcoming, we elected to apply an alternative return measure for public equities called the Public Market Equivalent (PME). Figure 1a: TVPI analysis by vintage year as of December 2009 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008* 2009* 95 02 95 07 US Buyout 1.37 1.32 1.46 1.12 1.50 1.58 1.56 1.51 1.67 1.28 0.92 0.80 0.81 1.43 1.30 S&P 500 1.42 1.29 1.09 1.02 1.06 1.15 1.13 1.12 1.10 0.96 0.89 0.84 0.89 1.16 1.08 Difference 0.05 0.03 0.37 0.10 0.44 0.42 0.43 0.38 0.57 0.32 0.03 0.04 0.08 0.27 0.22 *Too early to tell. Figure 1b: IRR analysis by vintage year as of December 2009 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008* 2009* 95 02 95 07 US Buyout 7.3% 5.4% 7.4% 2.1% 8.8% 12.1% 14.9% 14.3% 22.1% 10.5% 2.9% 10.2% 8.8% 9.0% 6.4% S&P 500 7.8% 5.0% 2.2% 0.4% 1.5% 4.6% 5.2% 4.7% 5.6% 1.5% 4.2% 7.7% 2.2% 3.9% 1.7% Difference 0.5% 0.4% 5.2% 1.7% 7.3% 7.6% 9.6% 9.6% 16.4% 12.0% 1.3% 2.6% 6.6% 5.1% 4.7% *Too early to tell. For Financial Professionals and Investors who are both qualified purchasers and accredited investors or professional clients. The information and opinions expressed are as of 9/1/10, are not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

BlackRock 3 Accounting for higher risk of buyout funds Compared to the S&P 500, buyout funds have outperformed public equities by a 0.22 multiple and a 4.7% IRR, on average, over the entire vintage year set. We also carried out a separate comparison based on vintage years from 1995 to 2002, a period in which distributions were a larger component of aggregate performance, as opposed to the following years, where valuations of as-yet unrealized investments in the buyout funds portfolios assume greater importance. For vintage years from 1995 to 2002, buyout funds have outperformed public equities by an even greater 0.27 multiple and a 5.1% IRR. Although Figures 1a and 1b present evidence that buyout funds outperform the public equity market, the reasons behind the disparity are less clear. The outperformance may be the result of fund managers adding value, or more basic structural differences between private and public equity. The structural differences include the increased use of financial leverage in buyout investing, as well as potential capitalization and industry biases that may exist across the buyout universe. For example, in a bull market, fund managers employing increased leverage in a portfolio of small cap technology companies may outperform public equity markets and appear to be adding value, when in actuality they are only benefiting from their higher risk. In order to address this question of differentiating between return sources, we adjusted the public equity index to better reflect the characteristics of the buyout fund universe. Market cap and industry adjustments Figure 2 shows a percentage breakdown by market capitalizations of buyout deals for each calendar year since 2000. We see a gradual increase in the percentage of deals concerning large cap companies from 2002 to 2007, followed by a retrenchment after the credit crisis. A similar breakdown by industry is presented in Figure 3. Unlike the market cap breakdown, there appears to be no prevalent industry trend. Prior to 2000, the private equity fund universe within the VentureXpert database includes reported fund cash flows, but actual portfolio company data for investments made by buyout funds is limited. Figure 2: Market capitalization of US buyouts by deal year 100 80 % of Total Deal Value 60 40 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Small Medium Large Sources: VentureXpert, BlackRock calculations.

4 Do Buyout Funds Outperform? Figure 3: Industry of US buyouts by deal year 100 80 % of Total Deal Value 60 40 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Consumer Discretionary Consumer Staples Financial Services Healthcare Industrials & Energy Technology Telecommunications To measure the impact on returns from market capitalization and industry biases, we created blended public equity indices that have characteristics identical to the buyout universe. For example, if the pooled universe of vintage year 2000 buyout funds had only two deals of equal weight, a small cap healthcare and mid cap consumer discretionary company, then the blended index would be composed of 50% S&P 600 Healthcare Index and 50% S&P 400 Consumer Discretionary Index. These blended indices are created for each vintage year based on market capitalization and industry characteristics of buyout deals occurring during the calendar years where capital is being drawn. Figures 5a and 5b elaborate on the TVPI and IRR analysis presented in Figure 1 by accounting for the capitalization, industry and leverage adjustments. First, the S&P 500 is replaced with the blended public equity indices that mirror the characteristics of the buyout universe, and the return metrics are recalculated using the PME approach. The capitalization/industry adjustment row in the figure represents the difference between the return metrics using the blended public equity indices and the S&P 500. This can be interpreted as the return contribution from market capitalization and industry biases that buyout fund managers have expressed in their portfolios. As evident in Figure 4, buyout fund managers have consistently benefited from their market capitalization and industry tilts, resulting in a higher multiple of 0.12 and an IRR of 3.8% for the average vintage year from 1995 to 2007. For Financial Professionals and Investors who are both qualified purchasers and accredited investors or professional clients. The information and opinions expressed are as of 9/1/10, are not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

BlackRock 5 Figure 4: Beta of US buyouts by deal year 2.5 2.0 1.5 Beta 1.0 0.5 0.0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Sources: Standard & Poor s, Bloomberg, BlackRock calculations. Accounting for higher leverage Next, each of the blended public equity indices is beta-adjusted to reflect the increased financial leverage utilized in buyout investing. This adjustment is based on an option-based approach to corporate valuation that incorporates data on LBO equity contribution, public company balance sheet ratios and stock volatility for each calendar year. Beta is assumed to be constant over time, due to the lack of information on potential deleveraging events that may have taken place. Then the return metrics are recalculated with the betaadjusted blended public equity indices using the PME approach. When comparing the leverage-adjusted beta of US buyouts by calendar year (Figures 5a and 5b), the highest level was in 1996 (2.29) when equity as a percentage of buyout deal financing was 22.9%. Following the credit crisis, the contribution of equity financing in buyout deals has increased dramatically to 50.6% for 2009, which has resulted in the lowest level of leverage-adjusted beta (1.32). In addition to the level of equity financing for buyout deals, inputs such as balance sheet metrics for public companies, equity volatility and interest rates also play a role in this calculation. The leverage adjustment rows in Figures 5a and 5b reflect the difference between the return metrics using the beta-adjusted blended public equity indices and those that are unadjusted and where beta is implicitly one. Unlike the market capitalization and industry adjustment, the increased leverage of buyout deals has a widely varying effect on return depending on the specific vintage year. This is intuitive as increased leverage will benefit performance in vintage years followed by a bull market (2003) and hamper performance in vintage years followed by a bear market (2007). In general, leverage has had a negative impact on buyout fund performance, resulting in a lower multiple of 0.06 and an IRR of 2.9% for the average vintage year. After accounting for these adjustments, there remains a component of buyout relative performance that is unexplained by biases in market capitalization and industry or differences in leverage profiles. This unexplained portion is captured in the Remaining Difference rows in Figures 5a and 5b. We consider this portion the operational value achieved by buyout fund managers, although there is an unmeasurable effect from specific company selection by buyout fund managers. For the average vintage year, the operational value-added component is a higher multiple of 0.21 and has an IRR of 5.3%. We find that this result is statistically significant at 99% confidence when performing a difference of means test. If we restrict our vintage year data set to 1995 to 2002 to put less reliance on valuations of unrealized investments, then the operational value-added component is a higher multiple of 0.20 and an IRR of 3.2%.

6 Do Buyout Funds Outperform? Figure 5a: TVPI analysis by vintage year as of December 2009 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008* 2009* 95 02 95 07 US Buyout 1.37 1.32 1.46 1.12 1.50 1.58 1.56 1.51 1.67 1.28 0.92 0.80 0.81 1.43 1.30 S&P 500 1.42 1.29 1.09 1.02 1.06 1.15 1.13 1.12 1.10 0.96 0.89 0.84 0.89 1.16 1.08 Difference 0.05 0.03 0.37 0.10 0.44 0.42 0.43 0.38 0.57 0.32 0.03 0.04 0.08 0.27 0.22 Capitalization/ Industry Adjustment Leverage Adjustment Remaining Difference 0.30 0.22 0.18 0.13 0.05 0.03 0.03 0.04 0.23 0.12 0.00 0.09 0.12 0.14 0.05 0.11 0.09 0.05 0.04 0.16 0.21 0.21 0.08 0.02 0.06 0.05 0.12 0.49 0.24 0.50 0.01 0.11 0.15 0.40 0.42 0.21 0.14 0.04 0.20 0.21 *Too early to tell. Figure 5b: IRR analysis by vintage year as of December 2009 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008* 2009* 95 02 95 07 US Buyout 7.3% 5.4% 7.4% 2.1% 8.8% 12.1% 14.9% 14.3% 22.1% 10.5% 2.9% 10.2% 8.8% 9.0% 6.4% S&P 500 7.8% 5.0% 2.2% 0.4% 1.5% 4.6% 5.2% 4.7% 5.6% 1.5% 4.2% 7.7% 2.2% 3.9% 1.7% Difference 0.5% 0.4% 5.2% 1.7% 7.3% 7.6% 9.6% 9.6% 16.4% 12.0% 1.3% 2.6% 6.6% 5.1% 4.7% Capitalization/ Industry Adjustment Leverage Adjustment Remaining Difference 5.7% 5.8% 5.2% 5.2% 2.3% 1.5% 1.5% 3.0% 5.6% 3.8% 0.0% 1.2% 3.0% 0.4% 1.4% 1.6% 1.9% 1.1% 1.3% 7.3% 10.5% 12.9% 6.2% 0.2% 2.9% 0.5% 1.6% 8.2% 2.1% 8.7% 0.2% 2.0% 3.3% 9.9% 17.0% 10.4% 8.8% 3.4% 3.2% 5.3% *Too early to tell. Conclusion: Buyout funds outperform Our findings show that from 1995 to 2009 buyout fund managers have historically outperformed public equities by approximately 3% to 5% after accounting for differences in market capitalization, industry and leverage. We believe this differential represents the operational value achieved by buyout fund managers. When considering the reason buyout fund managers are likely to outperform public equity markets, Swensen (2000) suggests that it is due to the difference that exists in governance models of companies within the private and public equity markets. According to this perspective, private equity companies benefit from a greater alignment between management and investors resulting from leverage, significant management stakes and a concentrated ownership group that exercises tight oversight. Buyout investing requires a certain level of outperformance versus public equity markets in order to justify the additional illiquidity of holding a 10-year investment. Investors must ask themselves if the additional return of 3% to 5% is adequate compensation for this additional illiquidity. Stated differently, this perspective would suggest that the additional illiquidity is a necessary condition for outperformance because management can then focus on long-term value creation instead of being overly fixated on quarterly earnings. For Financial Professionals and Investors who are both qualified purchasers and accredited investors or professional clients. The information and opinions expressed are as of 9/1/10, are not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

BlackRock 7 Data and methodology The data underlying the analysis is based primarily on the VentureXpert database from Thomson Reuters as of July 2010. TVPI and IRR metrics are based on cash flow data and residual net asset values of pooled US buyout funds in the VentureXpert database. This data is net of private equity fund manager fees and carried interest. Although private equity fund managers and investors voluntarily report this performance data, there is likely to be little survivorship or selection bias, since the data is blindly reported and subscribers to the data cannot see who is doing poorly. Residual net asset values are based on valuations of unrealized investments that are determined by private equity fund managers. A search of private equity deals restricted to US buyouts only tracked within the VentureXpert database was used to obtain market capitalization and industry information. Prior to 2000, the private equity fund universe within the VentureXpert database includes reported fund cash flows, but actual portfolio company data for investments made by buyout funds is limited. Market capitalization breakpoints are taken from the subcomponents of the S&P 1500 (S&P 500, S&P 400 and S&P 600) at each respective calendar year. The industry breakdown is based on the Moneytree industry classification system that is included in the VentureXpert database, which is subsequently mapped to the respective GICS industry. Data sources utilized in the leverage adjustment include average LBO equity contribution from Standard & Poor s LCD and public company balance sheet and price metrics obtained from Bloomberg. About the author: Jason Malinowski is a member of the Risk & Quantitative Analysis group with responsibility for BlackRock Alternative Advisors and Private Equity Partners. He advises portfolio managers and institutional investors on risk management issues and models related to hedge funds and private equity. Malinowski originally joined BlackRock in 2003 as an analyst responsible for relationships with high net worth families and private foundations. He also developed asset allocation and asset liability management models for insurance companies and pension funds. In 2005 he joined Quellos Group LLC, where he was a director and co-supervised the Quantitative Research Group. When the fund of funds business of Quellos was acquired by BlackRock in 2007, he rejoined the firm. References BlackRock Private Equity Partners, 2008. Bringing Private Equity into Focus. Kaplan, Steven and Antoinette Schoar, 2005. Private Equity Performance: Returns, Persistence and Capital Flows. Journal of Finance. Ljungqvist, Alexander and Matthew Richardson, 2003. The Cash Flow, Return and Risk Characteristics of Private Equity. NBER Working Paper. Phalippou, Ludovic and Oliver Gottschalg, 2008. The Performance of Private Equity Funds. Review of Financial Studies. Schonbucher, Philipp, 2003. Credit Derivatives Pricing Models: Models, Pricing and Implementation. The Wiley Finance Series. Swensen, David, 2000. Pioneering Portfolio Management. Free Press.

CTF 0204-0111 Total Value to Paid-in capital (TVPI) is the sum of the distributions and unrealized value divided by capital drawn from fund, expressed as a multiple. Internal Rate of Return (IRR), is the annualized implied discount rate calculated from a series of cash flows. It is the return that equates the present value of all invested capital in an investment (including allocated investment-specific expenses) to the present value of all returns (including unrealized returns) or the discount rate that will provide a net present value of all cash flows, plus any residual value, equal to zero. Leverage-adjusted beta represents the sensitivity of the buyout universe to performance of the public equity markets that adjusted upwards due to the increased role of debt financing. VentureXpert defines buyout funds as funds that make a leveraged buyout, management buyout or acquisition investments. 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