From the April 2008 issue of Investment Advisor • Subscribe!

April 1, 2008

Private Equity Pedigree = Persistent Positive Returns

Private equity firms may be struggling with the credit crunch, but they're here to stay. That's the conclusion of a recent report from the Boston Consulting Group. In the report, The Advantage of Persistence, author Heino Meerkatt, a senior partner at BCG, primarily maintains that private equity remains attractive because investments in this asset class have a strong likelihood of outperforming the market over time.

Meerkatt's first point is that while debt may cost more these days, it is still available. In the report he noted that capital is plentiful worldwide, despite the fact that U.S. banks have tightened credit, making debt more expensive.

Capital continues to flow into private equity, Meerkatt said, with large U.S. pension funds such as the $114 billion Teacher Retirement System of Texas and the $243.6 billion California Public Employees' Retirement System boosting their private equity allocations. What's more, new categories of investors are showing up, such as sovereign wealth funds that offer huge pools of capital. Last year, for instance, the government of China acquired a 10% stake in Blackstone and Abu Dhabi's sovereign fund bought a 7.5% stake in the Carlyle Group.

The second positive point, according to the report, is that private equity firms are less inclined to create value through high leverage. Instead, they've grown more focused on creating fundamental value. BCG looked at the sources of value at 32 companies in the investment portfolios of seven European private-equity firms. They found that only 11% of the value created came from leverage. The rest was attributable to fundamental improvements in the business, such as sales growth, margin improvements, or increases in valuation multiples.

Finally, in the report Meerkatt compared private equity returns with the returns generated by investment in public capital markets. This aspect of the research offered a more complex picture. Meerkatt first created a model to compare both types of risk-adjusted returns, isolating the three return factors that characterize private equity risk-adjusted returns: leverage; illiquidity; and the stability premium, or the fact that private equity firms tend to buy stable performers in order to offset the risk embedded with leverage.

No Reversion to Mean

In the long run, Meerkatt's research found, private equity returns avoid the reversion to average returns, which, over time, afflicts the vast majority of public investments, including stocks and mutual funds. The public companies that, over a given period, have generated above-average returns eventually decline to average performance, according to the study. Such is not the case with private equity firms. Or to be more precise, such is not the case with the best (top quartile) private equity firms, whose returns are more than double the public-company average.

That's because big and top performing firms have the size and the scale to get the best deals. In addition, top firms enjoy critical relationship networks, which give them the upper hand in the investment selection and deal-making processes.

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