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The Journal of Alternative Investments: Private Equity Attribution and Due Diligence

By Hossein Kazemi, Ph.D., CFA, Senior Advisor at CAIA Association.

Watch the conversation between Hossein Kazemi, PhD, CFA and Aaron Filbeck, CFA, CAIA, CIPM, FDP, where they discuss some of the highlights from the fall edition of The Journal of Alternative Investments.

Private equity has become an increasingly important part of the developed economies for the past three decades. Despite the enormous challenges of 2020 due to COVID-19, the low-interest rate environment and the digital revolution fueled further growth of the private equity industry during this period. While the buyout segment of the private equity industry experienced a sharp drop in the number of deals, it has come back strongly during the last few months. On the other hand, the U.S. venture capital segment displayed remarkable resiliency with reaching $560 billion in AUM and $160 billion in dry powder, both near-record figures.

The staying power of the private equity industry is also highlighted by the significant decline in the number of publicly traded firms during the last 20 years, declining from a peak of almost 7000 in 2000 to about 3000 by the end of 2020.  What has been the driving force behind the growth in the private equity industry and the simultaneous decline in the number of public companies? Many people will point to the increased cost of compliance with Sarbane-Oxley regulations by public firms in the U.S.  Another contributing factor is the earlier research by academics, arguing that the ownership model of private companies is superior to traditional public companies' ownership. Michael Jensen first articulated this argument in 1989, arguing that private equity solves an agency problem between widely dispersed and poorly informed shareholders of a public company (principals) and its managers (agents). (See Morris and Phalippou, 2019). While private companies with no separation of ownership and management can solve the agency problem, the GP-LP relationship in private funds creates its own set of inefficiencies and agency-related costs. Also, lack of transparency, complex fee structures, and performance measures have reduced the efficiency gains predicted by Jensen and other economists. However, they did not say how efficiency gains from going private should be shared among various participants.  

This issue of the JAI starts with four insightful papers covering the private equity industry.  In "When to Go and How to Go? Founder and Leader Transition in Private Equity Firms," Josh Lerner and Diana Noble examine leadership transitions in the private equity industry. The paper studies leadership transition at 260 firms, using empirical results and informed by extensive qualitative interviews with a small sample of highly experienced L.P.s and G.P.s. The authors show that private equity transitions display features that are very different from those in public corporations. In particular, they report that leadership transitions in private equity are exceptionally low relative to other corporate structures, and they have little accepted best practice or governance. Instead, they are driven by the philosophy of the founder and the context the private equity firm finds itself.  However, G.P.s are more likely to move on if their funds have outperformed.

Brown, Ethridge, Johnson, and Keck propose a method for decomposing private fund portfolio performance into effects from timing, strategy selection, geographic focus, sizing of fund allocation, and fund selection attributes in the paper titled "Private Portfolio Attribution Analysis." They test the method with a simulation study and derive approximate confidence intervals for assessing attribute selection skills using a large historical dataset of buyout and venture capital funds.  Asset allocators can use these intervals to statistically separate skill from luck. The method developed by the authors also provides a residual component, which investors can interpret this component as value-added by fund selection.

In "Impact of Quality of Involvement of VC/PE in IPO Firms: Evidence from India," Deb and Banerjee examine how the involvement of VC/PE managers can impact the long-run equity, and operating performance of Indian firms post their IPOs. Using a sample of IPOs backed by VC/PE funding, the authors show that post-issue, both equity market performance and operating performance of these V.C./PE-backed IPOs are unimpressive in general. The authors rule out several possible reasons for this lack of performance, concluding that increased flow of capital into the space in recent years and lack of investment opportunities may have led VC/PE managers to overpay for these portfolio companies. They find that the duration and the size of the stake that the VC/PE firms hold in the pre-IPO period positively affect the post-IPO of the listed stock.  The quality of VC/PE involvement has some positive impact on the post IPO performance of firms.

"The Role of Contracts in Venture Capital Returns," by Liu, examines the impact of contracts negotiated between entrepreneurs and V.C. funds on the subsequent returns realized by other stakeholders. The contract typically entitles V.C.s funds to receive preferred stock with additional cash flow rights, resulting in a higher return to V.C. funds than the yield to other stakeholders. The paper uses data to examine returns to V.C. funds. It concludes that while analysts tend to use the common share price to calculate payoffs to limited partners (LPs), incorporating contract terms can considerably change the payoff distribution. Consequently, according to the paper, the current post-money valuation method is an overvaluation of the true price of all outstanding securities.

In "Art as Collateral," Goetzmann and Nozari examine the effects of regional variations in economic and financial conditions on art-backed lending activities. High market values and the recognition of its investment potential have made art a source of collateral for loans. Firms specializing in art lending have emerged to serve this market. The authors show that demand for art loans increases when the economy experiences a downturn and liquidity needs are high. They compare the demand for art-secured loans with home equity loans and test a pecking order theory for the borrowing of high-net-worth individuals. Borrowers are likely to use art as collateral when other types of secured loans, such as home equity, are difficult to obtain and when housing prices decline. This finding is also consistent with the hypothesis that collectors borrow from non-bank creditors to meet liquidity needs in times of financial distress. 

Procasky and Petrus examine price discovery and informational flow in the credit markets based on the behavior of CDS indices and matched portfolios of stocks. The paper "Do Investors Trade Industry Sector-based Credit Risk Differently than Systematic Credit Risk?" finds that sector-based matched equity portfolios persistently lead CDS sub-indices in capturing new information. The only exception is the technology, media, and telecommunications sector, where the authors observe a two-way interactive effect. They attribute the effect to the comparatively greater growth prospects in this sector and related investor attention. These findings suggest that investors may trade sector-based CDS indices very differently than systematic indices.

In "GIPS and Hedge Funds: Is Compliance a Certification Agent?," Foster, Ngo, and Pyles examine a sample of global hedge funds, focusing on characteristics that consistently predict whether the fund will be GIPS compliant. The authors merge a database of hedge funds with the CFA Institute's list of GIPS compliant firms.  The authors find that smaller funds, with less experienced managers and those not denominated in U.S. currency, are more likely to be compliant.  They also find that firms with a robust internal control mechanism, defined as having one of the big four accounting firms as an auditor, are more likely to claim compliance. Further, funds with lower fees are more likely to claim compliance.  However, past performance does not appear to impact the choice of being compliant.  It appears that the primary benefits to investors are increased transparency and lower fees.

The last paper appearing in this issue is by Rodney Sullivan.  The paper, titled "Hedge Fund Alpha: What about Drawdowns?" is a follow-up to a paper by the same author that appeared in the JAI last year.  In that paper, the author examined the performance of hedge funds in recent years, demonstrating their declining alphas since the global financial crisis. This paper reviews the relative risks of hedge fund investing using various commonly used measures, including market betas, correlations, and portfolio drawdowns. The results are used to argue that the diversification benefits for investors in hedge funds have declined in recent years.  Most recently, during the 2020 pandemic, modest drawdown benefits bore out for hedge fund investors, although again much less so than in the earlier years.

CAIA Members can access the most recent edition of The Journal of Alternative Investments here (login required). 

About the Author:

Dr. Hossein Kazemi, Ph.D., CFA, is the Senior Advisor to the CAIA Association’s Program. He helps with the development of the CAIA program's curriculum and directs the CAIA Association’s academic partnership program. In addition he serves as the editor of Alternative Investment Analyst Review, which is published by the CAIA Association. Dr. Kazemi has been involved in the CAIA Association since its inception as a senior adviser and board member. In addition, he has worked with universities and industry organizations to introduce them to the CAIA program. Dr. Kazemi is a Professor of Finance at the Isenberg School of Management at the University of Massachusetts, Amherst. Dr. Kazemi is currently the Director of the Center for International Securities & Derivatives Markets, a nonprofit organization devoted to research in the area of alternative investments, a co-founder of the CAIA Association, and home to CISDM Hedge Fund/CTA Database and the Journal of Alternative Investments, the official research publication of the CAIA Association.