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Searching for Alpha in Private Equity
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I was at a private equity conference last week focused on issues of interest to Limited Partners. One of the things that struck me was several Limited Partners who described investing in private equity as “the search for alpha.” While in the past I have heard many Limited Partners talk about alpha, I have found very few who actually attempt to measure alpha. Without measuring alpha, how can one even pretend to be searching for it? What is alpha? Since it has probably been years since many of the readers of this blog have thought about finance theory, it’s worth exploring the definition of alpha. The textbook definition of alpha is “the abnormal rate of return on a security in excess of what would be predicted by an equilibrium model like the CAPM or APT” (Investments, Bodie, Kane & Marcus). In practice, it is used as a measure of manager skill. While alpha can be calculated using a variety of models, the Capital Asset Pricing Model (CAPM) is most frequently used. The CAPM states that the return on any asset equals: Ra = α + Β (Rm - Rf) where: Ra = return on the asset B = the correlation of the asset to the market portfolio (beta) Rm - Rf = the expected return on the market portfolio above the risk-free rate (the equity risk premium) In an efficient market, α is equal to the risk-free rate such that the return of a zero beta portfolio should be the risk-free rate. The challenge with calculating alpha in private equity Many hedge funds, especially those employing long-short equity strategies, currently report alpha in their monthly and quarterly reports. When assets are actively traded, funds can easily calculate the correlation of returns to market (beta). Using the CAPM or a similar model, the fund can then provide an alpha calculation given an assumed risk-free rate and equity-risk premium. The challenge in private equity is that the fund’s assets are not marked-to-market, complicating any calculations to correlate the market with the fund’s performance. As such, I am unaware of any private equity fund that reports either alpha or beta. Despite the challenge in measuring alpha in private equity, institutional investors should not give up. To measure the beta of a portfolio of illiquid assets (and then the alpha), the institution could create a basket of similar publicly traded securities. For example, to calculate the beta for a private equity fund that invests primarily in the transportation industry, the investor might begin with the beta of the Dow Jones Transportation Index. If the fund employed 3x leverage, the beta should then be approximately tripled. If a fund invested primarily in early stage venture capital, the investor might start with the NASDAQ index. While the method described can be challenged on many levels, all performance measurement requires some degree of estimation. Further, there are other methods that the investor could and should consider. Why alpha matters now I believe the changes in the private equity market have made it increasingly important for the institutional investor to think about the alpha in their private equity portfolio. Here are four reasons to consider:
In summary, rather than trying to find alpha, perhaps the investor should start by trying to measure alpha. The techniques aren’t perfect, but they should be the start for the true search for alpha. |
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June 1st, 2007 at 7:45 am
Using the observed Equity Betas (the “levered Betas”) of publicly traded comparable companies, an investor could approximate the Asset Beta (the “unlevered Beta”) for an industry or sector using the formula below.
Beta equity = Beta assets * [1 + (1 - t) * (D / E)]
Then, the investor could “re-lever” the Asset Beta to almost any assumed capital structure using the same formula to approximate the Equity Beta for a privately held investment.
It is also customary to exclude the Risk Free Rate from Alpha in your CAPM equation above to separate outperformance over the Expected Return from the Risk Free Return. Doing so yeilds the following:
Ra = Β * (Rm - Rf) + Rf + α
Cheers,
A.
June 1st, 2007 at 8:01 am
I couldn’t agree more with your general sentiment. The only thing I disagree with is:
“Larger portfolios may have a higher beta.”
Since beta by definition is a measure of market risk exposure, the size of the fund shouldn’t necessarily affect beta except to the extent that very large funds’ asset betas may trend toward 1.0 as they encompass the whole market.
June 1st, 2007 at 8:35 am
Aleksey,
Thanks for the comment. I’ve seen alpha calculated both with and without the risk-free rate. You are probably more correct than I am.
Tom,
Thanks for the comment. Your later point is exactly what I was driving at. I should have been more clear on this.
June 13th, 2007 at 12:28 pm
[...] In my last post (Searching for Alpha), I commented on how applying hedge fund metrics to private equity fund performance creates unique complications. Recently another phenomenon in the convergence of alternative assets has emerged as a hot topic—hedge funds making investments in illiquid private companies. In a large buyout deal announced earlier this year, KKR teamed with a consortium that included hedge fund S.A.C. Capital to acquire Laureate Education Inc. for $3.8 billion. On the venture side, Sequoia Capital teamed with San Francisco-based hedge fund Artis Capital Management to invest $11.5 million in YouTube. While Google’s $1.65 billion acquisition of YouTube made it one of the most successful venture investments of 2006, not every investment has a fairy-tale ending and the relationship between fund managers and their investors can change dramatically when the investment takes a turn for the worse. [...]
June 15th, 2007 at 5:08 am
[...] In my final post (Searching for Alpha), I commented on how applying hedge fund metrics to private fairness fund performance creates unique complications. Recently another phenomenon in the convergence of alternative assets has emerged as a hot topic—hedge funds making investments in illiquid private companies. In a large buyout deal announced earlier this year, KKR teamed with a consortium that included hedge fund S.A.C. Capital to acquire Laureate Education Inc. for $3.8 billion. On the venture side, Sequoia Capital teamed with San Francisco-based hedge fund Artis Capital Management to invest $11.5 million in YouTube. While Google’s $1.65 billion acquisition of YouTube made it one of the most successful venture investments of 2006, not every investment has a fairy-tale ending and the relationship between fund managers and their investors can change dramatically when the investment takes a turn for the worse. [...]