Can Steve Schwarzman Be Replicated?

Private equity “beta” can be replicated by quants for a fraction of the costs. But will investors sign on?

Illustration by II. (Patrick T. Fallon/Bloomberg)

Illustration by II.

(Patrick T. Fallon/Bloomberg)

Private equity has long been thought of as the ultimate actively managed investment strategy: Firms buy underperforming private companies at a discount, borrow money, fix them up, and sell them at higher prices.

But DSC Quantitative Group and other quant asset managers are increasingly replicating the performance of the entire private equity market, giving investors access to the “beta” of the asset class for a fraction of the fees charged by private equity firms. The rise of passive investments in private equity is highlighting the exorbitant fees charged by private equity firms as well as the cons of holding illiquid and opaque portfolios, and the costs associated with inefficient practices like committing capital over time.

DSC, founded in 2012, partnered with Refinitiv to create private equity and venture capital benchmarks that track the gross performance of each industry, as well as investable indices that can be used to create a portfolio. Refinitiv, formerly Thomson Reuters, has 20 years of data, including deal-level information, on private equity and VC companies. The PE Buyout Benchmark Index has 3,500 companies with a total market capitalization of $3 trillion. The VC benchmark has 7,000 companies.

Skeptics might argue that all the active work a private equity firm does with a business, from creating a strategy to hiring and firing management, cannot be replicated by a quant. But since the index’s launch in 2013, the strategy has outperformed Cambridge Associates’ private equity index, which tracks self-reported returns of the private equity firms. Using Refinitiv’s data, DSC calculated that between January 1997 and March 2019, its PE benchmark returned 16.59 percent annually. From 1996 to the third quarter of 2018, its PE Buyout index returned 17.03 percent annually. This compares to a 13.6 percent annual return by the Cambridge private equity index during the same time period. The difference between the two indices reflects private equity fees in the Cambridge index, according to DSC.

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“All the magic that the managers are doing at the portfolio companies is incorporated into the benchmark index,” said Jeffrey Knupp, president of DSC. “People ask me, ‘Does this mean that you’re not a believer in the value creation of private equity managers because you can replicate it?’ My answer is ‘No.’ Our process captures the creation of value in these companies. It’s embedded in there. We’re not at odds with what the industry is doing. We think there is a huge amount of value in private equity.”

But, he added, it’s expensive. “We were looking to solve a number of problems with private equity and venture capital,” Knupp said. “For one, could we compress the historically high fees charged by private equity and still preserve the return streams? Yes, we can reduce fees by 70 to 80 percent, so those fees go to the investor rather than the manager.”

Passively tracking the public stock markets has exploded in popularity, in part because it’s difficult to identify top-performing active managers. In the private equity world, that task is even more monumental.

“In the world of private equity, this undertaking is even more consequential than with public equities due to the larger dispersion of manager returns,” a recent paper from DSC contended. The wide range of results among managers means that an allocation to private equity will only yield the higher returns of the asset class if investors choose the right manager. Even when investors identify a winning manager, DSC argued that outperformance does not persist over time.

“There’s a wide spectrum of distribution of returns in private equity and venture,” said Art Bushonville, DSC’s founder and CEO. “It’s critical to pick the right manager. In the past, people would look for managers whose last fund was in the top quartile of performance. But persistence has been declining. Now it’s almost random. You can’t look to a previous fund for clues.”

According to J.P. Morgan Asset Management, private equity managers’ returns ranged from a low of 0.7 percent to 21.5 percent annually between 2013 and 2018. In comparison, global equities managers’ annual returns were between 7.7 percent and 10.8 percent during the same period.

In its paper, DSC cited McKinsey data showing the consistency of private equity returns decreasing over the last 20 years. Between 1995 and 1999, 33 percent of private equity funds were in the same quartile as their predecessor fund. Between 2010 and 2013, that fell to 22 percent.

DSC is targeting investors that want to maintain a consistent allocation to private equity and avoid problems associated with committing capital over time, or as an alternative to a fund-of-funds for smaller investors. A passive portfolio tracking the entire industry also helps with diversification. “Most PE investors diversify across vintages, and they make sure they have a lot of managers in each vintage,” Knupp said. “But that’s a lot of work and you have to be a very large player to do that well.”

But unlike traditional private equity, which is valued quarterly, DSC’s solution is public and liquid. Everyone can see the volatility. One institutional investor said the volatility would need to be explained to the board and “what-if” scenarios would need to be updated.

“An Achilles heels is that people say PE doesn’t have any volatility, that it’s a magical asset class that never goes down,” Knupp said. “Just because you can’t see the price change tick by tick doesn’t mean there isn’t volatility in the value of a company. That view is changing, but it’s still a factor.”