Are These Niche Strategies a Window into Trouble in the Massive Private Equity World?

Quant managers’ private equity replication funds have tanked. Real private equity investors should take note.

Illustration by II

Illustration by II

Funds that mimic private equity by investing in publicly-traded stocks have cratered right along with markets around the globe.

The decline may be testing the fortitude of investors in private equity replication strategies, which use different methodologies to provide the return streams of the asset class by investing in public companies and applying leverage. But perhaps more importantly, the dismal performance of these relatively new replication strategies is an early warning signal of what’s happening in the private equity world, where investors can’t see the decline in values quite so readily.

DSC Quantitative Group, for example, provides investors access to the “beta,” or the performance of the entire private equity market. The Thomson Reuters Private Equity Index is down approximately 39 percent on the year as of March 24th.

“The Thomson Reuters indices are doing what we expected. Most PE companies look like small-cap equities with levered balance sheets. The Russell 2000, which we aren’t tracking, but is a relative data point, is down 35 percent,” said Jeffrey Knupp, president of DSC.

“Another data point to look at are funds that hold publicly-traded private equity companies like Carlyle, Blackstone, and KKR. Those funds are also down materially. We’ve seen small caps hit hard in this downturn,” Knupp added.

DSC, founded in 2012, partnered with Refinitiv, which has 20 years of data such as deal-level information on PE and venture capital companies. The quant firm created 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.

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The rise of these investments has highlighted the exorbitant fees charged by private equity firms, the cons of holding illiquid and opaque portfolios, and the costs associated with inefficient practices like committing capital over time.

One of the largest differences between replication and the real thing is mark-to-market valuations, said Dan Rasmussen, partner at Verdad Advisers. Verdad, which has $207 million in assets according to its latest regulatory filings, runs a strategy that invests in leveraged small value stocks with quantitative characteristics similar to private equity deals of the 1980s and 1990s. The portfolios seek to offer systematic exposure to the drivers of PE performance.

“On the negative side [for replication] at a time like this, you’d say, ‘Wow, look how bad this is.’ When PE marks come out, they’ll be less volatile than the S&P 500. I’m guessing that PE marks for Q1 will be down 20 percent,” said Rasmussen. “They’ll say, ‘We looked at the fundamentals, and things haven’t changed that much.’ You could say, ‘Wow isn’t that outperformance phenomenal?’”

“Or you could say, ‘Is this real?’”

Rasmussen declined to provide details on performance, citing compliance reasons.

On the positive side, replications strategies are also liquid. “That’s a wonderful thing. If you bought a hotel company and now have a very different view on the hotel company, you can sell,” said Rasmussen. If you value liquidity, these are times when you want it, for good and for bad. And maybe PE is good, because you can’t sell,” he said.

At times like these, investors might not want to know just how volatile all of their investments are.

In a 2015 paper, Rasmussen wrote, “The greatest challenge to this strategy is the volatility of returns, which is significantly higher than broader market indices. Private equity has solved this problem by taking the companies private and thus masking the price volatility. But it is unavoidable in the public markets and can only be solved with a long-term and disciplined approach.”