Replicating Buyout Funds Through Indexing

October 23, 2013


An attractive investment alternative is for institutional investors to replicate buyout fund portfolios in the public markets, without the high fees and illiquidity issues of traditional buyout funds. This paper describes a modeling technique and software program that selects publicly traded companies that resemble buyout fund portfolio companies. The program produces a passive, dynamic index that generates returns—principally on a backtested basis—within the top decile of buyout fund returns. Indexes that replicate hedge fund strategies have been initiated by firms such as Goldman Sachs, Merrill Lynch, Deutsche Bank and IndexIQ. These strategies use a combination of publicly traded securities, contracts and derivatives to replicate, at a lower cost to the investor, most of the risk and return produced by hedge funds. Our buyout fund index, in contrast, adopts fundamental analysis techniques based on rules developed from the study of two decades of buyout transactions.

Research Overview
Institutional investors have flocked to private equity buyout funds in recent years. Buyout funds acquire principally small-capitalization (under $1 billion) private companies through the use of high leverage. The funds’ intent is to sell the companies at a profit in three to five years, and to provide fund investors with returns substantially exceeding the S&P 500. Equity invested (or committed) by these funds now exceeds $800 billion. There are two puzzling aspects of this popularity: 1) the average performance of buyout funds is about the same as small-cap stock funds, if one believes that buyout funds price their unsold investments properly; and 2) an investor can margin (or leverage) a small-cap portfolio (on his own) to enhance performance, much as buyout funds leverage their portfolio firms.

The private equity industry has not refuted the conclusions regarding buyout fund performance and valuations, and word of such findings has spread beyond the academic literature and into business media, with brief articles in The New York Times, Wall Street Journal, Financial Times, The Economist, Private Banker International and The Deal.

Two academic papers explored whether institutions can duplicate buyout fund investment attributes by using public market securities. Gompers and Lerner [2000] examined the investments of a single buyout fund and benchmarked individual buyouts against investments in indexes of publicly quoted companies operating in the same industries as the respective buyouts. The authors found that the buyout fund outperformed the industry comparables. They did not adjust the industry indexes for the high leverage used by the buyout fund, nor did they attempt to determine if the specific buyout fund was a better or worse performer than its peers.

Groh and Gottschalg [2009] examined the internal rate of return, leverage and industry sector of 133 U.S. buyouts. The data was derived from 122 private placement memoranda of fund partnerships. Returns of the 133 buyouts were compared with a mimicking portfolio of similar public market investments centered among peer industry stocks. The public stock selections were levered up with borrowed funds in order to match the equity beta factor of the corresponding buyouts. Unlike an actual buyout, however, the levered public market investments did not transfer company-specific credit risk to the lender; furthermore, many of the public market investments were not suitable buyout candidates. Groh and Gottschalg found significant alpha in the LBO fund investments.



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