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Top Research Papers Examining Trends in Private Capital Markets from 2021

The American Investment Council released its top research papers published in 2021 examining important trends in private capital markets. The report surveys research in key areas including: how private equity contributed to improving financial stability after the 2008 financial crisis, the benefits of allowing retail investors to access private equity returns, the resiliency of private equity-backed businesses during economic downturns, among others.

“Independent research from respected academic institutions, government economists, and market analysts continues to demonstrate the value of private equity in the American economy,” said AIC Vice President of Research Jamal Hagler. “The evidence is clear that private equity played a key role supporting our financial system after the 2008 crisis, providing public pension recipients with outsized returns, and adding value to businesses of all shapes and sizes across the country.”

The American Investment Council plays a critical role compiling and publishing data and reports that show how private equity has a positive impact on the American economy. Read the list of top 2021 research papers below:


Private equity was a source of financial stability after the 2008 Financial Crisis

1.)  Private Equity and Financial Stability: Evidence from Failed Bank Resolution in the Crisis

  • Emily Johnston-Ron, Federal Deposit Insurance Corporation
  • Song Ma, Yale University
  • Manju Puri, Duke University, National Bureau of Economic Research (NBER), and Federal Deposit Insurance Corporation (FDIC)

This paper examines how private equity investment in failed banks during the 2008 financial crisis helped to stabilize the financial system in the long term. Using data from the FDIC, Preqin, the Small Business Administration, the Internal Revenue Service and the Census Bureau, the authors found that private equity investors were a partner of last resort by acquiring failed banks that were underperforming and riskier than those acquired by other banks. Additionally, the authors found that private equity investors acquired failed banks when neighboring banks were also in distress and unlikely to acquire a nearby failed bank.

These findings imply that private equity investors can fill capital gaps when other types of acquirers are constrained. These private equity investments helped boost local income and employment, by increasing lending activities to small businesses. Finally, the study finds that private equity acquisitions of failed banks saved the FDIC billions in insured deposits. This paper highlights the stabilizing force private equity provides in times of financial crisis.


Allowing retail investors to access private equity’s outsized returns

2.) How Might Investing in Private Equity Funds Affect Retirement Savings Accounts?

  • Damir Cosic, Urban Institute
  • Karen Smith, Urban Institute
  • Donald Marron, Urban Institute
  • Richard Johnson, Urban Institute

This study from four researchers at the Urban Institute examines the effect of allowing retail investors to access private equity investments in their retirement savings accounts. In 2020, the United States Department of Labor released an information letter that private equity components may be offered as part of a retirement asset allocation fund if it is consistent with requirements of the Employee Retirement Income Security Act.

The authors constructed a capital asset pricing model, using estimates for private equity alphas and betas taken from the latest academic literature on private equity performance. Using the Urban Institute’s Dynamic Simulation of Income Model, or DYNAISM, the authors simulated defined contribution retirement accounts which allow investors to invest in private equity and then compared them to the baseline scenario that does not include private equity. The authors found that adding limited private equity to retirement savings funds would most likely increase the rate of return on retirement savings and increase average retirement account balances. These results likely occurred because of potentially higher returns for private equity and the diversification that private equity adds to a portfolio.


The growth of private debt as an asset class

3.) Direct Lending: Evidence from European and U.S. Markets

  • Laura Fritsch, University of Oxford – Saïd Business School
  • Wayne Lim, University of Oxford – Saïd Business School
  • Alexander Montag, University of Oxford – Saïd Business School, Institute of Industrial Economics
  • Martin Schmalz, University of Oxford – Saïd Business School, CEPR, CESifo, and European Corporate Governance Institute

This study from four scholars at the University of Oxford examines the growth of private debt as an asset class, particularly direct lending, and investigates why assets under management have tripled in the last decade. The authors find three direct causes for the growth of direct lending:

  1. First, a decrease in bank lending caused by bank consolidation and new regulation.
  2. Second, an increase in borrower demand driven by sponsor backed deals.
  3. Finally, investors searching for yield in a low interest rate environment.

These three factors are the main drivers in the growth of assets allocated to the asset class, which is averaging an annual growth rate of over 14 percent. The authors find that the choice between bank loans and direct loans is not a binary. 48 percent of firms examined used both private debt and bank debt, suggesting that banks and private debt providers provide complimentary roles. Using data from Preqin, the authors find that funds from 2008 to 2016 had median net internal rates of returns ranging from 9.2 to 10.8 percent depending on strategy. The authors conclude noting that as the industry continues to develop manager selection will be an important determinant of returns as competition for quality deals will only increase.

4.) Private Debt Fund Returns and General Partner Skills

  • Pascal Böni, Tilburg School of Economics and Management
  • Sophie Manigart, Ghent University – Vlerick Business School

This paper examines whether manager skill is an important driver in the performance of private debt funds. To study manager skill, the authors use Preqin data covering 448 funds from 1996 to 2018 with the most common strategies being direct lending, mezzanine, and distressed debt. The mean IRR is 9.2 percent with a wide interquartile range. They find that the average private debt fund outperforms investment grade and high yield bond market benchmarks, as well as the S&P 500 total market index. The authors then examine to what extent outperformance can be attributed to general partner skill.

Using regression analysis, the authors test the persistence of performance over successive funds and find that fund managers with more experience are better able to anticipate changes in credit market conditions. The authors do note that unpredictable conditions, like recessions, have a greater affect than general partner skill. This paper provides one of the first in-depth analysis of private debt as an asset class, while also attempting to determine the role of manager selection in outcomes.


Private equity investments continue to outperform

5.) Eye on the Market – Food Fight: An Update on Private Equity Performance vs. Public Equity Markets

  • Michael Cembalest, P. Morgan Asset Management

J.P Morgan Asset Management’s biennial analysis of private equity finds that private equity still outperforms public markets, though that outperformance is declining. The declining outperformance can be attributed to non-stop stimulus that has propped up public markets in a decade long bull run and because private equity deals have become more expensive as acquisition multiples have risen.

The analysis shows the average buyout fund manager has consistently beaten public markets. Additionally, underperformance among managers in the bottom quartile is relatively modest when compared to previous decades. The authors also found that operating improvements are an important driver in buyout performance. The study also examines the performance of venture capital (VC), and finds that this asset class consistently outperforms when looking at the average fund.

6.) Private Investments in Diversified Portfolios

  • Gregory Brown, University of North Carolina, Chapel Hill – Kenan-Flagler Business School
  • Wendy Hu, Burgiss
  • Bert-Klemens Kuhns, University of North Carolina, Chapel Hill – Kenan-Flagler Business School

This paper examines how the addition of private funds in a diversified portfolio will affect the overall performance of the portfolio. Using fund data provided by Burgiss and the Private Equity Research Consortium on 3,380 U.S. buyout, venture, and real estate funds, the authors examine the effects of private market assets on fund performance and diversification. The authors simulate the performance of a portfolio with 40 percent public equity, 40 percent fixed income, and 20 percent private funds and compare it to a traditional portfolio with 60 percent public equity and 40 percent fixed income. In almost all cases, portfolios benefit from allocating to private market assets. The portfolio with a combination of private asset exposure has a return (volatility) of 7.80 percent (9.80 percent) while the traditional allocation results in a return (volatility) of 6.58 percent (10.17 percent). The study highlights how private funds have generated greater risk-adjusted returns when compared to portfolios that lack exposure to alternative assets.


SPACs

Private equity-backed companies can withstand higher leverage

7.) Does Private Equity Over-Lever Portfolio Companies?

  • Sharjil Haque, University of North Carolina, Chapel Hill

This paper examines whether private equity firms expose their portfolio companies to too much leverage, increasing the likelihood of bankruptcy. The author posits that firms targeted for a leveraged buyout are better situated to carry higher debt levels and that their optimal debt-level is significantly higher than other firms. Using data from 2000 to 2020 covering 2,800 leveraged buyouts, the author creates a dynamic trade-off model to estimate the optimal amount of leverage for a portfolio company. The author finds that private equity-owned firms are able to sustain higher levels of debt – 49.8 percent compared to 23.3 percent among matched public companies. This is due to general partners’ ability to achieve higher return on capital and return on assets, while also lowering the portfolio company’s credit spread.

The paper also demonstrates that general partners are more willing to inject fresh capital into a company in the event of financial distress, leading the firm to be less of a credit risk in the eyes of its lenders. Compared to similarly matched public firms, private equity-owned firms are 4 percent more likely to receive equity injections, leading to a reduced cost of distress. These findings provide an early model to best capture how much leverage is optimal in a buyout and suggests that limiting leverage could destroy firm value.

8.) Capital Structure and Leverage in Private Equity Buyouts

  • Gregory Brown, University of North Carolina, Chapel Hill – Kenan-Flagler Business School
  • Robert Harris, University of Virginia – Darden Graduate School of Business
  • Shawn Munday, University of North Carolina, Chapel Hill – Kenan-Flagler Business School

This article in the Journal of Applied Corporate Finance examines the capital structure of buyouts and how it relates to investment performance. The study provides an overview on how leverage is introduced in private equity transactions, ranging from the portfolio company to fund, and explains the rationale behind capital structure decisions. The paper reviews previous academic literature on capital structure as it applies to private equity, citing various studies that show how PE-backed firms are better positioned than other companies to handle higher debt loads. These reasons include but are not limited to: sponsor relationship with lenders, closely held control, and capital available for equity injections.

After a review of the literature, the article offers an empirical analysis of leverage’s relationship to performance using deal-level data on 6,248 buyouts from 1984 to 2020 provided by the StepStone Group. The analysis found that when debt is measured as a percentage of deal value, there is a positive relationship with expected returns. When debt is measured as a multiple of EBITDA, there is only a weak relationship to performance. These results suggest that firms with high debt to value ratios are “value investments” while firms with high leverage ratios tend to be growth companies. Additionally, the authors identify that debt-to enterprise value has remained stable and below its historic average since the Great Financial Crisis. This trend contrasts with the narrative that leveraged buyouts place too much debt on portfolio companies. This report chronicles how private equity has employed unique capital structures to add value to portfolio companies.