Top Research Papers Examining Trends In Private Capital Markets From 2022

WASHINGTON D.C. – The American Investment Council released its top research papers examining important trends in private capital markets published in 2022. The report surveys research in key areas including how private equity outperforms public markets, how retail investors can benefit from private equity returns, how private equity investments in hospitals benefits doctors and nurses, the continued growth of private debt markets, among others.

  • “Independent research from respected academic institutions and market analysts continues to demonstrate the value of private equity to the American economy,” said AIC Vice President of Research Jamal Hagler. “The evidence is clear that private equity continues to generate outsized returns for public pension funds, drove the hiring of doctors and nurses at hospitals, and provided critical capital and expertise to small businesses.”

Growing Small Business – One study published by scholars from the University of Texas, Boston College, and the University of Georgia found that partnering with private equity helped businesses increase sales by 62 percent in the first year of a partnership. 

Hiring Doctors & Nurses – Another study from scholars at Georgetown and Indiana Universities found that private equity investments in hospitals led to increases in the number of doctors and nurses employed. 

Securing Retirement – Multiple studies reconfirmed that private equity outperforms and is less volatile than public market benchmarks. 

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 2022 research papers below:

Private equity outperforms public market benchmarks

1) Performance Analysis and Attribution with Alternative Investments

  • Matteo Binfare, University of Missouri-Columbia
  • Gregory Brown, Director of the Institute for Private Capital at the University of North Carolina Kenan-Flagler School of Business
  • Andra Ghent, David Eccles School of Business, University of Utah
  • Wendy Hu, Burgiss
  • Christian Lundblad, University of North Carolina, Kenan-Flagler Business School
  • Richard Maxwell, University of North Carolina, Kenan-Flagler Business School
  • Shawn Munday, Sonoco

The authors detail methods of analyzing the performance of alternative assets. The paper examines the current literature on how to conduct performance analysis for portfolios that include illiquid assets. The authors also create their own frameworks, using a factor model approach, to estimate excess returns. The authors use hedge fund and private investment return data, from Global Investment Performance Standards and the Burgiss manager universe to calculate the Direct Alphas for a global sample of private equity funds. In their tests, the authors document a decrease in risk-adjusted performance for hedge funds since the Global Financial Crisis.

Performance estimates suggest continued superior performance for private equity relative to public market benchmarks, when matched on a portfolio industry and geography characteristics. The authors find evidence of positive value creation stemming from the GPs role. Their framework allows for evaluation of asset allocation decisions across sub-assets and solves for optimal allocation based on numerous factors.

The authors conclude by explaining that their work provides a structure for understanding how historical portfolio performance can be decomposed into market-wide factor exposures and excess returns and, importantly, how to relate this performance to market-wide and idiosyncratic risk components.

Public markets are riskier than private markets

2) Risk and Return in Private Equity

  • Arthur Korteweg, University of Southern California – Marshall School of Business

This paper examines different methods of measuring performance and risk within private equity. For this analysis, the author surveys academic literature examining the usefulness and accuracy of different methods of evaluating the performance and risk of private equity portfolios.

The author estimates CAPM betas by regressing fund IRRs on the average annual return to the S&P 500 stock index over the first five years of the fund. Assuming all funds have the same risk exposure, they estimate a beta of 1.23 for VC and 0.41 for buyout, meaning that VC is riskier than the public stock market (which has a CAPM beta of 1 by construction), and buyout is less risky. For buyout, Capital Asset Pricing Model (CAPM) betas for NAV-based private equity returns are in the range of 0.7 to 1.0 when using a broad public stock index for the market portfolio while for VC, CAPM betas range from 0.9 to 2.2 depending on the data set, sample period and the factor used. Broad based stock market indices such as the S&P 500, Wilshire 500, or the CRSP value weighted index, the betas are around 1.2 to 1.4. Korteweg proves that overall, private equity’s beta is less than one.

Therefore, he concludes that public markets are riskier than private markets, even while desmoothing the results.

Debunking the misconception that private equity is more volatile than public markets

3) Private Equity and the Leverage Myth

  • Megan Czasonis, State Street
  • William Kinlaw, State Street
  • Mark Kritzman, Massachusetts Institute of Technology (MIT) – Sloan School of Management
  • David Turkington, State Street Associates

The authors evaluate the relationship between leverage and volatility. Utilizing data from the S&P 500 to represent public markets and State Street Private Equity Index to represent the private markets, they simulate the effect of leverage on volatility. The authors introduce random amounts of leverage, measured as the asset-to-equity ratio, modeled from a distribution with a mean of 1.5 and a lower bound of 1, to each hypothetical company. They record the monthly and annual returns for these companies over a 28-year period. The authors note that a typical private equity transaction increases debt-to-enterprise value from roughly 30% to 70% and that an investor in public markets would therefore need to invest about double the capital to generate returns like those of private equity buyouts.

The authors find that private equity firms are highly levered, yet their observed volatility is lower than that of public equity. They find that actual private equity volatility does increase over longer measurement intervals, which Is a function of its serial dependence. But it falls short of public equity volatility, where one would expect it to be twice as large. The authors find no evidence that volatility scales with leverage. The authors find that leverage is often stable for long periods while volatility is highly time-varying. They conclude that private equity volatility is like public equity volatility despite its higher leverage.

The authors debunk the widespread misconception that private equity has higher volatility than public equity volatility because of its higher leverage.

The benefits of private equity “governance engineering”

4) Public or Private? Determining the Optimal Ownership Structure

  • Gregory Brown, Director of the Institute for Private Capital at the University of North Carolina Kenan-Flagler School of Business
  • Andrew Carnelli Dompe, Pantheon Ventures (UK) LLP 
  • Sarah Kenyon, University of North Carolina (UNC) at Chapel Hill – Frank Hawkins Kenan Institute of Private Enterprise

The authors discuss the conditions under which firms maximally benefit from private ownership and argue that the “governance engineering” by private equity sponsors can ultimately explain the continued rise of private markets

The authors describe the benefits of private equity “governance engineering” in three implications.

  1. The first is the private market’s ability to raise funds for the IPO process. The authors find that one-time costs incurred during an IPO can be substantial, as high as 40 percent of gross proceeds for small firms. As a result, some firms have sought to reduce IPO costs using SPACs or direct listings.
  1. The second is the lack of fundraising ability of dividend-paying stocks as a dividend cut would create an adverse stock price reaction and decrease the value of the company.
  1. The third benefit is the ability of private markets to outperform the public markets overall, due to the illiquidity premium.

The authors use the 2013 take-private of Dell computers and its 2018 IPO as an example of how the decision to be a private or public company is often time dependent. The authors believe that there is a tight link between the benefits of the private governance model and the shrinkage of public markets.

The authors believe that the private model is strictly better than the public model from a governance perspective, and that the only limit to the growth of the private equity industry to the detriment of public markets will be set by the aggregate horizon, and need for liquidity, of institutional investors. In conclusion, the authors analysis states that governance engineering, a unique characteristic of the private model, explains the rise in private market over the public market.

Private equity buyouts create value at portfolio companies

5) Sources of Value Creation in Private Equity Buyouts of Private Firms

  • Jonathan Cohn, University of Texas at Austin
  • Edith Hotchkiss, Boston College – Carrol School of Management
  • Erin Towery, University of Georgia

The authors examine 288 private firms acquired by private equity sponsors between 1995 and 2009. They obtain financial information from confidential corporate tax return data in the IRS Business Return Transaction File for all C corporations involving firms with at least $10 million of total assets.

The authors assess three potential sources of value creation provided by their financial sponsors:

  1. Improvement in profitability
  2. Financial engineering
  3. Relaxation of financial constraints

The authors find consistent evidence of large and rapid increases in sales growth after a private equity buyout. The median increase in sales growth from the pre-buyout year to the second post-buyout year is 62 percentage points greater than the industry median change in sales growth.

Another mechanism through which value is created is acquisitions. The authors find that more than 40 percent of the buyouts in the sample involve post-buyout add-on acquisitions.

They find that sales growth is much larger for firms that undertake identifiable add-on acquisitions, though it is large even for those that do not. The authors’ analysis highlights important differences between private equity buyouts of private firms versus private equity buyouts of public firms and provides insight in how private equity sponsors create value.

How retail investors can include private equity their portfolio

6) Integrating Private Equity in a Liquid Multi-Asset Portfolio

  • Roger Aliaga-Diaz, The Vanguard Group
  • Giulio Renzi-Ricci, The Vanguard Group
  • Brennan O-Connor, The Vanguard Group
  • Harshdeep Ahluwalia, The Vanguard Group

The authors propose a framework for investors to construct multi-asset portfolios, which include private equity. The authors find that assuming frictionless and regular rebalancing to and from private equity will lead to overestimation of optimal allocation, in comparison with more realistic rebalancing under private equity liquidity constraints.

The authors address illiquidity in two ways:

  1. The first is the understanding that private equity is assumed to follow a buy-and-hold strategy
  2. The second is that any remaining capital allocated to private equity at the end of the investment horizon is assumed to be paid off.

The authors expand on these assumptions through the creation of a framework the encompasses all key aspects of private equity investing and how they fit together to construct a multi-asset portfolio. It also provides an approach that allows investors to consider private equity’s active risk and to integrate preferences into the asset allocation decision.

They conclude that the classic assumption of most asset allocation models of frictionless and periodic rebalancing to a constant best asset allocation is invalid for illiquid assets such as private equity. Furthermore, an asset allocation model that includes private equity must account for uncertainty in the size and timing of the private equity cash flows. Finally private equity investors are exposed to another risk: having to sell the investment in a timely manner and getting a price sale in the secondary market below intrinsic value.

Private equity investments increased the number of doctors and nurses at hospitals

7) Private Equity in the Hospital Industry

  • Janet Gao, Georgetown University McDonough School of Business
  • Merih Sevilir, Indiana University – Kelley School of Business
  • Yong Seok Kim, Indiana University

This study analyzes the changes that occur following the acquisition of hospitals by both private equity -backed and non- private equity backed acquirers. The authors discuss changes in employment, wages, hospital performance and patient satisfaction following the acquisition of hospitals.

The authors find that while private equity acquirers are associated with employment reduction, private equity acquisitions are also associated with a growing presence of core workers, including doctors and nurses. Compared to private equity acquirers, non- private equity acquirers cut employment without increasing the core worker ratio, in some cases finding that non-private equity backed acquirers reduce the overall quantity of core workers.

The authors find that private equity-backed acquirers do not decrease the core workers’ wages. The authors note that administrative inefficiency accounts for a major source of wasteful spending at hospitals, and private equity firms have the expertise to improve the efficiency of target hospitals. In terms of hospital performance, the authors find that private equity backed acquirers do not reduce the quality of medical treatment.

While patient satisfaction scores decline significantly at hospitals bought by non-private equity acquirers, it shows no significant change in hospitals that are acquired by private equity-backed firms.

The authors conclude that private equity -backed acquirers can provide hospitals access to increased capital and management capabilities to increase profitability and patient satisfaction.

75% of investors are optimistic about the continued growth of the private debt industry

8) A Survey of Private Debt Funds

  • Jorn Block, University of Trier
  • Young Soo Jang, University of Chicago Booth School of Business
  • Steven Kaplan, University of Chicago – Booth School of Business
  • Anna Schulze, University of Tier

Despite its large and increasing size in the U.S. and Europe, there is relatively little research on the private debt (PD) market. The authors surveyed 38 US and 153 European private debt investors, asking the general partners (GPs) how they source, select, and evaluate deals, how they think of private debt relative to bank and syndicated loan financing, how they monitor their investments, how they interact with private equity sponsors and how they view the future of the market. 

The authors note that private debt funds generate returns using significantly less leverage than banks or CLOs. Private debt funds are also reported to use methods that are used by banks to monitor investments, such as periodic meetings and financial statement updates, yet they appear to do so more frequently than banks do.

Private debt funds are cash flow-based lenders, which allows them to structure their investments with risks that banks tend to avoid – lack of accounting transparency, low tangible collateral value and firm sizes too small for syndication.

To source deals, private debt funds rely heavily on private equity sponsorship, especially in the US where private equity sponsored deals make up 78% of deals, compared to 42% at European funds. US private debt investors rate competitive positions as most important, followed by management team, and positive cash flow. The results also show that private debt funds actively seek board observation rights during renegotiation after covenant violation.

The authors conclude by asserting that 75% of the investors in both geographies thought the environment was good or very good and that both US and European investors were very optimistic about the continued growth of the private debt industry.