Democratising private equity through replication

A Funds Europe webinar, in partnership with Mackenzie Investments, discussed how replication helps investors access the benefits of the asset class in a cheaper and simpler way.

Private equity has long been sought after by institutional investors looking for high returns and portfolio diversification while reducing risk and volatility.

But many investors still struggle to access private equity efficiently due to capital lock-ups, high costs, and lack of internal staff expertise.

Our webinar, which took place on 24th February, discussed why private equity replication is an alternative route for investors seeking private equity-like exposure, but without the challenges of going direct.

Private equity is still attractive
Private equity returns have been 2%-3% higher than public markets in the past few decades and have outperformed even during times of market stress and volatility, according to data from Cambridge Associates and Bloomberg.

However, investing in direct private equity is simply out of reach for many investors as it requires high minimum investments, lock-up periods, high costs, and imposes challenging capital call schedules.

Private equity replication is an alternative way for investors to access the asset class and benefit from the returns, lower volatility and lower downside participation that direct private equity provides.

“Private equity replication aims to deliver the average performance of private equity firms in the industry on a net or after-fee basis, but using daily liquid securities,” says Allan Seychuk, vice president and senior investment director of alternative investments at Mackenzie.

By delivering the average net return for private equity, but in a much simpler and cheaper way, replication may be the only access route to private equity for smaller institutions and individual investors. But private equity replication can be used by many different sizes and types of investors.

Replication can stand on its own but also be used by mid-size and larger investors in conjunction with their direct private equity strategies.

Nelson Arruda, senior vice president, portfolio manager, co-lead of Mackenzie’s multi-asset strategies team, explains: “A large institutional investor, such as a pension plan, can be very adept at investing in private equity but deploying capital and waiting for capital calls is a challenge for them. Using Mackenzie’s strategy to help flexibly manage the liquid pool of assets set aside for those capital calls, while still maintaining that private equity exposure, is a good technique.”

Replication can also help as capital is returned and investors look for new private equity deals or relationships to invest in to keep their money at work.

A common issue, which even large, sophisticated investors grapple with, is building a diversified portfolio of several private equity investments. According to Seychuk, this can be very difficult and expensive, and it also requires a lot of expertise.

The theory behind the strategy
Mackenzie’s replication strategy is a joint effort between its global quantitative equity and multi-asset strategies teams.

It is different from competitor funds, which simply buy the publicly traded stock of private equity firms, such as Blackstone and KKR, explains Seychuk. “This is not true replication, and the performance pattern of those funds is more closely correlated to broad equity indices rather than to private equity,” he adds.

Mackenzie’s strategy blends theory on how direct buyout private equity firms generate success with the practical application of the theory by portfolio managers deeply versed in their respective areas of expertise. The strategy now has a budding track record of delivering private equity-like performance.

“It’s a true multi-asset replication approach that goes beyond stock picking and builds on academic research that helps us understand what makes private equity tick,” comments Arup Datta, senior vice president, head of Mackenzie’s global quantitative equity team.

The investment firm partnered with a Harvard Business School academic who has been studying the theory of private equity for two decades. They discovered six main drivers of private equity returns, explains Datta, of which Mackenzie’s strategy can replicate four –  industry selection, investment focus, leverage, and muted volatility.

Industry selection matters
Mackenzie’s strategy uses the Refinitiv Private Equity Buyout Universe database to tilt to aggregate private equity industry exposures which focuses on US buyout deals. When the strategy chooses companies, it allocates to small and mid-size companies within the Russell 2500 (which is representative of the market cap of the firms that buyout private equity tends to favour) and away from large and mega-size companies.

“Industry selection has played a reasonable role in private equity returns as [managers] seem to pick the right industries,” said Datta.

Private equity was underweight in tech in 2000-2006 when stocks went down, and then overweight in tech in 2014-2019 when stocks went up, explains Datta. In contrast to the recent overweight to technology private equity has been underweight in other industries such as financials and real estate over the same period.

After industry selection, Mackenzie uses a mixture of valuation, quality, and growth factors to rank the top 20% of stocks in each industry and aims to hold the most attractive stocks within each industry.

“Quant managers employ techniques to look for more innovative, higher-growth companies in the field” he adds. Like direct private equity, Mackenzie’s strategy also favours companies that can generate ample cash but trade at attractive valuations.

A liquidity screen further limits selection to around 300 to 400 names.

Downside protection and leverage
Replication also includes private equity’s leverage and downside protection characteristics.

Arruda says the strategy applies leverage through equity futures, which is “an extremely efficient, low transaction cost but also a highly scalable way to apply leverage to [even] a multi-billion-dollar portfolio”, and which “will amplify returns in the fund”.

As private equity avoids full markdown during equity bear markets, true replication incorporates downside mitigation strategies to mitigate left tail risk.

“To reduce volatility, we use equity options, using a collared structure where we try to smooth out returns. That smoothing helps to significantly lower the volatility profile,” says Arruda.

Mackenzie’s strategy cannot replicate the other two drivers of private equity – company selection and operational improvements – because private equity replication will not have access to confidential information and will not purchase controlling stakes.

However, the costs of direct ownership by a private equity fund that owns and manages companies subtract a significant amount from returns. “The net return of the average buyout private equity firm is something we can match, over time, with a liquid private equity replication strategy,” says Datta.

Mackenzie’s private equity replication has outperformed the Russell 2500 by more than 14% in its first year of live operation with significantly lower volatility, and by nearly 6% per year on a hypothetical basis over two decades, also with lower volatility.

Private equity replication is an innovative way to democratise this much sought-after asset class by helping investors access the benefits of private equity in a cheaper and simpler way.

You can watch the full webinar on our Webinars Channel.

© 2022 funds europe

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