Taking a page out of the Austin Powers movie “The Spy Who Shagged Me” the financial world has introduced its own Mini Me clones of the Private Equity Asset Class. The August 26 edition of The Economist unveils these two new offerings. One is offered by State Street Investments using their own database of private equity performance of the last 30 years, and the second is offered by DSC Quantitative Group using performance data on private equity from Thompsons Reuters. The former does not add leverage, but the DSC product utilizes 25% leverage.
I was fascinated by these products. What we do in private equity is not formulaic so I was interested to learn how these two firms could replicate our outstanding performance as an asset class over the last 20 years. Often our returns rely on accretive acquisitions, expense management, debt pay down and superb managers. It is hard to replicate.
I looked at the website where DSC/Thompson Reuters and State Street discussed their Mini Me process. The DSC index is shown below:
The blue line is the index performance which is back tested to 2007. It shows dramatic out performance of the private equity asset class which they are trying to replicate with individual stocks, exchange traded funds from seven industry sectors, derivatives and leverage.
According to the research on their own website, the secret sauce for the DSC product is the weightings for those seven sectors determined by econometric models that are way above my pay grade to explain:
So if I am understanding these products correctly, they will provide private equity returns for 20% of the fees and expenses by using a mix of sector ETFS, derivatives, individual stocks and some leverage. It is like asking what mixture of paint is necessary on a monthly basis to match blue walls as they fade in hue from 2007 to 2017 and then applying that formula to the future blue walls.
Wouldn’t it be a lot easier and a whole lot more representative just to buy a basket of publicly traded leveraged buy outs? They already have managers. They utilize real leverage proportionate to PE capital structures and that debt has to be repaid. They have valuations expressed as a multiple of enterprise value to EBITDA that are comparable to PE valuations. They report and consolidate the tuck in acquisitions they have made. They incent managers with performance plans that are tied to stock performance. They compete in real industries and are benefitted and hurt by the same industry dynamics as their competitors. The product would have to be a mutual fund, but it would certainly come closer to mimicking private equity’s actual business model.
Roll Your Own Mutual Fund
Here are a few suggestions for the basket by sector:
Consumer Non-Cyclical:
Constellation Brands (NYSE,STZ); wine and spirits;3.65x Debt/EBITDA; 20x EV/EBITDA
Consumer Cyclical:
Ply Gem (NASDAQ; PGEM)- siding, windows and doors;3.8x Debt/EBITDA; 6.8xEV/EBITDA
Technology:
First Data Corp (NYSE FDC); Information Technology; 6.56 Debt/EBITDA; 12.3x EV/EBITDA
Industrials:
Deere (NYSE,DE); diversified industrials; 6.6x Debt/Ebitda; 17.0xEV/EBITDA
Healthcare:
Kindred Healthcare (NYSE KND) general hospitals; 7.07x Debt/EBITDA; 8.36x EV/EBITDA
Last Derivatives Caused Big Recession
In any event, the last time theoretical derivative products (collateralized mortgage backed securities) were invented intended to give AAA protection to people buying a pool of substandard mortgages we had a Great Recession. I would bet right now that these two new products will not replicate private equity returns. In fact, I will bet they will not even beat the S&P 500. Why buy a derivative when you can create your own portfolio of real companies that act just like private equity? You can buy them for the price of the stock plus $4.95 per trade.
