Eileen Appelbaum and Rosemary Batt: How Academics Cook Their Studies to Flatter Private Equity

Yves here. This is the third part of an interview by Andrew Dittmer with the authors of an important new book on private equity, Private Equity at Work (see Part 1 and Part 2).

Here, Appelbaum and Batt discuss some important, widely publicized academic studies in which the results were skewed so as to favor the private equity industry. As an aside, this is one of the impressive and valuable features of their book, in that they read a tremendous amount of academic work on private equity and scrutinized the methodologies.

Bear in mind that the papers they discussed here don’t suffer from the crude and obvious problems that we’ve discussed at length in academic and consultant work on private equity returns, most important, the widespread use of internal rates of return (IRR) as the way to measure private equity results.

Appelbaum and Batt don’t discuss the rampant conflicts of interest among the academics studying private equity. First and most powerful is that finance faculties sit at business schools, and most business school professors make far more consulting than they do at their day jobs. Needless to say, an academic that writes skeptically about private equity is not going to be engaged by the industry, and those firms happily pay very handsome fees to blue chip validators. Second, private equity firms and their partners as individuals are the biggest donors to business schools. It is not hard to imagine that writing papers critical of private equity firms is not a career-enhancing strategy. Third, as we’ve discussed, the industry is famously secretive. For instance, getting fund return data requires the cooperation of either private equity funds or fund investors. Again, that forces scholars to play nicely with the industry in order to be permitted to study it at all.

Finally, I do have some minor differences with Appelbaum and Batt. They advocate using public market equivalent for calculating private equity returns. While public market equivalent is a vast improvement over IRR, I’m still not keen about it, in part because it buries the assumption of what “public market equivalent” as in benchmark, you used. Many academic studies, and too many limited partners use the S&P 500, which is again flattering to private equity, because S&P 500 hundred members are vastly larger than private equity portfolio companies and thus exhibit slower growth. I see no reason not to use the gold standard of discounted cash flows. Oxford professor Ludovic Phalippou also recommends this approach.

By Andrew Dittmer, who recently finished his PhD in mathematics at Harvard and is currently continuing work on his thesis topic as well as teaching undergraduates. He also taught mathematics at a local elementary school. Andrew enjoys explaining the recent history of the financial sector to a popular audience

Andrew Dittmer: There were a couple of papers you discussed in your book, and in both cases, the way in which the authors summarize their findings was much more favorable to the private equity industry than what you found when you actually delved into the details of the papers. One was the Harris, Jenkinson, and Kaplan paper on fund returns, in which they made a fairly questionable lifespan assumption. Their results were also significantly changed if they used the Russell 2000 as their benchmark.

Eileen Appelbaum: Right – as it turns out, it was not a lifespan assumption. In my view, it was even more questionable.

Kaplan is one of the two scholars who originated the use of public market equivalent, which I think is the best way to evaluate private equity returns. In the paper that you referenced, he and his coauthors do calculate the public market equivalent over the life of the funds. Once you work out the return over the life of the fund, you are able to calculate the annual rate of return that would give you that overall return.

But in this paper, after he and his coauthors work out the return over the life of the funds, instead of calculating the corresponding average annual return, they stop. They adopt someone else’s methodology, which is still based on the internal rate of return (IRR) and not the public market equivalent. We know from other work by Kaplan that this is not the best way to look at returns.

So they use that method to calculate the average annual return, and as a result they get this ridiculously high number that does not in any way match what you would get by working out the annual return from the public market equivalent. I don’t understand exactly why they did this, but it certainly puts private equity annual returns in a very favorable light.

Andrew Dittmer: Another example was the Steven Davis et al. set of papers on employment where it seemed their results were heavily inflated by including the effects of acquisitions and divestitures.

Rosemary Batt: Exactly. The thing is, their econometrics are incredibly carefully done. They use a variety of estimation techniques, and they basically show that PE firms buy the better performing firms — so that in the acquisition year those companies have higher employment growth and wages compared to similar the companies that are not acquired by private equity.

Post-buyout, however, employment and wages in the private equity -owned companies fall relative to the companies that are not owned by private equity – leading to an employment gap of between 2% and 6% depending on the estimation and the whether it’s a 2 year or (I think) a 5 year period. All of that is very clean, and the implications are clear.

But then they go on and add in the effect of acquisitions. That reduces the gap between the private equity-owned companies and the public companies to 0.81%, and they end up concluding, “You see, they’re just about the same.”

But obviously, as you’re pointing out, if you buy another company and “acquire jobs” this way, that’s buying jobs, it’s not the same as creating jobs. There’s no net new employment in the economy. But the conclusion that PE-owned and public companies have ‘about the same’ effect on jobs was picked up by the media throughout the Romney campaign. The 2011 version of the paper was cited a number of times by the media, who clearly only looked at the abstract and didn’t read through the details of what the paper actually showed.

Andrew Dittmer: In the studies estimating fund returns, sometimes they look at the IRR, but sometimes they do what seems to make more sense, and compare PE returns to investments in the broader market (the “public market equivalent”). Even in that case, though, it seems like an appropriate benchmark wouldn’t be the public market equivalent, it would be an appropriately leveraged public market equivalent.

Eileen Appelbaum: Correct. In other words, these studies are not taking into account the difference in leverage between publicly traded companies and private equity owned companies.

Rosemary Batt: Another point, a little different from the one you make, is that the studies discussed in our book show that about 25% of the PE funds beat the stock market. But none of the studies compare the top quartile of PE funds to the top quartile of public corporations.

Andrew Dittmer: That’s a really good point. Another thing I was wondering… often a PE fund will require that a certain amount of money be committed to the fund, but they won’t actually call up the money until the time when they have appropriate investments for it. But what that means is that the investor needs to keep a lot of that money in liquid investments like cash or treasuries. That creates an opportunity cost, and I don’t think it would show up the way most studies look at private equity returns.

Eileen Appelbaum: That’s absolutely correct. We asked somebody who was on the other side at a private equity firm, and we asked them exactly what you asked. We said “When you tell them what their returns are, does this figure into it?”And he said, “Oh no. We would have no way of knowing even what that was.”

Rosemary Batt: However, the academic studies that we’ve looked at estimate that you need to make at least 3% above the stock market return in order to compensate for the liquidity risk of keeping your money in for ten years.

Andrew Dittmer: Did the 3% mainly have to do with not being able to get your money out?

Eileen Appelbaum: The liquidity risk is both that you can’t get your money out and that you can’t tell them how to spend it and that they may not have invested it. One thing I will say is that this used to be a much bigger problem before the latest stock market boom. Now the pension funds are just putting money in the stock market. And when it’s called, they sell some stock.

When the market was not on a tear like this, they couldn’t count on stocks having gone up. They might have gone down in the meantime, and so, as you say, they were putting money into treasuries or other short term bond investments.

What’s going on right now, however, leads to short-sighted thinking on the part of institutional investors. A lot of pension funds are doing much better than they were in the past just because the stock market has recovered, but they’re not thinking it through that way.

The market is high and the second quarter of 2014 had the most IPOs since the fourth quarter of 2006. PE funds are selling whatever companies they can. What this means is that the limited partners are getting distributions and now have a bundle of cash in their hands, and their PE investments look very, very good.

If these investors were to compare their earnings to the public market equivalent (what they would have made in the stock market), they might be very disappointed to see that they either haven’t beaten the market or have barely beaten the market. In most cases, they have certainly not beaten the market by enough to compensate for the lack of liquidity and the increased risk. If they made that calculation, they might know that this wasn’t the best thing since sliced bread, but very few of them are equipped internally to make those calculations.

Consequently all they realize is that they’ve gotten a pile of money. “That looks good to me. I think I’ll put it right back into a private equity fund.” But as we know from the academic literature, the private equity industry is highly cyclical, so if you put money into private equity funds launched near a stock market peak, you are unlikely to beat the market in the future.