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1 April 2014 CFA Institute Journal Review

Performance Measurement in Private Equity: Another Look at the Lagged Beta Effect (Digest Summary)

  1. Lawrence Gillum, CFA

Recent accounting rules have tried to address the challenges of measuring and disclosing the fair value of illiquid investments, including private equity (PE) investments. Previous research has shown that the value of PE investments may not reflect current movements in the public markets. The author reprises previous research to determine whether these new accounting rules have reduced the impact of stale pricing in PE valuations.

What’s Inside?

Because of the illiquid nature of private equity (PE) investments, accurate valuation measurement has been a problem, leading investors to potentially underestimate the influence of movements in the public markets on PE valuations and overestimate the value added by fund managers. New accounting rules were passed to help determine a fair valuation for PE investments, which should incorporate current movements in the public and financial markets and thus represent more up-to-date market prices. The author tests this hypothesis and finds that because of the discretion in the new set of rules given to fund managers, stale pricing remains at levels and directions consistent with prior periods.

How Is This Research Useful to Practitioners?

Given the claim that PE investments outperform their public market counterparts, it is important for investors to understand the extent to which PE returns are driven by systematic influences versus independent price movements. Historically, PE funds have recorded the investment’s value at the initial transaction and maintained that valuation until a new “price” was determined through additional financing, recapitalization, or additional funding. Previous research found that this “stale” price, which was largely independent of current public market movements, exhibited significant serial correlation, meaning historical values were influencing current values. Previous research also identified a lagged beta effect that was statistically significant for up to four lagged quarters of returns, which means up to a year of past returns could be influencing current returns. The result of this serial correlation could potentially cause investors to underestimate the correlation of PE returns with public market returns and simultaneously overestimate the return enhancements of PE fund managers.

Although new accounting rules were put in place to eliminate or significantly reduce stale pricing in PE funds, the author finds that the rules have made no substantive change to the lagged beta effect found prior to the new rules. He points to the considerable discretions given to fund managers to determine the market value of the portfolio companies as the reason the lagged-beta effect remains.

In addition to determining that the new accounting rules fail to affect the overall stale pricing phenomenon that occurs in PE funds, the author also finds a conservative predisposition remains among fund managers. He confirms that PE fund managers are slower to mark up their portfolio companies but faster to mark them down. This behavior is also consistent with trends found prior to the accounting changes.

Finally, the author finds that growth equity style indices do a better job of explaining the returns of PE investments than value indices do, which is consistent with previous research. The author does note, however, that the size effect was inconclusive, whereas previous research indicated a small-cap effect bias was prevalent for a number of PE styles.

How Did the Author Conduct This Research?

To determine whether recently implemented accounting changes had an effect on valuation behaviors, the author uses the Cambridge Associates US Private Equity Index, which includes more than 1,000 private equity funds with history dating back to 1986, as the sample dataset. To test the hypothesis that PE funds are doing a better job of carrying investments at current market values, the author breaks up the universe of PE funds into two regimes of before and after the accounting change: 1986–2007 and 2008–2013.

For each time period, PE returns are regressed against public market indices (including style indices to measure the value and size effect) along with several quarters of prior market returns in an effort to calculate beta. Using multiperiod regression models, the author calculates the sum of the betas for the contemporaneous and lagged periods to determine the true amount of systematic risk embedded in PE returns. He uses a Chow test to compare the lagged beta effects between the two periods. A significant difference between period results would indicate that the lagged beta effect had changed.

Abstractor’s Viewpoint

Although the author does not necessarily provide a unique perspective, he is able to convincingly show that despite efforts to provide current market value information on PE investments, illiquidity and stale pricing remain. As such, it is important for potential PE investors to understand that basic quantitative analysis is insufficient for understanding the underlying return properties of a PE fund, particularly as it relates to the fund’s relationship with public market equities. What is unclear, however, is whether these results are relevant at the individual fund level and/or for the various substyles in PE or just for the PE sector in aggregate.

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