April 23, 2020– In Replicating Private Equity with Liquid Public Securities, learn how investors can attain private equity-like returns without the illiquidity, high investment minimums, poor transparency and high fees of traditional private equity.
Discover the formula for private equity replication with liquid public securities and discover a low-cost way of gaining exposure to the strategy.
Some Benefits of Private Equity Replication Include:
- Private equity-like returns
- Intraday liquidity
- Low fees
- Accessible for all investors, not just accredited, with no minimum investment.
About the Host
Julian is the CEO and Chief Investment Officer of Accelerate. Prior to founding Accelerate in February 2018, Julian was the Chief Investment Officer of Ross Smith Asset Management where he managed a number of alternative investment strategies for nearly a decade. He founded and managed a top performing Canadian alternative fund in 2017. Julian also managed a 6-time award winning market neutral hedge fund and founded an award-winning event-driven arbitrage fund. He started his career as an Analyst at BMO Capital Markets. He attended the University of Manitoba where he graduated with a Bachelors of Science (Engineering) and a Bachelors of Commerce (Finance). Julian is a Chartered Financial Analyst (CFA) charterholder. He is the author of the book Reminiscences of a Hedge Fund Operator and host of the Absolute Return Podcast.
Want to get your hands on merger arbitrage investment strategies? Learn more about the Accelerate Private Equity Alpha Fund (TSX:ALFA).
Webcast Q&A Transcript
1. I don’t really know what private equity investing is, never mind why I should be replicating it. Key opportunities, risks?
Private Equity refers to leveraged buyouts, which is a long-only asset class that has historically outperformed the S&P 500 and other broad-based equity strategies such as that. So it’s favored by institutional investors who are really seeking higher returns. That’s basically the opportunity set in private equity – seeking higher returns. Risks— we touched on it a lot in this presentation— the risks are really just higher volatility, bigger drawdowns, and you really just got to take a long-term view to harvest those long-term market-beating returns.
2. For the value factor, what are your preferred metrics? Why?
Historically, the private equity industry has relied on EBITDA multiples that really drive the industry, and the lower the EBITDA multiple, the higher the future returns. That’s basically the formula for future equity returns. That’s something to keep in mind. EBITDA is basically a loose proxy for cashflow, heavily relied upon by private equity firms. So that’s the one that we prefer to really replicate private equity returns.
3. Has the popularity of the value factor pushed some value stocks out of the category, leaving less quality names for value?
I don’t think that’s necessarily the case. The value factor hasn’t worked very well over the past 10 years. Which if you look at the spread vs growth stocks or glamour stocks, one of the widest points in history comparable to that of the 1990’s-2000’s, where you had this big rally of growth stocks in the late 90’s and value stocks basically did nothing. And over the next decade that relationship really reversed where you had a tremendous outperformance of value stocks and significant underperformance of growth or glamour stocks. That’s something to keep in mind when looking at the strategy.
4. Can you elaborate on mark-to-model vs mark-to market accounting?
Mark-to-market is very simple, you basically take your portfolio holdings and see where your public equities closed on any certain day and that’s the value, that’s where you market. If you want to mark-to-model, you can basically pick where you’d like to value your private equities because they don’t trade anywhere. If you want to value it at cost, you value it at cost, if you want to assume that the value went up 10%, so you market 10% higher. They’re granted a lot of leeway, private equity firms, on how they value their assets. However, regulators are starting to crack down on that, making it more difficult to do. But nonetheless, they do need to make up a valuation, but they do need to start to justify it.
5. How do you define small cap stocks? <$100 million market cap? Would you try to take a control position or a majority position with a small cap company like PE?
We define small cap stocks as anything below $5 Billion and this is a moving target as companies in general become larger and larger as the economy grows with inflation. The definition of small cap stocks traditionally grows and grows. A while back, small caps used to be less than a billion and you didn’t have any public companies worth more than $100 Billion. Now you have a couple of public companies worth more than $1 trillion so you need to move the goal post. At this point, we define small cap stocks as less than $5 billion. When you try to take a control position or a majority position with a small cap company like PE, I should mention the fund that we run, the Accelerate Private Equity Alpha Fund (TSX:ALFA), it is an ETF so from Accelerate standpoint, we never take a control position because our private equity strategy is structured as an ETF with intraday liquidity. So we have to be cognisant of the underlying liquidity because we give our ETF investors liquidity, so we don’t want an asset-liability mismatch. We need to be able to honor the liquidity of the ETF. We structure the investment such that we can liquidate them all in one day if we needed to. So we keep our position sizes quite low at this point.
6. How do you manage the leverage in the strategy? Do you target a specific volatility? Is it static or dynamic?
There’s a number of ways of doing it. The way we do it specifically—and there’s nothing wrong with other ways, some firms target stocks with higher leverage inherent in the company — the way that we do it is we apply leverage at the portfolio basis, our ALFA strategy is 130% long, so we lever our longs and we hedge that back to 100% net longs with 30% short position in S&P 500 Futures just to try to mitigate some of the volatility there. But we don’t necessarily target a specific volatility, this is a high-risk strategy. We set expectations with investors that if they want to get private equity returns even through replication or traditional private equity, it’s a very risky strategy, significantly more volatile than say the S&P 500 or other broad based equity benchmark such as that and so it’s a strategy that we’re really looking to generate high long-term returns without an attempt to manage volatility. It’s not like a traditional hedge fund where you’re looking to target volatility or manage volatility in a certain way.
7. How do you manage the leverage in the strategy? Do you target a specific volatility? Is it static or dynamic?
We filter rank and screen all 4000 liquid public North American securities and rank them according to our factor models. We filter out larger stocks and look at anything below $5 billion and above $100 million such that they have certain liquidity constraints. Really targeting those small capitalization securities. After that, we rank them by valuations, we look at EBITDA multiples here, ranking them into debt styles and we select the portfolio securities from the top decile, the cheapest stocks, on an EV/EBITDA basis. From there, we apply additional filters, we look at quality and certain risk metrics such that we can screen out potential securities that are going to go bankrupt or anything of that nature. We’re really targeting the high quality value stocks to help mitigate some risks. We also apply various sector and risk mitigation metrics, really trying to have a broadly diverse portfolio such that we’re not allocating too much to any specific sector and any specific stocks. So position limits, sector limits, risk limits, etc. Then from there. We select the securities, apply leverage to get to 130% and then we execute the short of the S&P 500 Futures 30% to get the net exposure down to 100%. So we have that small cap value stocks that are leveraged, we rebalance this on a monthly basis and it’s 100% systematic.
8. Where does strategy fit in my clients’ portfolios? Do I view the equity allocation as a whole OR treat private equity as an Alternative allocation?
Historically, it has been an alternative allocation but what is somewhat misunderstood with respect to alternatives is they span a wide myriad of strategies, each one with a very specific mandate. If we look at something like private equity, it’s goal is to generate high returns while taking a lot of risks. So on the alternatives side it would be one of the higher risk strategies along with venture capital. No one really manages risk in venture capital, they’re looking to generate the highest returns with no real attention paid to the underlying risk or volatility. On the opposite side of the alternative spectrum, you have certain arbitrage and market neutral strategies where they’re looking to generate single digit annualized returns with very low managed volatility. Then there is all sorts of alternative strategies that are in the middle- medium risk strategies- where there is risk parity, CTA, long-short equity, distressed debt, and other things of that nature. So when looking at alternative allocation, make sure that it’s diversified across various alternative strategies. Everything from low to medium to high risk. In the high risk bucket, I would long private equity in addition to venture capital and comparable strategies. That’s really where private equity strategy replication would fit in while some endowments allocate a sizeable chunk of their portfolios to private equity, as high as 20% or higher just given the risk profile. I’d advise investors to keep this allocation sub 5%, given that they won’t be spooked by the volatility in the drawdowns and be able to stick with it over the long term which is needed to generate those high expected returns.