Carey Study Questions Buyout Funds’ Valuation Accuracy, Claims of Lower Risk

LBO funds not less risky than public equity funds on S&P 500, paper argues 

It’s a longstanding claim of the trillion-dollar leveraged buyout fund industry: LBO funds carry less risk ― and therefore should be more attractive to investors ― than the public equity funds listed on the Standard & Poor’s 500 Index.

Not so, say two Johns Hopkins University researchers in a new study published by The Journal of Private Equity.

In their paper, Jeffrey Hooke and Ken Yook of the Johns Hopkins Carey Business School take the year-to-year, mark-to-market estimates supplied by buyout funds and compare them to valuations derived from both the S&P 500 and a customized replication designed to mimic LBO fund portfolios of non-traded companies. (“Mark-to-market” refers to valuations of assets, according to their current market prices.)

The differences they found are noteworthy, the authors state, calling into question the accuracy of the industry’s estimates as well as its claims of a less volatile, more reliable product than what’s available on the S&P.

For evidence, they cite the landmark year of 2008, when the stock market fell 38 percent. The buyout funds reported a loss of only 26 percent that year, despite their high debt levels, which should amplify returns, up or down. When the proxy replication index was adjusted for buyout leverage, it showed a loss of a whopping 75 percent.

LBO fund managers, Hooke and Yook point out, have broad leeway in how they set the year-to-year values of their portfolios. The authors suggest that these valuations sometimes lack full accuracy.

“If the industry’s mark-to-market estimates are unrealistic, then institutional investors may need to rethink their asset allocations,” says Yook, an associate professor of finance at the Carey Business School.

Hooke, a senior lecturer in finance at Carey and a former investment banker, adds:

“For years, the buyout industry and pension fund consultants have maintained that LBOs can achieve both higher returns and lower return volatility than the S&P 500, despite the more conservative leverage of the S&P 500 constituents. This assertion is a direct contradiction of classic finance theory, promulgated in the 1950s, which concludes that higher leverage leads to greater return volatility. Before our study, no one in the investment community pointed out this inconsistency.”

As Yook explains, with leveraged buyout returns apparently declining, the buyout industry has turned more and more to the “low volatility” pitch as a way to draw new investments.

“Many industry participants will say that buyout fund limited partners are ‘buy and hold,’ so year-to-year returns are irrelevant, but the accurate valuation of unsold investments should be a concern,” says Hooke.

The study, “The Curious Year-to-Year Performance of Buyout Fund Returns: Another Mark-to-Market Problem?,” appears in the winter 2017 issue of The Journal of Private Equity.