Beware of PE Managers Speaking Greek

So here’s a game I’m playing a lot lately: dueling Greek.  No, I’m not finally fulfilling my father’s long-dead wish that I attend Greek School.  It’s just that a lot of PE managers are slinging the Greek around.  Seven or eight years ago it was really rare for an LBO pro or VC to describe themselves as an “alpha” manager, but it seems commonplace today.

Of course, I understand what people are getting at.  They’re suggesting that they’re after improved risk-adjusted return.  But that’s where it gets dicey: how do you articulate risk in a PE context?  And what’s the appropriate level of return per unit of risk?

When I’m feeling saucy, I ask these self-proclaimed alpha managers: “ok, then, what’s your beta?”  At that point, the GP probably thinks that he’s got a smart aleck on his hands, but the question is sincere.  Really, it is!  (I’m not one of those Dollar and a Dream guys.)

As we all remember, alpha is the excess return of a portfolio relative to the return predicted by a portfolio of similar risk (expressed as beta).  Said more elegantly (note the gratuitous equation inserted to gain credibility with the quants):

Portfolio alpha = Portfolio Return - (Risk Free Rate + Portfolio Beta * Equity Risk Premium)

So assuming a long-horizon nominal equity risk premium around 6.5% and an average nominal risk free rate of about 4.5%, a portfolio with a beta of one should have a return of about 11% and anything above that is alpha, sweet alpha.  [We could quibble about time-varying premia and risk free rates, but the generic point is valid, no?]  Here’s the catch: I just don’t believe that PE betas are anywhere close to one; on the buyout side, higher levels of debt implicitly raise beta while the venture guys have incredible volatility of outcomes.

Fortunately, most folks decide to play along with the spirit of the question and we typically get into good discussions of risk appetite, tolerance, and management.  It’s always a stimulating chat, but people rarely answer my question directly.  To be a sport, a GP once argued – with a grin – that the beta had to be less than 1 because most people thought the correlation of PE to the public markets was about 0.65.  Without skipping a beat, he acknowledged that appraisal effects and stale prices made that number totally meaningless.

So, what is the beta of PE?  Is it 1.25 (kinda like Vanguard’s small-cap Explorer fund)?  Or more like 2.0?  If it’s the former, you’ve got to generate net returns greater than about 13% to have positive alpha; if it’s the latter, your bogey is closer to 18%.  [Interestingly, the time-worn PE goal of 500 bps of excess return probably implies a beta of about 1.75, which is about the beta exhibited by some public managers with concentrated portfolios].

At this point – like Chevy Chase playing Gerald Ford – I exclaim, “I was told there would be no math here,” so why sling numbers around in search of a pedantic point?  Because PE supposed to be a return enhancer relative to public market alternatives (the opportunity cost of risk capital).  I’m finding that when people say “alpha,” they typically just mean “top quartile,” and that’s not alpha at all.  Maybe “top quartile” will equal positive alpha over time – I have my doubts – but right now it’s just a worn marketing slogan.  Don’t get me wrong, I love firms who can outperform their peer group, but unless we can figure out how to find the folks who are generating true risk-adjusted excess return, we need to keep asking ourselves the question: why bother? 

Comments

[Jake Kaldenbaugh]

What a great way to think about PE alpha! You're right, PE alpha should be way above 1 because PE needs business cycles to create their buying and selling windows, so it stands that their realized returns should be correlated to the market! And you've already covered the leverage effect as well which is most (if not all) of any good PE player's excess return toolbag.