Thursday, April 19, 2007

Asset Class Reader: Private Equity

Investing in Private Equity Funds: A Survey
by Phalippou, Ludovic (2007)

This literature review covers the issues faced by private equity fund investors. It shows what has currently been established in the literature and what has yet to be investigated. In particular, it shows the many important questions to be answered by future research. The survey shows that the average investor has obtained poor returns from investments in private equity funds, potentially because of excessive fees. Overall, investors need to gain familiarity with actual risk, past return, and specific features of private equity funds. Increased familiarity will improve the sustainability of this industry that plays such a central role in the economy.

Private Equity Performance: Returns, Persistence and Capital Flows
by Steve Kaplan and Antoinette Schoar (2004)

This paper investigates the performance and capital inflows of private equity partnerships. Average fund returns (net of fees) approximately equal the S&P 500 although there is substantial heterogeneity across funds. Returns persist strongly across different funds raised by a partnership. Better performing partnerships are more likely to raise follow-on funds and larger funds. This relationship is concave so that top performing partnerships grow proportionally less than average performing partnerships. At the industry level, market entry and fund performance is cyclical; however, established funds are less sensitive to cycles than new entrants. Several of these results differ markedly from those for mutual funds.

The Performance of Private Equity Funds
by Phalippou, L., and O. Gottschalg. 2006

Using a dataset of 1,579 mature private equity funds, the authors find that the performance estimates found in previous research and used as industry benchmark are overstated. They show that commonly used samples are biased towards better-performing funds and that accounting values reported by mature funds for nonexited investments are substantial and mostly represent “living dead” investments. After correcting for sample bias and overstated accounting values, average fund performance changes from slight overperformance to substantial underperformance. Assuming a typical fee structure, they find that gross of fees, these funds outperform by about 4 percent a year.

An Index For Venture Capital
John M. Quigley and Susan E. Woodward (2003)

In this paper we build an index of value for venture capital. Our approach overcomes the problems of intermittent, infrequent pricing of private company deals by using a repeat valuation model to build the index, and it corrects for selection bias in the reporting of values. We use a unique data set from Sand Hill Econometrics. The index measures the return and risk for venture capital. Its covariance with other asset classes from 1987-1999 enables us to explore the role of venture capital in diversified portfolios during a period of increased importance of venture capital in the economy.

John H. Cochrane (January 2001)

This paper measures the mean, standard deviation, alpha and beta of venture capital investments, using a maximum likelihood estimate that corrects for selection bias. Since firms go public when they have achieved a good return, estimates that do not correct for selection bias are optimistic.

The selection bias correction neatly accounts for log returns. Without a selection bias correction, I find a mean log return of about 100% and a log CAPM intercept of about 90%. With the selection bias correction, I find a mean log return of about 7% with a -2% intercept. However, returns are very volatile, with standard deviation near 100%. Therefore, arithmetic average returns and intercepts are much higher than geometric averages. The selection bias correction attenuates but does not eliminate high arithmetic average returns. Without a selection bias correction, I find an arithmetic average return of around 700% and a CAPM alpha of nearly 500%. With the selection bias correction, I find arithmetic average returns of about 53% and CAPM alpha of about 45%.

Second, third, and fourth rounds of financing are less risky. They have progressively lower volatility, and therefore lower arithmetic average returns. The betas of successive rounds also decline dramatically from near 1 for the first round to near zero for fourth rounds.

The maximum likelihood estimate matches many features of the data, in particular the pattern of IPO and exit as a function of project age, and the fact that return distributions are stable across horizons.

Caveats when Venturing into the Buyout World: Is the Devil in the Details?

by Phalippou, Ludovic, (July 2007)

This paper discusses performance of buyout funds, the contracts between funds and investors and the information contained in fund-raising prospectuses. It shows that economically significant sources of variation in fees as well as the explanation for their high level are in the 'details' of the contracts. The most striking facts are that incentive fees can be received by a fund while the rate-of-return is negative. Also, management fees are only 2% but are charged on more than capital invested. In addition, a number of economically significant fees are charged to portfolio companies by fund managers and thus indirectly to investors. Finally, several additional fees are charged and are economically sizeable.

This article then shows that most of the actual contracts may exacerbate potential conflicts of interest rather than mitigate them. The fact that those in control (fund managers) have some discretion in charging fees to portfolio companies (owned by investors) could lead to some conflicts of interest. In addition, several contract clauses provide steep incentives to exit investments too early (short horizon). Furthermore, contracts do not seem optimal as they reward shirking. I show that a buyout fund that would pursue a passive investment strategy (a closet index fund) would have received more than 6% per year of fees in the 1990s.

Finally, it shows i) how flexibility in the aggregation of fund performance offers room for exaggerating performance figures, ii) that low IRR figures are often not mentioned in fund-raising prospectuses, iii) that good track records are seen much more often by investors than inferior ones, iv) that information needed for assessing past performance is often missing, and and vi) that the lack of rule/standard for valuing on-going investments provides yet another way to inflate performance reports.

Friday, April 06, 2007

Asset Class Reader: Art

Art as a Financial Investment

by Campbell, Rachel A.J. (March 2007)

The comparatively poor performance of traditional asset classes in recent years has driven the search for greater returns via alternative asset classes. The desire to reap higher risk adjusted returns from diversification into assets which offer low and even negative correlation with equities and bonds is extremely desirable. There has been a huge growth in the traditional alternative investments such as real estate, commodity futures, private equity and hedge fund investments.

Additionally, a number of funds specialising in art have recently emerged. These also appear to offer a highly beneficial diversification strategy with extremely low correlation with traditional asset classes. It is important for investors to understand the risk and return characteristics of this new alternative asset class.

In this paper we take a closer look at art as an alternative asset, and look specifically at how this new alternative asset is expected to perform, also during bear markets, when the benefits of diversification are most needed. We look at the risk and return characteristics of art using art market indices, and the prospects for portfolio diversification in the art market using a variety of data across art market sectors, including the Old Master, European Impressionist, Modern and Contemporary art markets. Due to the low correlation of art with other asset classes, we find opportunities for portfolio diversification across art markets and across asset classes. The results hold, even allowing for the high transaction costs, which are encountered when trading art, when spread over a longer time horizon.

Art as an Investment and the Underperformance of Masterpieces

by Mei, Jianping and Moses, Michael (February 2002)

This paper constructs a new data set of repeated sales of artworks and estimates an annual index of art prices for the period 1875-2000. Contrary to earlier studies, we find art outperforms fixed income securities as an investment, though it significantly under-performs stocks in the US. Art is also found to have lower volatility and lower correlation with other assets, making it more attractive for portfolio diversification than discovered in earlier research. There is strong evidence of underperformance of masterpieces, meaning expensive paintings tend to under-perform the art market index. The evidence is mixed on whether the "law of one price" holds in the New York auction market.

Dealers in Art

by Shubik, Martin (September 2001)


A brief narrative and descriptive discussion of the role of private dealers in art together with some suggestive statistics is presented.

How Did Japanese Investments Influence International Art Prices?

by Hiraki, Takato, Ito, Akitoshi, Spieth, Darius Alexander and Takezawa, Naoya (2005)


This study examines dynamics among the art, Japanese land, Japanese and U.S. stock market prices during the sample period from 1976 to 1998. We find that the Japanese land prices caused both art and Japanese stock prices to co-move during the sample period. We interpret this finding as suggesting that the accelerated appreciation of land prices in Japan stimulated Japanese investor demands for both international arts and Japanese stocks, especially, in the late 1980s. We further show that the Japanese land index as well as own art index returns are dominant factors in generating fluctuations of returns in most art indexes. We also find that an influence of the Japanese land prices on art prices was preserved and even increased in the 1990s after the burst of bubbles. We interpret this as suggesting that in the 1990s the decreasing land prices in Japan urged some Japanese investors to sell their holdings of arts at a considerable bargain.

The German Art Market

by Kraeussl, Roman, (May 2007)

This paper discusses various aspects of the German art market, including a brief history of German art throughout the twentieth century and the great influence of World Wars I and II. Different styles and movements, such as Expressionism (e.g. Die Brücke, Der Blaue Reiter), Neue Sachlichkeit (New Objectivity) including Dada and Bauhaus and the classification of Entartete Kunst (Degenerate Art) during the Nazi regime, will be discussed. It also elaborates on German art after World War II, including East Germany's Socialist Realism and West Germany's international influences, the influence of Conceptual Art on contemporary German art and the more recent emergence of German photography and figurative paintings of the Neue Leipziger Schule (New Leipzig School). This paper analyzes the specific characteristics of collecting and dealing as it takes place in Germany. It therefore provides a more detailed account of galleries, auction houses and art fairs, as well as a short overview of museums and exhibitions. Finally, it discusses the position of the German art market in the international market and analyses transactions and sales turnover data. It also evaluates the recent market performance of different styles and individual artists. Finally, this chapter closes with a discussion of whether art might serve as an alternative asset class, with a special focus on the first German art fund.