Replicating Nordic private equity : capture private equity return and risk in the Nordic stock market

Abstract

Private equity is widely known as an asset class delivering highly impressive returns. Still, critics like to point out the excessive fee structure in the industry. This paper investigates whether a passive stock portfolio, mimicking the asset selection and leverage level of private equity funds, to a lower cost can emulate the risk and return yielded by Nordic private equity. We find that buyout funds have a tilt towards selecting relatively small firms within specific sectors of the economy. Further, we find that buyout targets tend to be relatively more leveraged, relatively more capital-efficient and to have a relatively lower asset growth turnover than comparable Nordic stocks. Overall, two of our 24 characteristics-matched and leveraged-matched replicating portfolios offer returns that exceed the attractive returns yielded by Nordic private equity in the period June 2006 to June 2018. A five-year buy-and-hold portfolio, selecting stocks based on size, sector, EBITDA and asset growth turnover, yielded an annualised excess return of 18.6% in the investment period, outperforming the pre-fee private equity return of 17.2%. After accounting for fees and transaction costs, 13 of the 24 replicating portfolios earned a higher return than the benchmark. However, none of the passive replicating portfolios can reproduce the risk-adjusted return of private equity. Our analysis indicates that the lower risk of private equity may be explained by i) the active management approach, ii) beneficial interest rates and loose covenants of their long-term corporate debt, and iii) the existence of return smoothing. Nevertheless, we conclude that a replicating portfolio offers a cheap and accessible investment strategy for investors that deny paying the excessive fees of private equity and can accept large fluctuations in portfolio values.