|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.