The Curious Year-to-Year Performance of Buyout Fund Returns: Another Mark-to-Market Problem?

Abstract

Buyout funds are essentially leveraged portfolios of a certain kind of U.S. company—that is, a small-cap, low-tech, nonfinancial, nonutility, generator of consistent earnings before interest, taxes, depreciation, and amortization with moderate cyclicality. These characteristics enable lenders to provide high debt levels with a reasonable expectation of repayment. Recent academic studies have raised doubts regarding the alpha of buyout fund returns against mimicking publicly traded portfolios, and buyout investors have sometimes responded that lower returns are offset by the funds’ lower volatility relative to public stocks. Regarding the volatility of such returns, several studies have used a cash-flow-only estimation (CFOE) approach to calculate risk, as an alternative to relying on (1) actual cash flows paid to limited partners and (2) the asset valuations of unsold investments as determined by buyout fund general partners. These studies have suggested that buyout funds’ reported return volatility is understated relative to times-series public market equity returns. This study uses a methodology other than CFOE to evaluate buyout fund return volatility. The authors use a publicly traded mimicking portfolio, adjusted for buyout-type leverage, to measure risk, and conclude that buyout fund returns are more volatile than public equity market returns.