Performance – August 2008

What can be learned from past performance about the future prospects for private equity? Introducing the Peracs PE Barometer, Oliver Gottschalg of HEC School of Management and Robert Ryan from Peracs Due Diligence Services assess the attractiveness of today's environment for private equity.

Following the sharp drop in deal volumes as a result of the credit crisis, it is tempting to conclude that the private equity industry is in a collective state of hangover. Last year’s euphoria about the buyout market has given way to more negative sentiment about the short- to medium-term prospects for the asset class today. This is understandable, but is it justified? The Peracs PE Barometer1 sheds some light on this question based on a detailed analysis of the hi s tor ic relat ionship between macroeconomic conditions and private equity performance. What this analysis suggests is that neither last year’s optimism nor the current pessimism is warranted in its entirety.

Clearly the economic environment changed substantially over the past 12 months. But what does this imply for the expected profitability of private equity going forward? Even a casual look at past performance cycles of the industry suggests that a good part of private equity performance is linked to prevailing macroeconomic conditions. Historically, private equity investments made during periods after a major market downturn – such as the early 1990 and the first two years of the present decade – were among the most profitable in history of the asset class.

It makes intuitive sense that private equity performance is linked to factors such as GDP growth, the stock market, credit market conditions and the supply and demand dynamics in the market for private equity capital. What is challenging, however, is to determine how exactly each of these factors is linked to private equity performance and – most importantly – through which mechanisms they jointly influence private equity returns. What we are aiming to capture is the empirical link between a set of macroeconomic conditions and private equity investment performance. This link is the foundation of the Peracs PE Barometer, a model that assesses the relative attractiveness of private equity investments at a given point in time based on current macroeconomic conditions, just like a barometer can be used to predict future weather conditions based on current atmospheric variables.

In a joint research effort by HEC School of Management and advisory firm Peracs, we have developed this model for private equity performance using a database of 3,634 buyouts made between 1973 and 2003 worldwide. This data corresponds to over 50 percent of worldwide buyout activity during that period and can be considered representative with respect to its coverage of different geographies, industries and deal sizes. Thanks to the breadth and depth of the database, we have been able to comprehensively analyze the relationship between private equity performance and over 100 macroeconomic indicators, linking the performance of each buyout to the macroeconomic conditions that prevailed at the time the deal was made. Using non-linear multivariate regression techniques, we first identified the 20 most relevant factors that underlie these indicators and then derived a statistical model that captures how these factors collectively relate to private equity returns.

The characteristics of the resulting Peracs PE Barometer indicates a high statistical fit with historic data2, which can be illustrated through a graphical comparison of the model’s past predictions with historic private equity performance for that same period. Figure 1 compares the evolution of the average past performance of buyouts made in a given year with the Peracs PE Barometer’s performance prediction for that year, based on the macroeconomic conditions at that time. The Barometer identifies the broad trends in buyout performance with a high level of accuracy. 3

When we apply the Peracs PE Barometer to gauge the relative attractiveness of the present environment for buyout investments, we can assess whether the pessimists are right and the current environment really is less attractive than it has been in the past few years. Looking at the historic pattern of worldwide buyout performance predictions according to the Peracs PE Barometer shown in Figure 2, we observe that the Barometer suggests favorable conditions for 2008, which suggests that the current environment may be much more attractive for buyout investments than most people think. The Barometer IRR for a given point in time can be interpreted as the level of attractiveness of buyouts that are made over the next two to three quarters, relative to the historic performance pattern. For example, Barometer IRR of 24.7% for buyouts worldwide means that the environmental conditions at play suggest a hypothetical average return of 24.7% (though actual returns may vary).


The proprietary statistical model 4 behind the Peracs PE Barometer considers over 100 macroeconomic indicators, updated on a monthly and quarterly basis. These indicators cover a broad range of aspects of the economy, including debt and equity markets, private equity investing and fundraising activity, employment trends, price indices, general leading economic indicators and many more. The Peracs PE Barometer model captures the joint impact of these indicators on such performance of buyouts made over the next 12 months 5. Based on this model, we seek to identify the most relevant positive and negative drivers of expected buyout performance (see table below). It is important to remember that this table ranks the indicators according to their marginal impact on expected buyout performance. In other words, it considers the impact of each indicator, holding all other indicators constant. This analysis is more meaningful, and very different from, simply looking at the correlation between expected performance and each indicator separately 6.
While the counter-cyclical nature of private equity is already widely understood, Table 1 reveals just how counter-cyclical the performance expectations of buyouts really are. Expected buyout performance is strongly negatively related to a number of leading economic indicators, which means that in general the performance outlook for buyouts is best when the leading economic indicators point south.
Top negative drivers of expected Top positive drivers of expected
buyout performance buyout performance
1. Various leading indicators 1. PE Capital Overhang expressed
of consumer confidence, as the ration of un-invested capital
consumer sentiment and over last year’s investment volume
consumer expectations
2. New Construction Volume 2. Unemployment Rate
3. Tobin’s Q 3. 1-year-change in Crude Petroleum
4. Last Year’s Volu me of Buyout 4. New Export Orders
5. 1-year-change in Personal Income, 5. 3-month-change in number of
Labour Force and Hourly Wages `Help Wanted’ Newspaper ads
6. 1-year-change in BAA Corporate 6. Producer Price Index
Bond Yield