Episode Transcript
Indrani De: So mega buyout dominating private equity. That itself changes the nature of private equity over time. And we find that the return distribution for both public and private equity shows some break points that the markets are different after the dotcom bubble. So, you know, post 2000 the markets change. And again, another set of change after the GFC.
Hello and welcome to today's edition of FTSE Russell Convenes. Today we are going to be discussing a paper that we wrote. It's called Managing Risk Exposure to Private Equity through Public Equity. It's a joint research between FTSE Russell and Cboe. I am Indrani De, Head of Global Investment Research at FTSE Russell, our index business of the London Stock Exchange Group and I'm joined by my coauthor Edward Tom.
He is Senior Director in the derivatives market intelligence group at Cboe. And we will be discussing this two-part paper that we coauthored with the third quarter from my group, Mark Barnes. So, just a quick disclaimer FTSE Russell is not an investment advisor. So any findings on anything said in this paper and today's episode is purely for educational purposes.
Ed Tom: Thanks, Indrani. Let's start by asking you about your part of the paper first. What was your main research hypothesis?
Indrani De: So in this two-part paper, the part that FTSE Russell really wrote about is if you look at private equity as an asset class and you look at public equity, how similar or dissimilar are they, and try to narrow down their similarities over time. And what we have done in terms of data, we have worked with the Cambridge Associates for the private equity data and the Russell Indices, and we look at data starting from 1986 through, you know, 2023. It's a long time series. And we essentially try to see the similarities or dissimilarities over time between these two asset classes.
Ed Tom: And other additional methodologies that you would like to describe?
Indrani De: In a crux, the methodology is it's very commonly accepted that private equity returns are smoothened, which kind of helps their returns and the volatility picture. So they have a known autocorrelation structure. Predictability in returns up to four lags which show that they are smoothing returns.
So if you apply the same smoothing structure to public equity returns so that the two return series, public and private equity are more compatible and able to have a sense of comparison, then what happens? How similar are they? And when we talk about similarity, we are really using the metrics of core movement, correlation and tracking error.
Ed Tom: And what were you main findings that the implications of those findings?
Indrani De: So a couple of things as we look at the data series from, you know, 1986 till 2023, we find that the private equity market has changed over time. It's become more dominated by the buyout part of the market and more by the mega part of the buyout. So mega buyout dominating private equity. That itself changes the nature of private equity over time.
And we find that the return distribution for both public and private equity shows some break points, that the markets are different after the ‘dotcom’ bubble. So, you know, post 2000 the markets change. And again another set of change after the GFC. So if you take current market situations, let's say in the last ten odd years since 2013, and you do the smoothed public equity return so that you're doing an apple-to-apple comparison of public and private equity.
Then you find that their core movement is much higher than the market commonly acknowledges to be. The correlation is not of 90 percentage points. And, the tracking error of public to private equity is just around four percentage points. That means private equity and public equity in recent years are much more similar than markets commonly think, which then the most important implication is private equity obviously has a huge amount of risk in it.
So how can you hedge those private equity risks by maybe using more, you know, derivatives on the listed equity paths, which in turn, if you can do it successfully, has the implications for improving the capital efficiency of portfolios.
So Ed, let's now turn to the part of the research done by you, Cboe. As we talk about these findings by FTSE Russell. How do you take these findings? And what are the challenges to really translating that into option strategies in the listed equity market?
Ed Tom: Well, as you know, oftentimes, the challenges of translating academic findings into an actual trade, one is that, that actual trades require additional friction costs such as transaction costs, trading costs and such.
And there's an extra layer of complexity when dealing with options because, there are many different types of options parameters that one needs to take into account, such as building out the particular structure that one needs to use, as well as the option parameters for those structures such as the minus, the strike, the expiry, so basically like, everything that we need to account for, as far as an actual trade, will overlay the results for the overall option strategy.
Indrani De: So what are the main methodology that you followed in your analysis?
Ed Tom: Basically perform what's called a grid search, which means that, we looked at every conceivable combination and iteration of different options strategies, and every conceivable parameter for minus and for strike and expiry, in order to find the optimal results for both the tactical findings as well as the systematic findings.
Indrani De: That's interesting. So now let's come to what are the main findings and what implications does it have for a portfolio investor?
Ed Tom: I think the biggest surprise on our side was how effective the options overlay strategy was in hedging private equity returns. With respect to tactical tests of efficiency, the optimal Russell 2000 overlay was able to hedge effectively eight of the ten largest material drawdowns in private equity. And with respect to a systematic, always-on strategy, we were able to find that a 15 five delta put spread was able to hedge seven of the ten largest drawdowns, including the global financial crisis as well as Covid.
Indrani De: So I think in a nutshell, our paper really points out that private equity and public equity are much more similar than people think. Once you account for the autocorrelation and smoothening in private equity and apply that to public equity, the asset classes are much more similar.
And the Cboe research shows that you can really hedge the biggest drawdown risk through both tactical and systematic strategies. And this has immense implications for capital efficiency in portfolio construction. Thank you. This was super interesting.
Ed Tom: Thanks Indrani.
Indrani De: And this paper is available on the FTSE Russell website should you want to dig deeper into it. Thank you.
