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Schmalenbach Business Review

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27-06-2018 | Original Article

The Pricing of Liquidity Risk in Buyout Funds – A Public Market Perspective

Authors: Matthias Huss, Heinz Zimmermann

Published in: Schmalenbach Business Review | Issue 3/2018

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Abstract

This paper analyzes the structure and pricing of liquidity risk for international listed buyout funds. We use a time-series framework for our tests which allows us to discriminate between the exposure of buyout funds to two types of liquidity: Market and funding liquidity. We find that the innovation in funding liquidity is a priced factor for buyout funds, while changes in market liquidity are not. Investors require a risk premium of approximately 3% to 7% per annum in order to be compensated for bearing that risk. Controlling for funding liquidity risk decreases the alpha of the asset class to zero.

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In this paper, we refer to buyout funds as a subcategory of the larger private equity asset class, that also includes, e.g., venture capital.

In this respect, our paper contributes to a growing strand of literature that has documented liquidity risk, interpreted as innovations in aggregate liquidity, to be a priced factor for a broad array of asset classes. Pástor and Stambaugh (2003), for example, analyze the pricing of liquidity risk in the stock market. Chordia et al. (2005) provide a study on stock and bond returns and analyze the links between both markets. Sadka (2010) analyzes liquidity risk in hedge-fund returns and Bekaert et al. (2007) study liquidity and stock returns in emerging markets. Far less, however, is known on the relationship between private equity and liquidity risk.

Generally, market liquidity refers to the ability to trade large quantities of an asset (i) quickly, (ii) at low cost, and (iii) without influencing the price of the asset, whereas funding liquidity simply refers to the ease with which funding can be obtained (Pástor and Stambaugh 2003; Boyson et al. 2010).

Similar approaches have been followed by Cochrane (2005b) or Driessen et al. (2012).

Brunnermeier and Pedersen (2009) present a model that links market and funding liquidity in a mechanism they term “liquidity spiral”. Franzoni et al. (2012) refer to their model to explain the empirical relation of their findings to the initial hypothesis.

See, e.g., Gompers (1996) or Blaydon and Horvath (2002). Cumming and Walz (2010) present evidence that different legal frameworks across countries severely affect the information content of reported valuations.

Hall and Woodward (2003) and Woodward (2004) provide a more detailed discussion on stale pricing in private equity.

Early studies include Martin and Petty (1983) or Brophy and Guthner (1988).

Bergmann et al. (2010) provide a detailed overview of the organizational forms of listed private equity.

See Kaplan and Strömberg (2009) for a more detailed discussion on the private equity business model.

In untabulated results, we verify that the exclusion of the least liquid instruments does not lead to circularity issues in the estimation of liquidity exposures.

The numbers are based on 16 FoFs which disclose sufficiently detailed information about their investment portfolio in 2010.

Specifically, the Kaplan and Schoar (2005) “Public Market Equivalent” (PME) of traditional buyout funds is virtually one, when the cash flows of these funds are discounted with the returns of a portfolio of listed buyout instruments. The result is robust in all subperiods.

We have 22 FoFs with a buyout focus, while Jegadeesh et al. (2015) have 24 funds, including venture FoFs.

In case a fund is delisted from the stock exchange, the portfolio is rebalanced on the last trading day.

The time-series of the liquidity factors can be obtained from Lubos Pastor’s website, http://faculty.chicagobooth.edu/lubos.pastor/research/.

See e.g. Fama and French (1989) or Ferson and Harvey (1993), among others.

The correction for autocorrelation is based on the full sample and therefore may introduce a look-ahead bias. However the correction does not drive the findings presented below, which is verified from a robustness test.

See http://www.federalreserve.gov/boarddocs/SnLoanSurvey/default.htm. The survey asks a panel of large US domestic, and US branches of foreign banks, whether they tightened or loosened their credit standards relative to the previous quarter and reports the net-percentage of respondents that tightened their standards.

Similar data from e.g., individual member countries of the European Central Bank (ECB), or the Bank of England are available only from 2003 and 2007 respectively. We, however, find a correlation between the Federal Reserve’s survey and the results of the German “Bundesbank”, an important member of the ECB to be 0.61.

Drehmann and Nikolaou (2013) analyze the interaction between market and funding liquidity risk and report that a close relationship only emerges during the financial crisis; in particular, they find no significant relationship prior to the crisis. Their observation period covers June 2005 to October 2008, since the authors proxy for funding liquidity risk from banks’ bids on open market operations performed by the the European Central Bank. Similarly, Adrian et al. (2014) find that market and funding liquidity are not intertwined.

Some recent papers (e.g., Axelson et al. 2013) report higher betas for buyout funds. These estimates are based on gross-of-fees data, which overstates the true beta of a fund. Harris et al. (2014), for example, argue that fees, incentive fees in particular have a negative beta.

Franzoni et al. (2012, p. 2356).

The market price of risk for a non-traded risk factor must be estimated from the cross-section of asset returns. Assuming integrated markets, the price of risk of a traded position directly corresponds to the time-series average of the factor’s returns (e.g., Shanken 1992) or Balduzzi and Robotti 2008) and the cross-section of asset returns bears no additional information.

For further details, see, e.g., Jagannathan et al. (2010) or Cochrane (2005a). The basically same approach that we use has also been used by e.g., Pástor and Stambaugh (2003).

The data is obtained from https://fred.stlouisfed.org.

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Title: The Pricing of Liquidity Risk in Buyout Funds – A Public Market Perspective
Authors: Matthias Huss
Heinz Zimmermann
Publication date: 27-06-2018
Publisher: Springer International Publishing
Published in: Schmalenbach Business Review / Issue 3/2018
Print ISSN: 1439-2917
Electronic ISSN: 2194-072X
DOI: https://doi.org/10.1007/s41464-018-0050-6