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As investors increasingly embrace private equity (PE), they find themselves posing the following questions: How much should they allocate? What are good yardsticks for assessing performance? Are the higher fees of PE justified by higher expected returns over public equity counterparts? What is the risk and diversification potential of PE?
The comparison to public equity is not straightforward. In general, illiquid assets are inherently harder to model, and this is exacerbated by a lack of good quality and transparent data. We try to demystify the subject of PE risk and return, focusing on the medium-term (5 to 10 years) expected return (ER) of PE. We view the topic through multiple lenses: theoretical required returns, historical performance, and, finally, our favored approach of extending our discounted-cash-flow-based methodology for equity and fixed income to the realm of PE. A common framework helps highlight how the ER of PE is anchored to that of public equity by similar drivers, such as yield and growth. Although we focus on returns, our analysis also touches on the hidden risks and factor exposures of PE, and thereby suggests potentially better performance benchmarks and comparisons to public equity.
We observe that PE has grown in popularity despite a decreasing expected and realized return edge over public equity counterparts. We posit that this surprising outcome reflects the illusion of the lower risk of illiquid assets or the appeal of their artificially smooth return streams. Due to the absence of mark-to-market accounting, the reported volatility and equity beta of private assets tend to be understated, unless one desmooths their returns, which may not be a clear-cut exercise. This overstates their diversification potential or naïvely measured alpha.1 Even if one expected PE to provide zero excess return over public equity, the assumption that PE was less risky, and lowly correlated to public equity, would call for an increased allocation to PE. Furthermore, understating the reported risk compared to economic risk may, in itself, appeal to investors. The shrinking valuation gap between private and public equity, which we show later on, is one indication of investor willingness to pay, perhaps knowingly overpay, for these return-smoothing characteristics.
This report is targeted at investors interested in understanding the relation between private and public equity at some depth,...