I recently wrote a paper together with an INSEAD MBA classmate on the merits of Private Equity Investments vs. Public Equity Investments. I hope you enjoy reading it!
You can find the full paper Click Here, and an abstract below:
Re-thinking private equity risk and reward:
Abstract:
In this paper, we hope to provide a balanced, evidence-based view that challenges the current thinking around private equity risk and reward assumptions and the impact on LP allocations. We summarize existing research from academic institutions, capital providers, investment managers, and market research firms. This paper attempts to answer four questions:
1. Does private equity provide higher returns, lower volatility, and diversification benefits for institutional investors?
2. Can private equity returns be replicated with a public market strategy?
3. Do private equity lockups enhance returns or increase risk?
4. What are the implications for LP allocations to private equity?
We believe these topics are timely to re-visit as LP allocations to private equity have increased significantly, GP dry powder levels are at record highs, and private equity fund returns have been declining. Our research suggests that US private equity returns can likely be replicated in public markets using a levered US small-cap value index. However, reported levels of volatility for private equity returns are substantially lower than reported levels of volatility for public markets, due to systematic smoothing of returns. This implies unconstrained asset allocation models, using return and volatility input variables, may over-allocate to private equity and require intervention to adjust for the understatement of reported volatility in private equity returns. In addition, recent forecasts predict lower returns to private equity vs. historical levels and relative to other asset classes, which may also suggest that LPs should limit increasing allocation to private equity funds as a % of the total portfolio.
In support of increasing allocations to private equity, we highlight research on UK buyout funds that suggests private equity ownership indeed does provides significantly value-added services that cannot be replicated in public markets. This implies LPs should overweight allocations to private equity managers that can ‘add value’ to portfolio businesses in ways that cannot be replicated in the public market context (cheaper financing, higher leverage, more aggressive growth targets).
We also find evidence to support US private equity returns being negatively correlated with the S&P 500, therefore providing real diversification benefits to a traditional stock-bond portfolio.
Finally, we conclude long-term perspectives can enable investors to generate superior performance in a private or public market context. In this regard, private equity lockups can be viewed as an advantageous feature of the asset class, rather than an extra liquidity risk, as lockups act as an effective mechanism to focus investors on long-term returns over short-term volatility.