Private Equity Risk and Reward

Abstract

In addition to its high historical returns, private equity is widely viewed as an attractive asset class due to its relatively low return volatility and low return correlation with other asset classes. However, the illiquid nature of private equity presents a key challenge for investors in assessing the precise underlying risk and reward potential embedded in the asset class. Namely, sluggish adjustment of net asset values by general partners of private equity funds implies that the return volatility and return correlations with other asset classes are likely understated. In this report, we outline a methodology for mitigating this sluggish adjustment problem by using long-horizon return data to allow for a more accurate assessment of private equity's diversification benefits and underlying risk/return characteristics. While the use of long-horizon return data indicates an increase in the correlation between private and public equity returns, implying fewer diversification benefits than indicated by quarterly data, the Sharpe ratios (i.e., proxies for risk-adjusted returns) for private equity remain substantially higher than corresponding Sharpe ratios for public equity. Additionally, for investors with long investment horizons, where annual return variability and illiquidity costs are largely immaterial, the absolute long-run historical return differentials between private and public equity are very large and, therefore, imply very large differences in end-of-period wealth.