Demystifying Illiquid Assets: Expected Returns for Private Equity

Abstract

The growing interest in private equity means that allocators must carefully evaluate its risk and return. The challenge is that modeling private equity is not straightforward, due to a lack of good quality data and artificially smooth returns. We try to demystify the subject, considering theoretical arguments, historical average returns, and a forward-looking analysis. For institutional investors trying to calibrate their asset allocation decisions for private equity, we lay out a framework for expected returns, albeit one hampered by data limitations, that is based on a discounted cash-flow framework similar to what we use for public stocks and bonds.

In particular, we attempt to assess private equity’s realized and estimated expected return edges over lower-cost public equity counterparts. Our estimates display a decreasing trend over time, which does not seem to have slowed the institutional demand for private equity. We conjecture that this is due to investors’ preference for the return-smoothing properties of illiquid assets in general.

TOPICS: Private equity, performance measurement

Key Findings

• • A leveraged small-cap public equity index may be a better benchmark for the performance of private equity than the large-cap indices generally used. Further, internal-rates-of-return (IRRs) can be especially misleading if they are compared against the time-weighted returns used for public market indices.

• • The smoothed returns of private equity understate the true economic risk and are an artifact of the lack of mark-to-market for illiquid assets.

• • The richening valuations of PE may be a headwind for future returns for the asset class, suggesting a slimmer edge over public equity than long-term averages.