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The Journal of Alternative Investments

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Demystifying Illiquid Assets: Expected Returns for Private Equity

Antti Ilmanen, Swati Chandra and Nicholas McQuinn
The Journal of Alternative Investments Winter 2020, 22 (3) 8-22; DOI: https://doi.org/10.3905/jai.2019.1.086
Antti Ilmanen
is a principal at AQR and global head of AQR’s Portfolio Solutions Group in London, UK
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Swati Chandra
is a vice president in AQR’s Portfolio Solutions Group in Greenwich, CT
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Nicholas McQuinn
is an associate in AQR’s Portfolio Solutions Group in Greenwich, CT
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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.

TOPIC: Private equity

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.

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The Journal of Alternative Investments: 22 (3)
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Demystifying Illiquid Assets: Expected Returns for Private Equity
Antti Ilmanen, Swati Chandra, Nicholas McQuinn
The Journal of Alternative Investments Dec 2019, 22 (3) 8-22; DOI: 10.3905/jai.2019.1.086

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Demystifying Illiquid Assets: Expected Returns for Private Equity
Antti Ilmanen, Swati Chandra, Nicholas McQuinn
The Journal of Alternative Investments Dec 2019, 22 (3) 8-22; DOI: 10.3905/jai.2019.1.086
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