Private Equity and the Leverage Myth

Abstract

Investors have traditionally relied on mean–variance analysis to determine a portfolio’s optimal asset mix, but they have struggled to incorporate private equity into this framework because they do not know how to estimate its risk. The observed volatility of private equity returns is unrealistically low because the recorded returns of private equity are based on appraised values, which are serially linked to each other. These linked appraisals, therefore, significantly dampen the observed volatility. As an alternative to observed volatility, some investors have argued that private equity volatility should be estimated as leveraged public equity volatility, because private equity companies are more highly levered than publicly traded companies. However, this approach yields unrealistically high values for private equity volatility, which invites the following question: Why isn’t the appropriately leveraged volatility of public companies a reasonable approximation of private equity volatility? This article offers an answer to this puzzle.

TOPICS: Private equity, volatility measures

Key Findings

• ▪ Why isn’t the appropriately leveraged volatility of public companies a reasonable approximation of private equity volatility? The authors look for clues in the public markets where they find no association between volatility and leverage, counter to what financial theory would suggest.

• ▪ The evidence suggests that the relationship between leverage and volatility is hopelessly obscured by a variety of confounding effects in both public and private markets.

• ▪ This article arrives at the counterintuitive conclusion that private equity volatility is similar to public equity volatility despite its higher leverage. The likely explanation is that privately held companies are inherently less risky and thus able to bear greater leverage.