PT - JOURNAL ARTICLE AU - Antti Ilmanen AU - Swati Chandra AU - Nicholas McQuinn TI - Demystifying Illiquid Assets: <em>Expected Returns for Private Equity</em> AID - 10.3905/jai.2019.1.086 DP - 2019 Nov 15 TA - The Journal of Alternative Investments PG - jai.2019.1.086 4099 - https://pm-research.com/content/early/2019/11/15/jai.2019.1.086.short 4100 - https://pm-research.com/content/early/2019/11/15/jai.2019.1.086.full AB - 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 equityKey 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.