Putting private equity volatility into perspective

Horizons article
June 25, 2024

When comparing private equity to public equities, private equity often comes out on top with higher returns and lower volatility. It seems to defy the common investment rule that greater reward comes with increased risk. It seems too good to be true, but is it? In this Horizon, we try to shed some light on this controversy.

To be clear, this article is not about whether private equity is a good or bad choice for investors. Rather, we want to clarify the different ways in which the risk profile and volatility of private equity can be compared to public equities in order to make a more informed investment choice.

Smoothed returns give a false sense of volatility

Tracking the returns of publicly traded stocks is straightforward; they are marked to market, meaning that prices are based on daily trading activity with publicly available details. Private equity investments, on the other hand, are not traded daily, so the market value of a private equity portfolio company is unknown and a "fair value" must be estimated.

In most cases, managers calculate this fair value on a quarterly basis using comparable public equities (peers), comparable private equity transactions, and discounted cash flow models to arrive at a net asset value (NAV) calculation. When comparing these private equity fair values to public equity market values, private equity shows a "smoother" and less volatile performance.

However, the comparison is far from fair. Not only is private equity valued less frequently, but research has also shown that the fair value accounting practices of private equity firms tend to result in more conservative and (therefore) smoother valuation estimates. As Pitchbook explains in a 2021 white paper, this means that firms often underestimate both positive and negative changes in the economic value of the portfolio.

Unsmoothing is difficult

To solve the smoothing problem, investors, analysts, and academics have developed various methods, but they all have some shortcomings. For example, one method is to smooth the performance of listed stocks from daily prices to quarterly prices. However, this method still compares marked-to-market prices with fair values based on the private equity firm's opinion and calculation methods.

Alternatively, we can attempt to unsmooth private equity valuations, as State Street Global Advisors did in a 2019 research note. Using the State Street Private Equity index (SSPE), a database derived from the custodial information of 2800+ funds spanning 30+ years, and a specially designed econometric technique to quantify the degree of smoothing, they found an increase in volatility of private equity, but not as high as some critics believed.

The main reason for the lower-than-expected volatility is that private equity is less exposed to the so-called excess volatility that dominates public markets. While earnings expectations drive fluctuations in public equity valuations, other (technical and psychological) factors, such as momentum or fear, also affect stock prices, resulting in excess volatility. This excess volatility is evidence that markets are not perfectly efficient and sometimes inefficient.

Comparisons to listed private equity come with a catch

Can't we use listed private equity companies to compare public and private stocks? That way we are comparing apples to apples, right? Wrong! While this approach would allow us to compare market-priced assets, the assets in question are not the ones we want to compare.

Publicly traded private equity firms such as EQT, Blackstone or KKR value the private equity management companies, but we want to compare the value of their portfolios. Of course, the performance of portfolio companies is part of the PE firm valuation, but capital inflows and other factors will also affect the value of a listed private equity management company.

To remove the management company effect from the equation, we suggest looking at publicly traded private equity funds for a fairer comparison. Pantheon International PLC (PIP/PIN:LSE) offers one such fund. PIP is a private equity fund of funds. It invests in a diversified portfolio of private equity investments managed by third-party managers around the world.

In addition, PIP is a closed-end fund, which means that it has a fixed number of shares that investors can buy and sell on the (London) stock exchange. PIP does not issue new shares, which means it does not raise capital. However, it still makes money on its investments, which it uses to grow the fund through new investments.

Closed-end funds like PIP have a unique pricing feature that could solve our smoothing problem. Its shares are traded throughout the day, so its share price is market driven. However, it also calculates its NAV on a regular basis. This gives us the ability to calculate and compare the volatility of both its NAV and its share price.

As the chart below shows, using PIP as a proxy for private equity volatility shows that NAV volatility is lower than share price volatility. NAV volatility averages about 10%, while stock price volatility averages about 23%. Of course, there are some caveats to using this methodology. We are using the performance of only one trust as a proxy, even though it invests in several underlying private equity funds. Nevertheless, this method provides an alternative view of PE volatility.

Source: Bloomberg

No matter how you calculate and compare the volatility of private equity to public equities, there is always a catch. If you choose to invest in private equity, do it based on its merits. Lower volatility is one of its advantages, but not in the way it is currently sold (by some) as a comparison to public equities. As noted above, private equity suffers less from the excess volatility (or market inefficiencies) that plague the public equity market. In other words, private equity allows (or forces) investors to remain invested even through volatile times. 


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