Private Equity: Fooling Some People All the Time?

Debunking the Myth of Uncorrelated Returns

January 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Private equity return data should be viewed with caution
  • Returns are likely overstated while volatility is understated
  • Private equity returns are highly correlated to public equities

TWO MAGIC WORDS

“This time is different” might be the four most dangerous words in investing. “Uncorrelated returns” may just be the two most lucrative. These seven syllables have been applied across the span of the alternative investment industry, from hedge funds and venture capital (VC), to private equity and real estate.

Investors have allocated more than $10 trillion to these alternative investments, paying high fees while hoping that these provide positive returns and diversification benefits for traditional stock and bond portfolios.

But investor sentiment towards alternatives varies across the spectrum. Despite racking up impressive returns in recent years, VC is still tainted by the 2000 implosion of the tech bubble as well as complete write-downs of investments. WeWork-like debacles do give investors pause when they consider VC allocations.

Low alpha generation has sapped hedge funds of much of their prestige in recent years. Improved analytics have also shown that much of their alpha was really alternative beta that could be harvested more efficiently via cheaper liquid alternative products. Consequently, hedge funds have not grown their assets under management (AUM) all that much of late (read Hedge Fund Factor Exposure & Alternatives).

In contrast, investor bullishness on private equity may be at an all-time high. It is the most popular alternative asset class, according to the Preqin Investor Outlook for Alternative Assets in 2019, with a 9.9% target allocation for institutional investors based on the assumption of high absolute and uncorrelated returns.

Since some alternative asset classes have already disappointed, however, cautious investors might also question private equity’s core assumptions.

So does private equity provide uncorrelated returns relative to equities?

PRIVATE EQUITY VERSUS PUBLIC MARKET RETU