Private equity returns smoothing

We’ve written before about artificially low volatility in private assets. Some investors actively seek out unlisted investments in the (false) belief that they’re less risky because there’s no daily share price volatility. We’ve been told by fund managers in the private assets space that some institutional investors will admit (behind closed doors) that they’re willing to have lower returns if a manager can take an asset private and conceal its true volatility behind mark-to-model valuation.

TwoSigma have taken a quantitative approach to this problem, running the Prequin private equity index through a desmoothing process to get an estimate of private equity market return that can be compared to listed equities. (Results are in the table below.) They find that the desmoothed returns have similar risk and return to listed equities – they argue that equity risk is equity risk, and it shouldn’t matter over the long term whether the equity is listed or otherwise.

Note also that the original returns for private equity have a high degree of autocorrelation. That is, the returns for one quarter look a lot like the returns for the previous quarter. A good valuation model shouldn’t do this. It should take what we know currently and project it into the future, and only change when “new news” comes along and changes our forecasts. TwoSigma says, “levels of autocorrelation this high indicate that external forces have acted on the returns of this investment in an unnatural way relative to public markets. This may indicate that asset valuations are being used as a tool to reduce volatility via the smoothing process, and that skepticism of the current returns may be warranted.”

Source: Venn by TwoSigma, with data from Prequin and S&P

Full details are here.

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This document is based on information available at the time of publishing, information which we believe is correct and any opinions, conclusions or forecasts are reasonably held or made as at the time of its compilation, but no warranty is made as to its accuracy, reliability or completeness. To the extent permitted by law, neither Aequitas nor any of its affiliates accept liability to any person for loss or damage arising from the use of the information herein.

Please note that past performance is not a reliable indicator of future performance.

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