Private equity investments tend to be popular with longer-term investors because of the asset class’s perceived diversification benefits and excess return potential as compared with other asset classes. But the authors contend that the diversification benefits of the asset class may be overstated because of the underlying liquidity risk of the asset class; when this liquidity risk is taken into account, the excess return of the asset class is not statistically different from zero. The authors then explore a link between public and private equity investments through a common funding liquidity channel—namely, market liquidity—that they believe directly influences private equity performance.

Despite the widespread use of private equity investments, the authors contend that the underlying liquidity risk of the asset class remains unclear. In particular, they attempt to determine whether the asset class in general is affected by underlying market liquidity and, if so, to what extent this liquidity hampers diversification benefits and excess return potential.

Through careful examination of over half of the completed private equity investments between 1975 and 2006, the authors conclude that the liquidity premium of private equity might be understated. Practitioners typically use an 8% hurdle rate when evaluating private equity investments. But when the authors consider the underlying liquidity risk, they conclude that an 18% hurdle rate is more appropriate. This change would certainly affect the viability of the underlying investment as well as performance-based compensation metrics benchmarked to the hurdle rate.

Finally, understanding the real risk profile of the investment is important for risk managers. In times of market stress, private equity investments may not provide the diversification benefits managers expect.

Using data from CEPRES (the Center for Private Equity Research), which collects monthly cash flow information on liquidated private equity investments, the authors construct precise measures of the investment performance and aggregate liquidity conditions over the life span of each individual investment. This methodology allows them to observe more than 4,400 completed deals between 1975 and 2006—a dataset that represents 51% of all private equity deals over the period. The authors then create portfolios of private equity investments, grouped by start date, that are sufficiently diversified with 20 investments. They create portfolios to reduce idiosyncratic risk and to provide more robustness in the explanatory values. Modified internal rates of return (MIRRs) are calculated for each portfolio.

After the portfolios’ MIRRs are calculated, the authors derive the liquidity risk premium (beta) and alpha estimates relative to a public equity market proxy. They use three models with varying levels of specificity—the capital asset pricing model (CAPM), the Fama and French model (FF), and an augmented FF that captures a traded liquidity factor—and demonstrate the varying levels of total risk premium captured by the models, ranging from 7.3% (for CAPM) to about 18% (for the augmented FF). Finally, alpha estimates reveal that excess return diminishes as the number of factors in the model increases: 9.3% for CAPM, 3.1% for FF, and virtually zero for the modified FF. As such, the authors conclude that the liquidity risk premium is an essential component when accounting for private equity returns in aggregate.

The authors conclude with a hypothesis on why private equity returns are related to the liquidity of public equity markets. They consider individual private equity investments and use the Senior Loan Officer Opinion Survey on Bank Lending Practices as a proxy for funding liquidity, and they conclude that tightening credit standards, as measured by the opinion survey, is strongly correlated with private equity performance. The authors argue that because private equity investments have to occasionally refinance their debt, the liquidity of private equity lenders (mainly banks and hedge funds) is related more to the overall availability of credit than to the level and direction of interest rates.

The authors provide compelling and thorough evidence to suggest that private equity investments do not, in aggregate, provide sufficient diversification benefits and are not likely to add value to portfolios. But they do not measure the investment benefits of investing in private equity through actively managed private equity funds. The authors construct portfolios based on noninvestment-related criteria (diversified with 20 investments, same start date, etc.), but fund managers are likely to select investments based on underlying fundamental characteristics of a company as well as diversify across investment inception dates. Therefore, the article is unlikely to settle the debate on the viability of private equity investments within a diversified asset allocation. Nonetheless, the authors provide important information regarding the link between private and public markets.