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1 April 2014 CFA Institute Journal Review

Risks, Returns, and Optimal Holdings of Private Equity: A Survey of Existing Approaches (Digest Summary)

  1. Priyank Singhvi, CFA

There is substantial disparity in performance estimates as reported by studies on the risks, returns, and optimal holdings of private equity (PE) portfolios. Moreover, the traditional risk and return measures need to be modified because they are not applicable to this asset class. Fee levels in PE investments tend to be high, and optimal holdings for PE portfolios are much smaller once frictions are introduced into the traditional models of asset allocation.

What’s Inside?

The authors survey the academic research on the risks and returns of private equity (PE) investments. In addition, they assess the optimal allocation to the PE asset class as well as any associated intermediary issues.

How Is This Research Useful to Practitioners?

The authors review the challenges of applying traditional risk–return frameworks and asset allocation models to the PE asset class.

The application of conventional risk and return models to PE investments is challenging. Market values of PE funds are only available at the time of exit and not during the life of the investment, which means the capital asset pricing model (CAPM), alphas, and betas are difficult to apply. As a result, successful investments are overrepresented. Because of the fact that data availability is limited, alpha tends to be overestimated and beta tends to be underestimated. This problem is further aggravated by the fact that these measures cannot be interpreted in the same way because, unlike other financial assets, PE has greater friction and less transparency and liquidity. The adjustment methodologies are still in the preliminary stage of development, and results will need to be evaluated with caution.

Alternative measures, such as internal rate of return (IRR), total value to paid-in capital multiple (TVPI), and public market equivalent (PME), are used to address the limitations, but these measures are not grounded in sound theory. These measures are exposed to the time and value of individual transactions, further adding to interpretation and comparison issues.

The authors suggest that the traditional models of asset allocation may not be applicable for PE funds. Frictions lead to difficulties in continuous rebalancing and a requirement for very wide rebalancing bands. When factoring in these frictions, models allocate a substantially smaller proportion to PE. One of the studies the authors note suggested that the introduction of frictions resulted in the optimal allocation being reduced from 60% to 10%.

A review of the literature about PE suggests that total fees for PE investments are high at around one-fifth of gross PE returns. Incentive fees account for one-third of total compensation. High fees are justified by returns that can be attributed to unique factor and manager skill. It has to be taken into consideration that research on optimal PE contracts is still in the preliminary stages.

How Did the Authors Conduct This Research?

The authors perform a review of approximately 60 research papers focusing on three distinct areas. They consider PE risk and return metrics, optimal allocation to PE funds, and contracts in the PE asset class. On the basis of the literature review, they detail a number of key challenges and recommendations for investors in private equity.

Because of the absence of regularly quoted market prices, standard risk–return measures are not applicable in estimating the value of PE investments. This issue is further affected by the irregular nature of the investments and sample selection issues. Any reported risk and return estimate will need to be considered carefully. Performance measures of IRR, TVPI, PME, and performance persistence are equally problematic for use in PE valuations. Not only can they be manipulated by the timing and magnitude of investments, but they also apply only rough risk adjustments. Similar to standard risk–return measures, these measures should be considered with caution.

In addition, rebalancing PE portfolios is extremely difficult because of transaction costs and illiquidity. This factor needs to be incorporated when trying to determine the optimal PE asset allocation. Finally, unlike public equity, PE vehicles are subject to agency problems with high management and incentive fees. Provided that it results in increased efficiency, the authors believe that PE management is best handled in house.

Abstractor’s Viewpoint

Although private equity as an asset class has been gaining traction with just less than $3.5 trillion under management (as of June 2013, according to the 2014 Preqin Global Private Equity Report), the research on this industry has so far been limited. By surveying the academic literature on risk–return, optimal allocations, and contracts, the authors present and comment on the state of investment in the PE asset class, discuss the challenges of using traditional frameworks to value PE, and highlight areas in which more work is needed. It is a useful reference point for PE fund managers, portfolio managers evaluating the PE asset class, performance measurement and reporting professionals, and academics.

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