Rosenberg agrees that, in the past, some
people have considered private equity less volatile than public equity “because
private equity highs and lows have been cut off due to these valuation
problems.” Investment advisors know they are, essentially, dead reckoning when
it comes to private equity investments, and to compensate, they have simply
reduced their clients’ portfolio allocations—tantamount to driving more slowly
in the fog. However, for those of us who demand a best-of-breed investment
strategy, this approach falls short in two crucial ways. First, it has no
scientific basis; it is risk management by fiat and may seriously constrain our
private equity returns. Second, without data on a fund’s volatility and its
correlative behavior vis-à-vis other assets, we cannot ascertain whether it will
diversify our portfolio, or cause unwanted and risk-worsening asset
concentrations.
Beyond Markowitz
When Harry Markowitz formulated modern portfolio theory
in the 1950s, he realized that a person could find an optimal risk-reward
tradeoff in a diversified portfolio if its constituent assets’ prices,
volatilities and correlations were known. Unfortunately, this formula did not
cover alternative asset classes such as private equity. One of the
presumptions of this theory (the descendants of which still inform investment
decision-making today) is that markets are open, efficient and accurately
priced. “That enables you to capture risk and correlation between asset classes
in a portfolio,” says Citigroup’s Rosenberg. “But if that assumption is
incorrect, then the risk measurements of the entire portfolio could be
wrong.”
Most investment advisors use private equity IRR data collated by
Thomson Venture Economics, a data vendor, to assess returns across the industry.
They then make an assessment of risk, or volatility, by taking a proxy, such as
the volatility of public companies, and multiplying it by factors that account
for the ways in which it differs from private equity. For example, the financial
advisor might factor in private equity-backed companies’ lack of revenues,
unproven technology and management, and uncertain capital structure. The outcome
of this heuristic is clearly biased by the analyst’s belief in the prospects of
the private equity-backed companies.
Northern Trust’s Morgan explains his
firm’s approach: “We use the Russell 2000 plus a small premium and the standard
deviation of the Russell 2000 [to calculate volatility]. It is not strictly
correct, and there probably is not a correct answer, but it is a suitable base
on which to make assumptions,” says Morgan. “Of course, that is only for
modeling purposes; you need to more fully understand the asset class to
appreciate how it performs and how the investment works.”
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