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Wisdom & Fair Warning
Laurence Neville
04/01/2004
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The Thomson Venture
Economics data also has some intrinsic problems, creating an illusion of low
risk because it is not market-to-market. It also has selection bias: “The best
managers don’t tend to report their performance,” Rosenberg says. “If they don’t
need to raise funds, then many feel there is no need to provide
information.”
Private equity risk estimates differ, but not by too much. JP Morgan Private
Bank’s current assumption is that the public market has around 15 percent
volatility, while the private equity market has 30 percent volatility. Derek
Sasveld says that UBS calculates that the risk level of private equity is 1.6
times that of the public market: While the public equity market has 16 percent
anticipated total risk (based on standard deviation or volatility), the
private equity market risk is 26 percent, including the illiquidity risk. |
This data also suffers from survivorship bias. If a fund ceases
operation, which usually occurs because of poor performance, it is removed from
the index, and its returns are extracted from the data from the day the fund
started. “These biases thus remove the best and worst performers from the
database in the index, making the volatility appear much lower than it really
is,” Rosenberg notes.
There are a number of ways to counter these problems.
Sasveld says that to compensate for the lower volatility of reported private
equity returns, UBS turns all public equity investments into hypothetical IRR
figures, so that they can better show the correlation between public and private
equity. “In other words, we treat the S&P 500 as if it were an illiquid
private equity fund.”
The benefits of private equity may never be fully
quantifiable using the tools developed for other asset classes. But some argue
that this presents no significant problems. “What’s nice about private equity is
that, to a large extent, it doesn’t fit into any model,” says Morgan. “By that I
mean the asset class is different from public equities, with different return
patterns, cash flows and valuation methodologies. It’s more inefficient than the
public markets, and it’s those inefficiencies of the market that create the
return opportunities. Investors need to understand this to profit from it.”
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