Asset allocation is perhaps the most important choice facing CIOs. It requires evaluating the risk-return profile of various asset classes, including forward-looking estimates of expected returns, as well as risk measures typically derived from historical data.
This can be a challenge for some asset classes, however, in particular those where prices reflect historical costs rather than market-clearing transactions. This is an acute problem for private equity, creating artificial smoothing in historical returns, which dramatically understates risk measures such as volatility, equity beta and correlations with other asset classes. This understatement of risk can lead to flawed portfolio decisions.
Unsatisfied with using currently available private equity benchmarks given the potential to understate the risk characteristics within this segment of a portfolio, we embarked on a research project to establish a proxy for private equity that better informs the asset allocation process.
The first option is to turn to the index return streams themselves, but use statistical techniques to address the smoothed nature of the reported quarterly returns and interpolate monthly returns.
This process works fairly well to get a more accurate assessment of the historical risk in private equity. However, it is not useful for making assessments of expected returns.
In addition, the process of de-smoothing involves a somewhat unreliable index performance number, particularly for recent vintages. This is because the returns of a particular fund are only estimated until the final cash is distributed as a realised gain or loss.
This process could take six-to-10 years with Cambridge Associates’ research showing that most funds take at least six years to settle into their final quartile ranking. The combination of addressing solely the risk aspect of an asset allocation question with potentially less meaningful recent vintage return data makes de-smoothing index returns a less than ideal input to address asset allocation for private equity.
Another approach is to use the return series of publicly-listed private equity funds. This takes a large step towards using public market pricing to establish a true return stream for private equity.
Unfortunately, this measure has flaws. The market prices of listed private equity funds more likely represent a claim on private equity fees, not the underlying portfolio companies. While the growth in fees could be a proxy for the growth in those portfolios, the link is not direct. In addition, the largest publicly-listed private equity firms have other business lines that can skew the interpretation of the resulting return stream. Lastly, the resulting return stream is volatile, which could lead investors to overstate the risk with private equity.
Since private equity can be thought of as public equity liberated from the burden of daily mark-to-market, a public equity proxy may be a useful comparison.
Mapping private equity allocations to comparable industry and size sector ETFs provides a basic intuition for how private equities perform. After all, many portfolio companies were at one time publicly listed before the private equity sponsor took them private and a public listing is an often-pursued exit strategy.
With this linkage between public and private equities, mapping exposures also offers flexibility and customisation for an investor’s particular portfolio. For example, typical industry allocations of private equity are to companies with strong cashflows and the ability for the sponsor to either improve operations or revenues (eg, firms in industrials, services, technology and transportation). Mapping private equity allocations to these various sectors and using the S&P 400 Midcap Index creates a return series that closely approximates that of a de-smoothed private equity index.
In addition, both the sector weights and size approximation can be adjusted to match an investor’s portfolio, offering a more customised approach to the role private equity can play in a broader portfolio.
Alexandra Coupe is an associate director at hedge fund investor PAAMCO