For (professional) investors it is after all, or at least should be, about risk adjusted returns. And with that, and following up on the last post “Does private equity outperform public equity” this post looks at the risk side of that.
Private equity is risky
And this, not least due to leverage and illiquidity, certainly, all else equal, more so than public equity. However, while it would be great if it was as straightforward at this, it is from a risk adjusted return point of view unfortunately not.
It is important to also consider downside risk
And for public equities this is not negligible. As Bain & Co. note in their 2020 report, equity bull runs are almost inevitably followed by market corrections and mean reversion. They further make the observation that “In the decade following the dot-com crash, the PME index’s annual return fell to 0.08%, while private equity maintained a 7.5% average”.
For a decade impacted by both the dot-com crash and the GFC not too shabby for private equity!
These points are reinforced in Figure 1. While the S&P 500 has averaged 8% returns for the past 140 years, and certainly merits investment, it was in negative territory 31% of the time.
I.e. investing in public equities, and this should not be much of a surprise, is also quite risky!
Figure 1: S&P 500 inflation-adjusted returns (incl. dividend reinvestments)
Source: Bain & Co., 2020
It is not only about upside, it is also about risk of loss
Taking the above point a bit further, this is something that Hamilton Lane picks up in their latest Market Overview. If, as seen in Figure 1, you get the timing wrong, loss can be quite substantial in public markets.
And in this context it is interesting to see in Figure 2, that in the worst 5-year performance Developed market buyout did not lose money. Compare this to a the MSCI World, which in its worst 5-year performance lost -5.7%.
Figure 2: Lowest 5-year annualized performance, 1995 - 2020
Source: Hamilton Lane, 2021
But, then just buy and hold public equities
At this point, one could possibly make a reasonable argument that investors could simply buy and hold a passive index fund and get 8% over time. Quite compelling, not least when also considering the greater simplicity, lower fees, and less risk, as compared to PE. And if looking for more upside, although also with greater risk, simply add a bit of leverage – not unlike PE.
For buy and hold investors this might be true. However, in reality most investors, except maybe Warren, are not just buy and hold. They engage in stock picking and try their hand a market timing trading in and out. And, as seen from Figures 1 and 2, if you get your timing wrong, this is not without risk, and the average of 8% may in fact be significantly less.
Private equity’s illiquidity advantage
This takes me back to a post I wrote two years ago: “If you are not in private equity, you are missing out!”.
In this post I make the point that private equity investors in times of market stress, i.e. around the GFC, gain an illiquidity advantage, see Figure 3.
This is because PE investors, unlike their public market brethren, simply cannot “panic” sell in a downward market, thus potentially crystallizing loses and subsequently not buying back in in time and missing the bulk of the upswing.
Figure 3: If you are not in PE, you are missing out!
Source: PE Compass, August 2019, data from Preqin 2019
Note: Net average returns from Q12001 – Q2 2018. To allow for comparison the two public market indices have been restated as public market equivalent. Past performance is not indicative of future results.
But, as with performance, you can’t compare private equity and public equity risk
Risk is normally measured by volatility with which the Sharpe ratio can be calculated, expressing excess return per unit of risk.
However, because of the way valuations work in PE, a best with a quarterly frequency, PE returns are artificially smoothed, which in turn systematically lowers volatility, i.e. understating risk. Andrew Akers of Pitchbook wrote an excellent piece on this.
This is absolutely true and also, like performance, subject to much debate. However, from a pragmatic investor point of view, this is really critical in regard to asset allocation, where correctly measuring risk can have a significant impact.
As with performance, this is not a case against public equities or for private equity, but rather more pragmatically, to Mr Akers’ point, for investors to include private equity in a portfolio.