Why Investors Should Steer Clear of Private Equity

Understanding the Debate Around Private Equity

Private equity has long been a topic of discussion among investors, with many believing it offers higher returns compared to public markets. However, recent research challenges this notion and suggests that private equity may not be as beneficial as once thought. This new study from Verdad Advisers provides valuable insights into the performance and risks associated with private equity investments.

The Appeal of Private Equity

Private equity refers to investments in companies that are not publicly traded on stock exchanges. Unlike public equity, which is represented by market benchmarks such as the S&P 500, private equity involves investing in companies that are not subject to the same level of transparency and regulation. Historically, private equity has been seen as a way to generate higher returns, especially with the success of figures like David Swensen at Yale University's endowment.

For many years, the allure of private equity was strong, with institutions following Yale's lead and enjoying significant gains. However, in recent years, the performance of private equity funds has not matched that of the public market, leading some to question its value.

The Risk Argument

Despite the lagging returns, some proponents of private equity argue that it is less risky than the public market. They suggest that even if the average private equity fund underperforms the public market, it could still outperform on a risk-adjusted basis. This argument has been supported by data showing that private equity funds have lower volatility compared to the public market.

However, skepticism remains around these reported returns. Critics argue that the valuations used by private equity funds are based on internal assessments, which may not reflect the true volatility of the companies they invest in. This practice has been dubbed "volatility laundering" by AQR’s Cliff Asness.

Resolving the Debate

A new study titled “When Private Funds Are Publicly Traded” aims to resolve this long-standing debate. Conducted by Daniel Rasmussen and Julia Grinstead, the research focuses on private-equity funds that are publicly listed. By comparing the net asset values calculated internally by these funds with their actual market prices, the researchers were able to assess the extent of volatility laundering.

The study analyzed 10 of the largest and most liquid private equity funds listed on the London Stock Exchange. While the internal valuations showed these funds to be 10% less volatile than the global public equity market, the actual market prices revealed a much higher level of volatility—on average, one-and-a-half times more than the public market. Even the least volatile of these funds was 25% more volatile than the public market.

Implications for Investors

The findings of this research indicate that volatility laundering is widespread and significant, reducing the actual volatility of typical private equity funds by 40%. This means that the perceived lower risk of private equity is largely an illusion, as the true volatility is much higher.

For most individual investors, the conclusion remains clear: the best strategy is to invest in low-cost broad-market index funds and hold them for the long term. This approach has consistently proven to be effective and reliable, without the complexities and risks associated with private equity.

Conclusion

The recent research from Verdad Advisers highlights the importance of critically evaluating investment strategies. While private equity may offer the promise of higher returns, the evidence suggests that it comes with hidden risks and potential misrepresentations. For the average investor, sticking to a diversified, low-cost index fund remains the most prudent choice.