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Is private equity too good to be true? [video]

Discover why it's wise to avoid this type of asset class

It may seem very promising for investors, but how do returns compare with those of publicly quoted stocks?

Nicolas Rabener, Founder & CEO of FactorResearch, shares his thoughts on why investing in private equity rather than public markets may result in higher market volatility...

RP: One of the most talked about asset classes in recent years has been private equity.

It’s traditionally seen as an asset class for institutional investors. But individual investors increasingly have access to it as well.

One of the reasons investors like private equity is that they’re keen to avoid too much exposure to public equity markets.

NR: You had the implosion of the tech bubble in 2001, you had the global financial crisis in 2008, and you had the COVID-19 crisis in 2020. So, from an investor perspective it’s great if you have an asset class that does look different to equities, and that explains the interest in private equity, and why you’ve seen so many inflows in the last few years.

RP: So, private equity has become very popular. But how do returns compare with those of publicly quoted stocks?

NR: It is worth highlighting that in general it’s difficult to compare the returns of private asset classes, like real estate and private equity, and public market returns, because they are being calculated differently.

Now there are some data providers, one is Cambridge Associates Investment Consultancy that does provide effectively private market returns that you can compare with public market returns, and they give you 20 or 30 years of data.

Now what you do see is that private equity historically has achieved much higher returns than public markets. And it used to be about 400 basis points per year, which is actually quite attractive in terms of getting an additional return from an asset class. Having said that, over the last four or five years, that additional excess return has continued to shrink, and over the last few years has been almost zero. And that naturally does make you question why investors do allocate to an asset class that effectively returns the same as public markets but does require you to lock up capital for seven to ten years, and charges high management fees.

RP: One of the attractions of private equity is that it appears to be less volatile than the stock market.

But, says Nicolas Rabener, it’s largely an illusion.

NR: So effectively if you look at public markets they tend to be very volatile, from quarter to quarter, day to day, month to month. That does not get reflected in private equity, because valuations are on a quarterly basis, and they tend to be smoothened simply because the valuers don’t like to change valuations too dramatically, because they look like fools, simply said.

So effectively, private equity does seem to be lower from a volatility perspective on paper. Having said that, there’s no reason why you shouldn’t be using public market multiples to value private equity companies on a daily basis. And researchers have done that, and that shows if you do look at private equity companies exactly like you look at public companies, then the volatility is actually higher than of stock markets.

RP: So, however appealing it may seem, investors are probably wise to avoid this asset class altogether.

The private equity industry can be very persuasive, but the benefits are just good to be true.

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