Asset Allocation

CHAPTER 11The Private Equity Leverage Myth

FALLACY: PRIVATE EQUITY VOLATILITY SCALES WITH ITS LEVERAGE

The global private equity market has expanded rapidly in recent years as investors have sought to participate in the high returns that the asset class has delivered historically. Assets under management rose from $2.4 trillion in 2010 to an estimated $6.5 trillion in 2020.¹ Yet, investors who employ mean-variance analysis to form portfolios still struggle to identify the optimal allocation to private equity because they are unsure how to estimate its volatility.

It is widely understood that the observed standard deviation of private equity is artificially low due to the positive autocorrelation of its quarterly returns.² When returns are positively autocorrelated over shorter intervals, deviations accumulate more quickly than when returns are independent from one period to the next. As a result, the standard deviation over longer intervals is higher than what we would estimate by extrapolating the shorter-interval standard deviation.³ Put differently, volatility no longer scales with the square root of time in the presence of autocorrelation. This positive autocorrelation arises in privately held assets due to the way they are priced. Prices of listed securities are available continually when markets are in session, whereas secondary private asset transactions occur infrequently, if ever.⁴ Private equity investors therefore resort to quarterly appraisals to value their funds ...