Demystifying Illiquid Assets: Expected Returns for Private Equity
January 31, 2019
Topics - Alternative Investing Asset Allocation
The growing interest in private equity means that allocators must carefully evaluate its risk and return. The challenge is that modeling private equity is not straightforward due to a lack of good quality data and artificially smooth returns. We try to demystify the subject, considering theoretical arguments, historical average returns, and forward-looking analysis. For institutional investors trying to calibrate their asset allocation decisions for private equity, we lay out a framework for expected returns, albeit one hampered by data limitations, that is based on a discounted cashflow framework similar to what we use for public stocks and bonds.
In particular, we attempt to assess private equity’s realized and estimated expected return edges over lower-cost public equity
counterparts. Our estimates display a decreasing trend over time, which does not seem to have slowed the institutional demand for private equity. We conjecture that this is due to investors’ preference for the return-smoothing properties of illiquid assets in general.
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