Reframing private-equity risk: a fundamentals-based perspective

For asset allocators, volatility assumptions are critical to decisions about risk budgets and position sizing. When it comes to sizing private equity allocations, a debate has emerged in recent years about how best to measure that volatility. But we think the argument too often boils down to an unnecessary binary of sorts, focusing on extreme options and overlooking the realities of private company dynamics.

The starting point for the debate is the common view that periodic, appraisal-based private equity valuations suppress measured volatility, so industry series should not be used directly in portfolio construction or risk management. This “volatility laundering” critique is fueled by the gap between reported private-equity manager volatility and public-market volatility — a gap of 700+ bps over the last 20 years (Figure 1). In need of a volatility substitute, allocators often turn to public-equity volatility as a yardstick for “company risk” and try to unsmooth private returns to match it.

Figure 1

As we discuss in this paper, this debate needs to be reframed, distinguishing between underlying company fundamentals, public-market prices, and private appraisal-based marks. We agree with many in the industry that anchoring to reported private volatility alone risks understating company risk as well as liquidity and drawdown risk. On the other hand, anchoring mechanically to public-market volatility can result in overstating company risk by importing short-horizon repricing that may not track underlying business fundamentals (e.g., repricing driven by macro shocks). We believe that an SAA framework is meant to capture long-term risk and portfolio outcomes, and that fully unsmoothing private-equity performance violates this premise by artificially adding short-term public-market dynamics that, by definition, do not exist in private markets.

We think the solution is a third option: fundamental volatility, derived from a fundamentals-based estimate of public-company value (intrinsic value), which should be more representative of actual company performance and long-term value. In the following pages, we share the research behind this approach and discuss the portfolio implications. Importantly, we are not trying to produce a single “correct” private-market volatility metric or a new strategic asset allocation input for volatility-based optimizations. Our aim is narrower: to separate business-value volatility from market-price volatility so private-equity risk can be framed more coherently in a role-based, total portfolio approach to asset allocation and risk management.

To read more, please download the full paper below.