Saïd Business School study reveals a greater degree of volatility in private equity than previously thought

MUMBAI: A new methodology for estimating private equity returns has taken the guesswork out of analysing the ebb and flow of performance in this asset class, and suggests that these markets may be more volatile than was previously assumed. This could have a major impact on the decisions made by institutional investors such as, pension funds, endowments, colleges and foundations.

"The value of investments in listed companies is easy to measure. You just have to look at the share price," said Ludovic Phalippou from Said Business School, University of Oxford, one of the academics involved in the project. "But valuing private equities has always been more a matter of opinion, little more sophisticated than dinner party discussions about what people's own houses are worth. Our methodology should change that."

The methodology, developed by an international team of academics (Andrew Ang, Bingxu Chen, both at Columbia University, and Will Goetzmann at Yale University, together with Oxford's Phalippou) has been designed to give investors and commentators a more accurate picture of the risks and returns of investing in private equities such as real estate, venture capital, buyout and debt. Instead of focusing on measures such as volume (commonly used to assess property markets and other private equity assets), and subjective valuations (commonly used in venture capital and buyout), Phalippou and the team have used only the actual cash flows paid and received by investors in different funds to estimate returns measured over time.

The result was an index demonstrating the dynamics of private equity between 1993 and 2011, which allowed the researchers to test theories about the cyclical nature of private equity returns.

"We found that the cycles shown in our index made sense when compared with commentary about the markets at the time," said Phalippou. "However, they also revealed a greater degree of volatility within the overall cycle than standard industry indexes. For example, the volatility of our cash flow-based return time series for buyout funds is 25% per annum compared to 11% for the Cambridge Associates buyout index. Similarly, the NCREIF real estate index has a volatility of only 5%, while our estimated volatility of private real estate funds is 19%."

Phalippou argues that the index shows that, over time, private equity investments do outperform a size-weighted index of listed companies. However, compared with the average listed company, and/or correcting for risk, "Returns are at par at best."

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