Private equity does not diversify portfolios

(Bloomberg Opinion) — Low interest rates can lead people to justify all sorts of bad ideas: investing in companies that will never make a profit, debt-funded stock buybacks, just to name a few. funding, billions of dollars spent on terrible streaming content, etc. But perhaps the most irrational belief promoted by the low interest rate environment is the notion that private equity provides diversification for investment portfolios.

Of course, this is possible, especially if your portfolio doesn’t include many publicly traded stocks to begin with. But even so, there are cheaper and more efficient ways to diversify.

Private equity as an asset class has grown significantly over the past decade, more than quadrupling to approximately $7.6 trillion. While there are many explanations for its growth, such as public pensions chasing yield or a decline in publicly listed companies, a common justification is that it provides diversification to investors’ portfolios. Thing. And it is considered so because it is a so-called alternative asset.

The purpose of diversification is to reduce risk. For example, if he had invested all his money in Apple in the 1980s, he would have made more money than if he had invested in the S&P 500. But it would have been a much riskier investment, as Apple could have failed. Diversification doesn’t just mean a large number of stocks, it can also mean a large number of asset classes, such as commodities, bonds, and more recently, alternatives such as private equity. With the right mix of assets, you can theoretically achieve the perfect risk-reward balance: maximum profit with minimum risk.

However, at some point, adding more assets does not change the risk/return calculation. In fact, new assets may even increase your risk, depending on how they correlate with the rest of your portfolio. This is common in private equity, depending on the type of fund. Private equity often just adds leverage to a portfolio without much diversification. This increases expected returns but does not reduce risk.

Private equity funds include investments in venture capital, real estate, infrastructure, and more recently, private debt. If these funds include investments not found on the public market, they may provide diversification benefits. But in many cases, “private equity” funds are simply buyout funds, and they accounted for 28% of the market in 2022, as measured by assets under management. These funds raise money from investors, take on debt (using leverage), and purchase significant stakes in companies. That is, taking a public company private or acquiring an existing private company.

From a risk perspective, this is in many ways no different than buying shares in a publicly traded company. Measuring private equity returns and comparing them to public market returns is not an easy task. Private investments are illiquid and have no objective market returns. Funds report internal rates of return, but they are easily manipulated and are not updated very often. Nevertheless, returns are highly correlated with public market returns.

When economists consider the actual cash flows from private equity funds, the market beta (correlation between private equity and public markets) for leveraged buyout funds is between 1 and 1.3, which means that the This suggests little diversification value. Private equity does offer high returns, but that’s due to leverage and the managers’ stock selection. A 2020 research paper shows that investing in value stocks with leverage can yield similar returns and risk profiles, with more liquidity and much lower fees. The paper acknowledges that private equity fund managers may be skilled at selecting assets, but also notes that their strategies can be “easily and cheaply imitated.” There is.

So why would someone want to invest in a private equity fund? Perhaps they want more risk and illiquidity, and are willing to pay fees for it. And from a larger economic perspective, private equity can play an important role in increasing the efficiency of some of the companies in which it invests. (This has been less true over the past decade, however, as the industry has grown and more low-quality funds have sought yield.) Still, even in the best cases for private equity investing, It cannot claim to provide greater variance. and Higher returns.

In the market, as in the rest of life, reality eventually catches up with us. Interest rates are now rising, leverage is more expensive, and the pursuit of higher yields is less enthusiastic. The private equity industry is already showing signs of shrinking. We hope the same goes for the belief that leveraged buyouts reduce portfolio risk.

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To contact the author of this story:
Alison Schrager [email protected]