Has Volatility Turned Pensions off Private Equity?

Academic papers published this week have shone light onto investor habits around the asset class.

(January 22, 2014) — Pension funds are investing far less in private equity than other institutions as evidence suggests volatility in the sector has been drastically underestimated.

Pension funds around the world, on average, had allocated just 5.64% of their portfolios to private equity by the end of 2012, London Business School’s Collier Institute said in a paper this week. Although this had risen from 4.5% in 2005, the amount was substantially lower than the 10% allocated by endowments and 18% from sovereign wealth funds, the authors said.

Within the pension sector, private funds allocated slightly more—5.33%—with some of the largest investors doubling their exposure between 2005 and 2012. Some 80% of smaller pensions and 60% of medium-sized investors reported using fund-of-fund vehicles to access the asset class.

Despite these relatively small allocations, investors’ larger capital pools have pushed private equity’s total assets from private pensions up by $240 billion and by $350 billion from public funds, the paper said.

However, further research has shown that investors of all stripes maybe underestimating the volatility private equity brings to their portfolios.

“The value of investments in listed companies is easy to measure. You just have to look at the share price,” said Ludovic Phalippou from Saïd 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.” 

A team of international academics came up with the formula: Andrew Ang, Bingxu Chen, both at Columbia University, and Will Goetzmann at Yale University, together with Oxford’s Phalippou.

Instead of focusing on measures such as volume, which is commonly used to assess property markets and other private equity assets, and subjective valuations, the team used only the actual cash flows paid and received by investors in different funds to estimate returns measured over time. They said their method should give a more accurate picture of the risks and returns of investing in private equities such as real estate, venture capital, buyout, and debt. 

“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%.”

This month, a paper by Harvard Business School doctorate candidate Kyle Welch, a former member of Stanford’s endowment team, said changes in international accounting standards had laid bare just how closely related public and private equity returns were.

Related content: Dispersing the ‘Diversification Illusion’ of Private Equity & Has Private Equity Evaluation Been Wrong From the Start?