Well-heeled individual investors and institutions have flocked to private equity funds in the last few years. The reason is clearly performance driven, as the asset class is known for market-beating returns with less volatility than most equity indexes. But the superiority of PE seems to dim when one considers its so-called “lag beta.”
Here’s how it works. PE funds report returns quarterly, based on the value of their underlying portfolio companies. There is some leeway on how quarterly net asset values are calculated, and a good bit of evidence to suggest that reporting smoothing takes place (i.e., really good quarters are trimmed down, while bad quarters are a tad underreported).
Fortunately, there is a way to adjust for these biases. The results show that PE funds in aggregate are considerably more market-dependent than the numbers originally suggest.
Don’t get me wrong – I still think PE can be a great choice for many investors – but those big returns aren’t as alpha-centric as one might think.