Private Equity and the Leverage Myth
Posted: 20 Feb 2020
Date Written: February 11, 2020
Investors have traditionally relied on mean-variance analysis to determine a portfolio’s optimal asset mix, but they have struggled to incorporate private equity into this framework because they do not know how to estimate its risk. The observed volatility of private equity returns is unrealistically low because the recorded returns of private equity are based on appraised values, which are serially linked to each other. These linked appraisals, therefore, significantly dampen the observed volatility. As an alternative to observed volatility some investors have argued that private equity volatility should be estimated as leveraged public equity volatility, because private equity companies are more highly levered than publicly traded companies. However, this approach yields unrealistically high values for private equity volatility, which invites the following question. Why isn’t the appropriately leveraged volatility of public companies a reasonable approximation of private equity volatility? This paper offers an answer to this puzzle.
Keywords: Fundamental risk, Leverage multiple, Leverage myth, Mean-variance analysis
JEL Classification: C1, C10, C15, C18, G10, G11, G32
Suggested Citation: Suggested Citation