Private Equity and the Leverage Myth

21 Pages Posted: 20 Feb 2020

See all articles by Megan Czasonis

Megan Czasonis

State Street Corporate

William B. Kinlaw

State Street Global Markets

Mark Kritzman

Massachusetts Institute of Technology (MIT) - Sloan School of Management

David Turkington

State Street Associates

Date Written: February 11, 2020

Abstract

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

Czasonis, Megan and Kinlaw, William B. and Kritzman, Mark and Turkington, David, Private Equity and the Leverage Myth (February 11, 2020). MIT Sloan Research Paper No. 5912-20, Available at SSRN: https://ssrn.com/abstract=3540545 or http://dx.doi.org/10.2139/ssrn.3540545

Megan Czasonis

State Street Corporate ( email )

1 Lincoln Street
Boston, MA 02111
United States

William B. Kinlaw

State Street Global Markets ( email )

One Lincoln Street
Boston, MA 02111-2900
United States

Mark Kritzman (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

David Turkington

State Street Associates ( email )

United States

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