Private Capital: Expected Return and Risk, Asset Allocation

Abstract

Preqin and Pitchbook data are classified and analyzed to derive a coherent set of risk-return assumptions to combine with Listed liquid assets in a traditional mean-variance framework. We find expected returns of 11%-12% for PE and 8% for PD, PC detailed per subclass. Risk is decomposed in Class CoVariance, applicable from five positions upwards, and Single-fund CoVariance. Class CoVar is mainly derived from timeseries, Single from vintage data. PE Class CoVar is comparable to that of listed equity types found in market assumptions published by asset managers. Single CoVar is comparable to that of stocks. A scaling method derives Single correlations from Class. Return expectations are split into an interest rate part and a spread part to do long-term (30-year) cashflow simulations in an LDI-context, with focus on Funding, USD or EUR, Diversification, Class or Single, Sep2022 or low interest rates Sep2021. Adding PE and PD reduces LDI-risk very much and delivers substantially higher returns across all reasonable probabilities, as shown both by LDI-measures we propose as by traditional asset-only measures like IRR that increases by 5% when a large part of a 60%equity-40%bond portfolio is replaced by PE-PD. Commitment and illiquidity handling by NAV-pattern functions is described. Adding PC renders portfolios less risky in a long-term LDI-context. Accounting-wise they also reduce short term P&L volatility. Long-term LDI-investors should endeavor to increase PC insofar liquidity and other constraints allow.

To derive the PC Class-Single Covar framework an extensive mapping of return-risk for listed equity is provided that covers single stocks, portfolios, indices and PC-funds simulated with listed stocks. This reveals that, due to the lognormal distribution of stock returns for the volatilities of single stocks and PC-funds the PC-investment method can cause a return pickup of 5% what could partly explain the high PE returns. This also shows how by random selection of stocks their market indices can be outperformed. This needs follow-up research.

Keywords: Investing, Private Capital, Private Equity, Private Debt, Real Estate, Infrastructure, Venture Capital, LDI, ALM, Asset Management, Asset Allocation, Risk Management, Capital Management, Risk Appetite, Expected Return, Risk, Insurance, Pension Funds

JEL Classification: G11, G12, G22, G23, G31, G32