Why Does Private Equity Get to Play Make-Believe With Prices?

Investors and managers are playing a dangerous game of “volatility laundering,” Cliff Asness writes.

Illustration by II

Illustration by II

If you wanted to come up with the one-liner about investing most likely to make my head explode, you might try, “The way to choose investments is to just jump on whatever’s done the best over the past three to five years.” Or, getting more creative: “Hey, did you know Cathie Wood is still getting inflows?” Yet more creative: “The war in Ukraine was caused by stock buybacks.” But you couldn’t do much better than “Interim valuations don’t really matter,” as Christopher Schelling says in reference to private equity investing. If exploding my cranium was the goal, then well played, sir. Otherwise, oh, hell no.

Although not alone, I have, IMHO, become one of the chief gadflies of the PE industry. But I’m a selective gadfly. I’m certainly not negative on the whole idea of private investing. Some companies aren’t ready to be public (I’m lumping in venture now). Some need active outside restructuring expertise. Some are just being misvalued by the public markets (more on this later). Private investing serves a vital economic purpose. Furthermore, though to what degree and how much the premium has diminished over time can be debated, there’s little doubt PE has been a historical success (of course, adjusting for factor risk, there are still some cynics). And I live in Greenwich, Connecticut, where the slightly modified cliché that “some of my best friends are PE managers” is literally true — and these men and women know more about how actual companies work than I could ever dream.

My criticism has been narrowly focused on PE’s lack of mark-to-market valuations and some of the implications this brings. The illiquidity and nonmarking were once implicitly acknowledged, appropriately, as a bug, but are now clearly sold as a feature. The problem is logically you get paid extra expected return for accepting a bug (possibly explaining some of PE’s historical success), but you pay by giving up expected return for being granted a feature. This is a potential problem going forward.

Let me sum up Schelling’s entire argument: It’s okay not to mark things to market — it’s even preferred — as the market is grossly inefficient, with prices that are often wildly wrong, and thus just using PE managers’ own marks is, doggone it, better for everyone.

Schelling and I actually agree on a lot here. I was never a pure efficient marketer, even in the 1980s when I was Gene Fama’s Ph.D. student (my dissertation on the success of price momentum was a hint!). Living through the tech bubble, the global financial crisis, and the insane trouncing of value stocks from 2018 to 2020 led me to drift even further away from pure market efficiency. I still think markets are the best way for society to allocate capital, but that’s as much about how bad nonmarket alternatives are. So although the issues are complex, I am quite sympathetic to the feeling that sometimes market prices are pretty far away from what’s really justified.

Of course, in the public markets we don’t get to not tell our investors the current market valuations of our investments just because we think the markets are wrong. In early 2000 (i.e., the tech bubble peak), after losing a ton on long-short value investing, we didn’t tell our clients, “Your money is all still there; it’s just in a bank we call ‘short the Nasdaq.’” No, we told them, “We’re down X percent, and here’s why we expect to make back more than X percent when you need it most.” (Narrator: “They did.”) Yes, I argued this because I thought market prices were wrong. But I didn’t get to play make-believe.

So why does PE get to? Though some will plead the opposite, it’s not that hard to adjust even private marks in line with the market. If you’re levered long equities (and yep, PE’s “low-risk and low-beta” investments are often levered long) and equities fall by 25 percent, you probably dropped at least that. Perfect estimates are not the point, and shouldn’t be the enemy of good estimates (for instance, some argue private equity betas are near 1.0 even with leverage, but nobody serious argues they are near zero). Sure, sometimes it’s more complicated. But remember, PE managers are among the world’s foremost experts in company valuation. You wouldn’t think the question “Approximately what would we get if we sold in today’s market?” would be particularly tricky for them. That is, of course, if they actually wanted to tell you the answer and if you actually wanted to hear it. It does take two to do the nonmarking tango.

Many retort, “But doesn’t the illiquidity leave investors better off long-term, as they act more rationally?” Sure, maybe, sometimes . . . well, actually, it depends. It certainly induces some behavior we advocate in the public markets, such as taking a true long-term perspective. But a few problems emerge.

First, if investors increasingly value the “PE is easier to stick with as the prices don’t move so much” feature, they’ll invest more and more in PE (sound familiar?), and, as with any asset class or strategy, this can lower future expected returns. Anecdotally (i.e., like you might hear if you got a PE manager a little tipsy on Greenwich Avenue), this is going on through private deal valuations that are higher than they used to be because there are more bidders for the same deal, credit is less investor-friendly than previously (I believe “covenant light” is the term), etc. Maybe this ain’t David Swensen’s PE market anymore.

Unlike Swensen’s PE market, which was primarily about earning extra return, today’s PE market is now seemingly as much about not having to report market prices. That kind of investment should return less over the long term than the appropriate levered public equity benchmark (and I haven’t even gone into the fees on fees on fees). Admittedly, this is educated conjecture. The net of the above could be a smaller return premium for private versus public equity, as opposed to a deficit. But I do stand by my conjecture, and though the magnitude is impossible to be precise about, it’s difficult to imagine the drop-off is not directionally right and nontrivial.

Second, it’s dangerous to understate risk. Many investors use PE to up their overall equity allocations while avoiding the occasional short-term excruciation that accompanies public equity market investing. The only way this increased risk can be justified without simply announcing, “We’re taking it up a notch” is to assume that this ever-growing PE allocation is relatively low-volatility and low-correlation. You can find many examples of these assumptions — people like to tweet them at me! — though whereas some managers are certainly honest or smart enough to avoid them, others lean in, shamelessly bragging that the assets they don’t mark to market outperform in a bear market. Some have taken to calling the understatement of PE risk “volatility laundering.” Okay, that’s mainly me, but it’s catching on, and volatility as a risk measure more generally gets a bad rap from those who erroneously think it means “short-term fluctuation that you definitely get back and shouldn’t worry about.”

Those understated risk assumptions likely become a problem only in a real extended bear market — not a one-to-three-year bear like we’ve occasionally seen in the past few decades, nor, certainly, a super short crash and rebound like the one in spring 2020. PE can ride those out using its patented ostrich technique (though the GFC was starting to get scary). But say we get an ugly ten-to-20-year bear market, not just “end to end” (like 2000–2009, which started out at a bubble peak and ended in a bear market trough, even though both ugly periods were only two-to-three-year affairs). This hasn’t happened in the U.S. in a long time but is well within the realm of possibility. If and when that happens, your starting assumptions of high-single-digit volatility and low correlation to public equity markets for your private, levered equity portfolio will not save you. And what is risk management about if it is not concerned with this low-probability but extreme long-term wealth-destroying outcome?

Third, doesn’t admitting what you’re doing break the spell? Once you say out loud, “We know the prices move, but it’s useful to fool ourselves,” doesn’t the fooling yourself part stop working? Well, apparently not! Once you, the investor, admit to yourself, “This may be levered equity exposure likely offering less versus public markets than in the past, but I’m doing it this private way so I can stick with it long-term,” why on earth can’t you be long-term in public markets? Asking for a friend :-). Okay, I do admit part of my motivation here is professional jealousy. For reasons that obviously escape me, many investors can’t be as long-term in public markets as in private ones, and we in the public markets actually have to live with day-to-day market reality. Heck, I was so jealous I once even took my own shot at marketing a private investment fund. It didn’t catch on.

But seriously, run the thought experiment where PE managers actually told investors their best guess of what the portfolio could be sold for (not in a panic sale) today. If they did this but still delivered market-beating returns, would all their investors flee? Would the appeal be gone? If so, isn’t that telling? Now run it backward. If a liquid strategy that had a healthy positive long-term expected return was able to report its returns like PE, would the appeal go way up?

It’s hard to avoid the idea that my confusion over “Why be long-term only in privates?” is resolved by noting a principal–agent problem where the PE managers get paid a ton so intermediaries can then report unrealistically rosy assumptions and unrealistically calm returns. The chickens come home to roost only if long-term returns no longer beat public markets (i.e., no bear market needed here, just a reversal of the historical illiquidity premium) or, even scarier, a real long-term bear hits and the portfolio’s risk was seriously underestimated. But both parties involved, principal and agent, may be assuming that in ten-plus years that’ll be someone else’s problem. With this bare-knuckles truth-telling, I’m running a real risk of upsetting my clients, many of which have healthy PE allocations. But I am truly trying to help, and, as usual, I will let the chips fall where they may. Truth be told, it’s whoever the agents report to who really need to improve here (i.e., understanding that asset prices actually move and not needing to be fed imaginary unchanging numbers) — not the agents themselves, who are just responding to incentives.

Of course, I’m certainly not alone in my worries. For instance, a survey of top academics agrees PE is understating its volatility, and some rather obscure yet somewhat successful active stock pickers seem to agree too.

So basically, Schelling is right about one important thing. Markets aren’t perfectly efficient, and sometimes they’re grossly inefficient. We both heartily endorse leaning against this in your portfolio while taking a truly long-term perspective, as inefficiencies can be a hard thing to fight short-term. Where we differ: I don’t endorse (1) doing so by making up prices and returns you think are more metaphysically accurate than the market’s current prices; (2) quite possibly today, unlike in the past, accepting a lower expected return on privates versus truly comparable public markets for this volatility-smoothing “feature”; and (3) seriously understating the true long-term risks to client portfolios if a real long-term bear market hits. I do endorse valuing your portfolio at where you think you could sell it today in a reasonably orderly fashion — and if you think that’s too low, making that case to your investors, as the rest of us have to do in the real world.

Given the massive popularity of private investing today, it may very well be true that, as a great man once almost said, “Never have so many paid so much to so few for the privilege of being told so little.”

Cliff Asness is the co-founder of AQR Capital Management.