Does private equity beat the market?

(MoneyWatch) Private equity has become more popular as an asset class, thanks largely to significant investments from America's pension funds and endowments. However, such investors are best suited to hold these illiquid investments. As for individual investors, who typically need more liquidity in their portfolios, recent research shows that they would be better served staying away.

The Journal of Finance study "Private Equity Performance and Liquidity Risk" aimed to put a price on the liquidity risk in private equity. After all, the less liquid an investment is, the higher the risk premium that needs to be offered to investors for them to invest. The authors found that private equity funds have significant exposure to liquidity risk, as well as market risk (the risk of investing in stocks) and the risks of value stocks. After accounting for these risks, the authors found no special outperformance. In other words, the returns to private equity are well explained by their exposure to the overall risk of the stock market, the risks of value stocks and the risks of investing in less liquid securities.

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In addition, the authors noted that private equity's considerable exposure to liquidity risk exceeded the liquidity risk for the large majority (86 percent) of traded stocks. The authors noted: "These results suggest that private equity is significantly exposed to the same liquidity risk factor as public equity and other asset classes." They then add: "The diversification gains that can originate from private equity may thus be lower than previously thought given the exposure to liquidity risk."

The following are some of their other interesting findings:

• The liquidity risk premium is large, about 3 percent annually.
• There was little difference across countries/regions and across time.
• If you bought all the investments used in the sample, you would have earned 19 percent annually. However, those returns would have been reduced 4 percent due to the carried interest payable with such a return and 3 percent for management fees on invested capital.

In summary, there doesn't appear to be anything special about private equity. You also have to consider PE's other negatives, such as high fees, lack of transparency, daily pricing and the inability to harvest losses. And there doesn't appear to be significant, if any, diversification benefits, one of the explanations used to justify investment. The returns are largely explained as compensation for the different risk factors to which these investments are exposed, with liquidity risk being an important source of the risk premium. This paper also contributes to the recent literature showing the pervasiveness of liquidity as a priced risk across asset classes.

Image courtesy of Flickr user tristanf.