Account for why investors choose to put money into private markets.
The idea
Investors accept the lock-ups, capital calls and opacity of private markets for three main reasons. First, an expected return premium over comparable public assets, usually called the illiquidity or complexity premium. Investors with long horizons and little need for cash are paid for tying money up. Second, access. Many companies, loans and real assets never trade publicly, so private markets widen the opportunity set, and skilled managers can add value through control, restructuring and operational work. Third, reported diversification. Smoothed, appraisal-based returns show low volatility and low correlation with listed assets. The usual mistake is to accept that third benefit at face value. Reported risk understates economic risk, so after unsmoothing the diversification and the Sharpe ratio shrink, and fees plus wide dispersion between managers eat into the premium. The exam point is that the premium must be judged net of fees and for the risk actually borne.
A practice question
Which of the following is the most commonly cited reason for an institutional investor to allocate to private markets?
- An expected return premium over public markets for bearing illiquidity, plus access to opportunities not available in listed markets - correct
- Frequent mark-to-market pricing that makes private asset risk easier to monitor than public asset riskWhy not: Confuses private markets with public ones: private valuations are appraisal-based and infrequent, not market-observed.
- Contractual protection of capital because the general partner guarantees the investors' commitmentsWhy not: Invents a capital guarantee; limited partners can lose their entire investment.
- Lower fees than comparable index funds, so more of the gross return reaches the investorWhy not: Reverses the fee comparison: private funds charge management fees and carried interest well above index funds.
Investors accept lock-ups and capital calls in exchange for an expected illiquidity or complexity premium and for access to private companies, loans and real assets. Fees are higher, valuations are less frequent and nothing is guaranteed.
A harder one
A fund of private equity buyouts earns a gross return of 13.0 percent a year. Management fees and carried interest reduce this by 3.2 percentage points. Public equity is expected to return 7.5 percent. The net expected premium of private equity over public equity is closest to:
- 5.5 percentWhy not: Compares the gross private return with public equity and ignores fees; investors earn the net return.
- 9.8 percentWhy not: Reports the net private return itself rather than subtracting the 7.5 percent public return to get the premium.
- 2.3 percent - correct
- 4.3 percentWhy not: Subtracts the fee drag from the public return (7.5 - 3.2) instead of from the private return.
Net private return = 13.0 - 3.2 = 9.8 percent. Premium over public equity = 9.8 - 7.5 = 2.3 percent. The premium must be judged after fees and is compensation for illiquidity and risk, not a free excess return.
The hardest tier
A portfolio holds 80 percent in public equity (volatility 16 percent) and 20 percent in private equity. Reported private equity volatility is 10 percent with a correlation of 0.30 to public equity. After unsmoothing, the analyst estimates true private equity volatility of 20 percent and correlation of 0.75. The portfolio volatility using the unsmoothed estimates is closest to:
- 16.0 percent - correct
- 13.54 percentWhy not: Uses the reported smoothed volatility and correlation; this is the flattering figure the unsmoothing is meant to correct.
- 14.5 percentWhy not: Corrects the volatility to 20 percent but keeps the reported correlation of 0.30, so half the correction is missing.
- 16.8 percentWhy not: Takes the weighted average of the two volatilities, which ignores diversification (correlation below 1) altogether.
Variance = (0.8x16)² + (0.2x20)² + 2x0.8x0.2x16x20x0.75 = 163.84 + 16 + 76.8 = 256.64, so volatility = 16.02 percent. Reported inputs give 13.5 percent, so smoothing understates the risk of the portfolio and exaggerates the diversification benefit.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Private Markets Investing (up to section 3.3.10)
- Outline the structures through which private assets can be held and contrast their features.
- Use and contrast the various ways of measuring private equity performance, outlining the strengths and weaknesses of each.
- Show how investors in private markets come to face different risks and judge how those risks can be measured.
- Characterise co-investing in private markets and weigh up its benefits and drawbacks.
- Explain what investors gain and what obstacles they meet when they reach private markets by way of a pooled vehicle like a private equity or private debt fund.