Private equity and real estate are more correlated with their publicly traded counterparts than many investors would think. And the volatility differences aren't as great, either.
Investors have been trying to determine for some time if alternative investments in general — and private equity and real estate, in particular — are worth the lockup periods and high fees.
It begs the question researchers and investors are struggling to answer: Are alternatives worth it?
"The difference between listed and unlisted assets is not nearly as large as people in the industry would expect you to believe," said Alexander D. Beath, Toronto-based senior research analyst at CEM Benchmarking Inc., a global benchmarking company.
Without accounting for leverage, the average U.S. buyout fund generally has been shown to outperform the S&P 500 by about 2.5% to 3% per year over the life of the fund. But when calculations account for leverage, institutional investors' private equity returns from 1998 through 2016 were similar to the S&P 500, he said.
A substantial portion of the outperformance is attributable to leverage, he noted. The average buyout fund is levered with debt equal to two times equity, whereas the embedded leverage of S&P 500 portfolios including manager and underlying company debt is about 1.25 times equity invested, Mr. Beath said.
The delevered private equity return is about 4.89%, compared to 5.39% for large-cap equity during that same period, Mr. Beath explained.
The difference reflects private equity's higher cost of debt as well as manager skill, sector bias and geography bias, he said.
Private equity and public equity "continue to track along with one another," he added.
After adjusting for reporting lags, private equity was the most volatile asset class at 26.8%. The large volatility reflected both market risk — the standard deviation of average returns over a period of years — and idiosyncratic risk, the dispersion of returns among funds. Private equity's market risk, 20%, is similar to U.S. small-cap stocks at 19.4%, the CEM study shows.
There are few research papers on the correlation between private equity and public equity because private company information is not public, said Steven N. Kaplan, the Neubauer Family distinguished service professor of entrepreneurship and finance at the University of Chicago.
"It's hard to measure ... because it's not public information," Mr. Kaplan said. "People have tried and it's hard to do. You have to make a lot of assumptions."
It has been argued that private equity is less correlated than it used to be because there are more private companies and fewer public companies than ever before, he said.
This means that private equity can offer a diversification benefit, Mr. Kaplan said.
"With fewer public companies, private equity gives investors exposure that is not moving exactly like the S&P 500," Mr. Kaplan said.