Have US Buyout Funds Delivered on a Risk-Adjusted Basis?
Key findings
- Comparing the risk-adjusted performance of private and public assets is crucial for informed asset-allocation decisions.
- Examined with three distinct methodologies, the Sharpe ratio of U.S. buyout funds, calculated over 10-year rolling windows from 2012 to 2023, averaged from 0.46 to 0.49 and exhibited a moderate-to-high correlation with the Sharpe ratio of small-cap stocks.
- Despite delivering higher returns, U.S. buyout’s Sharpe ratio outperformed U.S. small caps only in the last decade.
Many investors believe that private equity can yield higher returns than public equity. This belief is not unfounded, as private equity has indeed shown superior performance compared to public equity. From 2014 to 2023, the MSCI U.S. Buyout Closed-End Fund Index (Unfrozen; USD) delivered an annualized time-weighted rate of return of 15.8%, while the MSCI USA Investable Market Index returned 11.0%. Discussing performance without considering risk does not provide a complete picture for informed asset-allocation decisions, however. Equating private- and public-asset performance after risk adjustment poses a significant challenge due to the absence of a standard approach to measure the realized risk of private assets. Overcoming the challenge, we found that U.S. buyout funds had delivered a higher Sharpe ratio[1] than U.S. small caps in the past decade, but a similar Sharpe ratio over a longer period.
Three approaches for measuring risk
We used one approach based on company fundamentals and two time-series approaches to measure the realized risk of U.S. buyout and then compute the corresponding Sharpe ratio. The first approach, a model-free approach, considers leverage as the main driver for the risk difference between U.S. buyout funds and public equity. This leverage-adjusted approach calculates U.S. buyout's realized risk based on the realized volatility of U.S. small-cap equity, scaled by the relative leverage of U.S. buyout's portfolio companies to U.S. small-cap companies.[2]
The second method, known as the long-horizon-return approach, measures the realized risk of U.S. buyout using four-year-horizon log returns.[3] Private-asset quarterly valuations are smoothed; hence using the standard deviation of quarterly valuation-based returns understates the risk of private assets. Measuring risk from long-horizon valuation-based returns, which tend to converge to true returns, can mitigate the problem.
The third approach, the beta-adjusted approach, estimates the realized risk based on U.S. buyout funds' beta and pure private risk. Under this approach, the risk of U.S. buyout's returns is assumed to be driven by its exposure to the public-equity risk and pure private risk. The latter, unique to private assets, captures uncertainties in the illiquidity premium, investor sentiment in fundraising, and dynamics in the exit market. Both beta and the realized pure private risk are estimated from ordinary-least-squares regressions.[4]
Three versions of the Sharpe ratio are computed as the ratio of U.S. buyout's returns to its realized risk estimate based on leverage, long-horizon returns and beta. Since investors typically hold private assets over a long horizon, we compute the Sharpe ratio with returns and risk over a trailing 10-year period at the end of each quarter from 2014 to 2023. The exhibit below shows the results.
Correlation among versions of the Sharpe ratio
There are three noteworthy observations. First, when comparing the Sharpe ratios of U.S. buyout funds under the three methods, a remarkably similar pattern emerges. The Sharpe ratio of U.S. buyout was in the range of 0.25 to 0.5 prior to 2018 and has stayed at an elevated level since then.[5] Although estimated with different methodologies, all three versions of the Sharpe ratio experienced a deterioration during the COVID-19 pandemic and have been trending down since 2022. Second, the Sharpe ratio of U.S. buyout and the MSCI USA Small Cap Index demonstrated a moderate-to-high correlation. The average correlation from all three versions is 67%. Third, although displaying big discrepancies from time to time, U.S. buyout and small caps have delivered similar average risk-adjusted performance over the entire sample period. The average 10-year Sharpe ratio of U.S. buyout ranges from 0.46 to 0.49 across three approaches, while the average Sharpe ratio of U.S. small caps is 0.49.
US buyout funds' rolling 10-year Sharpe ratio
Performance over different horizons
Providing insights on performance over different horizons, the exhibit below shows the performance of U.S. buyout and the MSCI USA Small Cap Index before and after risk adjustment over the past eight to 16 years. Before risk adjustment, U.S. buyout has consistently outperformed small caps in all horizons, by as much as 4% annually. After risk adjustment, however, the performance rank of U.S. buyout and small caps varies depending on the lookback period.[6] The outperformance of U.S. buyout is mainly present in the last 10 years. The conclusion holds regardless of whether U.S. Sharpe ratio is leverage- or beta-based.
Performance of US buyout funds and small caps by horizon
U.S. buyout has yielded higher returns than small-cap stocks prior to risk adjustment over various periods ranging from eight to 16 years, ending in December 2023. After accounting for realized risk, U.S. buyout's performance surpassed that of small caps only over the past decade.
Understanding the Sharpe ratio of private assets allows investors to make informed asset-allocation decisions in several ways. Investors can decide whether to invest in private assets based on their risk tolerance and return expectations. When determining the target allocation between private and public assets, investors can also evaluate private and public assets on the same footing. In addition, knowing the similarity in the risk-adjusted performance of private and public equity, investors can fairly evaluate the diversification effect from investing in private assets. Ultimately, this comprehensive understanding helps investors optimize their portfolios for superior risk-adjusted returns, ensuring they are well-positioned to achieve their financial goals.
1 The Sharpe ratio is defined as the ratio of realized asset returns in excess of risk-free rates to the realized volatility of the returns.2 Fund leverage is not included in the relative leverage. Since fund borrowing is much less than the borrowing of the portfolio companies, its inclusion is not expected to change the conclusion. Leverage is defined as the ratio of total enterprise value over the value of equity. Relative leverage is the ratio of the average leverage of U.S. buyout funds' portfolio companies over the average leverage of the public-company constituents in the MSCI USA Small Cap Index. Realized risk of U.S. buyout is computed as the realized risk of MSCI USA Small Cap Index times the average relative leverage over the trailing four quarters.3 We studied the statistical properties of volatilities of log returns using simulations. We found that the annualized volatility of log returns increases with return horizon due to return smoothness, but stabilizes when the return horizon goes beyond four years. However, the standard deviation of long-horizon log returns may still understate true risk by as much as 30-40%, depending on the sample size. When computing the realized risk from log returns, we correct the underestimation bias, which is quantified from simulations.4 We assume that the annual returns of U.S. buyout follow an autoregressive process with one lag (AR(1)). To avoid the distortion of the estimates from return smoothness, U.S. buyout funds' annual returns are regressed on their lagged annual returns and the contemporaneous MSCI USA Small Cap Index returns. U.S. buyout's beta is computed from the regression coefficient on the MSCI USA Small Cap Index, adjusted for the smoothing effect. Realized pure private risk is computed from the regression residual volatility, adjusted for the smoothing effect.5 The rise in the Sharpe ratio of U.S. buyout after 2018 was primarily driven by the decrease in realized volatility.6 Since at most 16 years of data is used in this analysis, it is unfeasible to estimate U.S. buyout funds' risk using long-horizon log returns. Hence, only the leveraged- and beta-based Sharpe ratios are shown in the second exhibit.
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