Performance Measurement and Appraisal of Private Equity Investments Relative to Public Equity Markets

Abstract

In this paper we investigate the risk return relationship of Private Equity (PE) relative to Public Market Equity (PM) investments to assess the adequateness of PE’s return premium. We analyze cash flows of PE projects gross of fees and any other externalities. Our analysis is based on simulated PM investments, mimicking the cash flow patterns of the PE investments. The comparison of alternative cash flow based performance measures reveals a substantial impact of the reinvestment hypothesis. Prior to any risk adjustment, PE investments outperform their PM counterparts with varying levels depending on the chosen benchmark (broad, industry specific, local). Next we compare standard risk measures and find downside deviation and shortfall to better describe the characteristics of not normally distributed PE investment returns than standard deviation. Thus, it is not surprising to observe substantially higher Sharpe Ratios for PM relative to PE investments. We adjust the Sharpe Ratio measuring risk in terms of downside deviation and still observe underperformance of PE relative to PM investments, with very heterogeneous results regarding industry, stage and size of the investments. Last we introduce Omega as alternative risk adjusted performance measure, because its risk definition better suits the characteristics of PE investments. For our PE sample we observe adequate excess returns over public stock markets given the higher shortfall risk. Our findings question the existence of an illiquidity puzzle on the fund level. Overall PE returns are highly skewed and very heterogeneous. We find later stage to be more attractive than early stage investments due to higher risk adjusted returns. As the PE investment universe is on average of poor quality compared to public equity markets, investment selection ability is of crucial importance.