A Fair Comparison Framework: Risk and Reward in Private & Public Investments

Abstract

How does an asset with a higher expected return but higher risk compare to an asset with a lower expected return but lower risk? A natural answer is to rank them based on their risk-adjusted returns. But what if the expected return and risk are not estimated reliably? This is the challenge of investing in private markets and comparing their performance with public markets. We offer a framework to fairly compare private and public investment performance.

We present a methodology to reliably estimate the expected return and risk of private assets using the notion of a self-contained, self-financed portfolio. Our estimates are intuitive as they are based on terminal wealth outcomes (rather than a time-series analysis) resulting from investing in private markets. Using these estimates, we compare a variety of investments including PE funds, private debt, public equity and bond indices. Our comparison also accounts for the limits and cost of leverage, when applicable.

We find that terminal wealth-based means and volatilities of private investment returns are significantly different from those computed using traditional time-series return observations. We show that the ranks of various investments based on levered returns (with interest, fees, expenses and manager alpha) can be potentially different from those based on unlevered returns. Importantly, levered returns in mezzanine investments are competitive with buyout investments and that investment in long public market Baa-corporate bonds are, when levered to match risk, competitive with private market investments.