Volatility laundering and private equity - A big potential problem

An ongoing issue with private equity is that these investments may have more volatility than suggested in the data. It is not the volatility by itself that is the problem but rather the likelihood that there will be more downside risk with these investments than suggested with the standard deviation estimates. With no mark-to-markets on a daily basis, and prices determined usually at year-end by a process not based on sales and purchases, it is not easy to say what these investments are worth. This illiquidity and lack of pricing transparency suggests that the return for private equity should be higher than those of similar public investments. Yet, sellers have not marketed the infrequent pricing as an advantage given the smoother prices versus public investments. This is not really a benefit.

Cliff Asness describes this private equity volatility issue as "laundered volatility", generating lower volatility than the true investment will lead to excessive allocation or a strong demand by investors who want to have a lower overall portfolio volatility. Investors love return-smoothing and really don't want to know how managers got it. 

If volatility applied to private equity is too low, then for a given expected returns versus other assets, an optimizer will generate significantly higher allocations than what would be expected from an unlaundered volatility. The volatility should be roughed-up or at least made more realistic.

The argument is that since these are long-term investments, there does not need to be daily pricing, yet there are other investments that are long-term and are public with daily pricing. Should we smooth the prices of any long-term investment? These pricing issues have major ramifications for portfolio construction and asset allocation. We should get this right. 

For more on this issue see: "Demystifying Illiquid Assets:

Expected Returns for Private Equity"