Chapter 19
Private Equity
Ask for much but take what is offered.
—Russian proverb
Rising allocations by institutional investors to alternative asset classes such as private equity have sharpened interest in how returns and risks are measured relative to public equity benchmarks. This is especially true for public pension plans since private equity generates a clear opportunity cost as dollars are allocated away from public equity. Thus, whether private equity is a viable alternative to public equity will depend upon how private equity returns are measured, benchmarked, and adjusted for risk.
In this chapter, I evaluate various measures of return and risk for private equity investments, including public market equivalents (PME), PME alphas (unadjusted for risk), internal rates of return (IRRs), and the Long and Nickels alpha (which is an excess IRR measure). This is referred to officially as the index comparison method (ICM) at www.alignmentcapital.com. We also discuss generalized method of moments (GMM) alpha and beta estimates, using both a capital assets pricing model (CAPM) and the Fama-French three-factor model with bootstrapped standard errors as outlined in Driessen, Lin, and Phalippou (2008). I highlight two important findings: First, the various performance measures often tell wildly different stories about performance. In particular, users should be aware of the sensitivity of IRR estimates to the timing of cash flows and, in general, should adopt several performance ...
