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
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.