Private equity: is illiquidity more valuable?

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Private equity may make investors' balance sheets look better in the short term, but it does not reduce the real investment risk in underlying assets.Investors should fully understand their investment characteristics and risks before entering the market.

In the year just ended, total global private equity (PE) investment reached $478 billion, up 3.9 percent from $460 billion in 2018 and the highest since 2007.

Some big pension funds have publicly said they want to increase their allocations to private equity.In an interview with the financial times, meng yu, chief investment officer of Calpers, the largest us public pension fund with $372.6 billion in assets under management by the end of 2019, said he planned to increase the fund's private equity allocation to more than 10 percent from 7 percent now.

There are several reasons behind pension funds' decision to increase their allocation to private equity.One of the main reasons is the pressure of return on investment.After the 2008 financial crisis, the central Banks of the world's major developed countries cut their benchmark interest rates sharply, and they remain at a low level to this day.Some European countries have even had negative interest rates.This situation poses a new challenge to national pension funds.To cope with future pension liabilities, some pension funds have had to increase their appetite for risk, raising their return expectations by increasing their equity-based investments and reducing their fixed-income investments.

In explaining his investment decision, Mr. Meng cited the benefits of investing in private equity.The following paragraph is worth analyzing:

In the primary market, because private equity does not trade in the secondary market, these assets are valued less frequently.Its valuation is based on financial models, not transaction prices, with a time lag.Therefore, investing in private equity can reduce the investment risk from two aspects: first, alpha can be reduced through diversification;The second is beta due to market price fluctuations.

In financial statistics, the risk of an asset is usually expressed by the volatility of its price.The higher the volatility, the higher the risk.To calculate the volatility of an asset, you need to know its daily, weekly, monthly, or quarterly market value.If the stock is traded in the secondary market, we can see its opening, closing and daytime trading prices every trading day, so the calculation is very transparent and hardly controversial.But when it comes to private equity investments that don't trade on the secondary market, valuations are not as straightforward, often based on models used by financial professionals or subjective valuations based on discussions among several experts.At the same time, the frequency of such valuation may be quarterly, semi-annual, or annual, which is far lower than the frequency of daily or even minute-by-minute valuation in the secondary market. Therefore, private equity investment in the primary market creates a sense of lower volatility and lower risk.

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关键词：Illiquidity Liquidity Illiquid valuable Private