Private Equity Returns : Is There Really a Benefit of Low Co-Movement with Public Equity Markets?

In this paper we show how cross-sectional correlations between Private Equity (PE) and Public Market Equity (PM) returns can be approximated, resolving the lack of time series PE data. Based on a sample comprising 2,380 realized PE projects, we observe low cross-sectional correlations between PE and stock index returns (e.g. 0.18 for Nasdaq Composite Index). Despite overall low correlations, we find that investor can not benefit from a diversification effect when they really need it - during times of low PM returns. We point out differences between early and later stage PE investments regarding hedging capabilities triggered by distinct valuation approaches and exit channels. In PE, financial statements become more relevant for valuation purposes as firms mature. As early stage investors do not have meaningful fundamental information they rely more on comparable market valuation when pricing acquisitions. Furthermore, IPOs are their most important exit channel. In contrast, later stage investors price projects based on fundamental information and have better functioning alternative exit channels, such as trade sales or secondary transactions. They thus are less dependent on PM developments. We find significant statistical evidence for the negative correlation between early stage investments and excess returns over PM in bearish market conditions. Later stage investments exhibit a significant positive relation with excess returns over low PM returns. Investors seeking diversification benefits in PE should not solely rely on correlation coefficients, but need to carefully consider a fund's investment strategy. The conflict of objectives for Venture funds between active market timing and smoothing of PM returns is resolved in favor of active market timing. Buyout funds' returns are less dependent on PM developments and are thus the better complement for PM portfolios if investors seek diversification