Benefits of private equity in a volatile market

May 7, 2020

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Fran Kinniry

Fran Kinniry

Ted Dinucci

Ted Dinucci

The COVID-19 pandemic has spared no corner of the markets, bringing unease to even the most sophisticated and tenured investment committees. Although stressful, volatile market conditions highlight the importance of strategic asset allocation: building an allocation that aligns with the goals, objectives, and risk tolerances of the institution and maintaining that allocation as market conditions change.

Private equity can play a vital part of that discipline, as its structural characteristics, such as appraisal-based valuations and illiquidity, provide important diversification and behavioral advantages often overshadowed by the asset class's impressive long-term returns.

Private equity during stressed markets

The potential benefits of private equity's structural characteristics are perhaps most evident when markets are under stress. During previous U.S. bear markets, private equity experienced about half of U.S. equities' total downturn, on average, as shown in Figure 1. However, it's important to remember that no two bear markets are the same.

Figure 1. U.S. equity and private equity performance during adverse market environments

Chart 1 US Equity

Sources: Vanguard calculations, using U.S. equities as represented by MSCI USA Index; and private equity as represented by Cambridge Associates Private Equity Index. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

The smaller drawdown experience of private equity is largely structural, in that the nature of private and public equity returns are different.

Private equity returns reflect the appraised value of the underlying portfolio companies. Public equity returns reflect the prices at which participants are able to transact. If public markets were perfectly efficient, transaction prices and company values would match one-for-one. But we know this is not the case. Even though public markets are highly efficient, stock prices deviate from companies' intrinsic value for a variety of reasons: fear and emotions, forced selling, liquidity discounts and premiums, and more. In this way, private equity is not swayed by the emotions of public equity price swings—whether up or down. And, given that most private equity allocations come from public equity within the portfolio construction process, its lower drawdowns and volatility during episodes of market stress demonstrate that private equity is valuable not only as a potential long-term return enhancer but also as a potential means of mitigating the impact of down markets.

"For these reasons, private equity can be appealing to organizations balancing the need to exist in perpetuity with the risk of potential equity downturns," said Ted Dinucci, senior private investment specialist for Vanguard.

Importantly, however, private equity offers no investable beta—which means it must be implemented actively, often through a third-party fund manager. As a result, actual investment committee experiences could be quite different depending on the quality of the underlying fund managers and the degree of diversification within the private equity exposure. Manager selection, then, is critical.

Liquidity versus illiquidity

Public equity markets are among the deepest and most liquid financial markets in the world. The annual transaction volumes chart shows that tens of trillions of dollars transact annually in public equity markets—often at multiples greater than the total market capitalization of all listed companies. By contrast, total transaction volumes for private equity in 2018 reached just $74 billion, or 2% of private equity assets—even with the growth of secondary markets for exchanging limited partner interests.

Figure 2. Annual transaction volumes
Listed global equity, private equity secondary market

Chart 2 Annual Transaction Volumes

Sources: Vanguard calculations, based on data from World Federation of Exchanges Database, World Bank, and Greenhill.

Inherent in the advantage of public equity's liquidity and the constraint of private equity's structural illiquidity are their opposites. "It's paradoxical," said Fran Kinniry, principal and global head of private investments for Vanguard, "but strengths can be weaknesses and weaknesses, strengths."

Market liquidity is intrinsically positive, but only if it's actually needed. As can be inferred from Figure 3, individual investors have a tendency to use the efficiency and liquidity of public markets to their detriment, often chasing returns and incurring frictional trading costs at the expense of their long-term objectives.

Figure 3. Rolling one-year equity returns and cash flows

January 1995 to February 2020

Chart 3 Rolling One Year Equity Returns

Sources: Vanguard calculations, based on Morningstar data. Equity returns represented by MSCI USA Index. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Similarly, private equity's illiquidity can be a boon. By largely avoiding the emotional component of public price swings and limiting the ability to act on the price movements, private equity—as a portion of portfolio risk assets—can promote better investing decisions than a portfolio of completely liquid securities. Private equity can serve an important function in Institutional portfolios beyond the potential high returns associated with this asset class. Although private equity cannot replace the value of working with an outsourced chief investment officer,¹ the structured discipline that it confers is one more tool for investment committees of pensions, endowments, and foundations to help stay the course as they navigate changing market environments.

¹ Michael A. DiJoseph, CFA; Sneha Kasuganti; Christopher Celusniak; Donald G. Bennyhoff, CFA; Francis M. Kinniry Jr., CFA, 2018. Vanguard Institutional Advisor's Alpha™: Quantifying the Value of a Consultant. Valley Forge, PA: The Vanguard Group.


  • All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • This communication does not constitute an offer to sell or the solicitation of an offer to buy any specific investment product sponsored by, or investment services provided by Vanguard Advisers Inc. or its affiliates. Any such offer may be made only to qualified investors by means of delivery of a confidential Private Placement Memorandum or similar materials that contain a description of the material terms of such investment. No sale will be made in any jurisdiction in which the offer, solicitation, or sale is not authorized or to any person to whom it is unlawful to make the offer, solicitation, or sale. Private investments involve a high degree of risk and therefore, should be undertaken only by prospective investors capable of evaluating and bearing the risks such an investment represents. Investors in private equity generally must meet certain minimum financial qualifications that may make it unsuitable for specific market participants.
  • Past performance is no guarantee of future returns.