PitchBook News - How far have risk premiums fallen?

At the end of the day, equity is equity.

That was one of the themes during our recent lively conversation with Third Wire's Daniel Harms and Educational Alpha's (and CAIA's former CEO) Bill Kelly.

The sentiment also underpins the thought process behind our latest innovation in collaboration with Morningstar's Index team, the Morningstar PitchBook Buyout Replication Index (BRI).

PE buyout strategies have long been regarded as an alternative asset class, yet their fundamental investment principles closely resemble those of traditional public equity strategies.

At their core, both involve the ownership of corporate earnings, with sector and security selection playing key roles in generating alpha. With that framework, we created the BRI using a data-driven approach to track the risk-return profile of PE buyouts using publicly traded equities.

The index methodology was developed by my colleague, Andrew Akers, using machine learning techniques trained on historical take-private transaction data, quarterly financial statements, and stock price history to identify US public companies that share key characteristics with traditional buyout targets.

Unlike commonly used public equity benchmarks, the BRI systematically captures PE's sector tilts, leverage effects, and security selection tendencies, particularly of buyout megafunds, and adjustments for leverage exposure further enhance the model.

This will allow investors to track a portfolio of companies that mirror the buyout investment style—but with the transparency, liquidity, and daily pricing of public markets.

The BRI also aims to address a persistent challenge in PE investing: the lack of a reliable public benchmark equivalent. Traditional public market indices fail to reflect PE's unique characteristics, and our PME analysis has found that buyout funds launched between 2014 and 2018 performed roughly in line with the Index, unlike the Morningstar US Small Cap Extended Index.

 

The BRI tracks closer to buyout funds than standard indexes.

Investors have long allocated capital to risky assets based on an expectation that the potential reward outweighs the additional risks.

But what happens when that reward gets smaller and smaller?

That is the challenge facing investors today. Over the past decade, we have seen expected risk premiums compress across public and private markets.

As compensation for taking risk decreases, allocators may need to change playbooks to continue to meet their goals.

 

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