"Phony Happiness" in Private Markets

Alpha is down and fundraising is up in private equity. What explains this seeming contradiction?
 
One contributing factor is the accounting.  It is an open secret among large allocators that the accounting for private funds might understate the true risks. 
 
Private equity funds value their own portfolios once per quarter, and the valuations they report are far less volatile than the changes in valuations of publicly traded stocks. The hurly burly of the public markets is replaced by the considered judgment of an accounting firm that just so happens to be employed by the private equity fund.
 
Institutional investors seem to value these “smoothing effects.” In a recorded public presentation, the CIO of the Public Employee Retirement System of Idaho called this the “phony happiness” of private equity. 
 
"We did know that our actuaries and accountants would accept the smoothing that the accounting would do. It may be phony happiness, but we just want to think we are happy," he said. "If [private equity] just gave public market returns, we’d be in favor of it because it has some smoothing effects on both reported and actual risks." 
 
In other words, the Public Employee Retirement System of Idaho is allocating more capital to the asset class not to make the public employees of Idaho more money but because the CIO of the system values the “phony happiness” of the smoothed accounting.
 
George Washington University professor Kyle Welch argues in an excellent paper on private equity accounting that portfolio managers “have incentives to obfuscate systematic risk and to choose investments that appear low-risk.” If public markets take a dive, portfolio managers with large private equity holdings might not have to book large losses. We saw this vividly when oil prices fell 50% and public energy stocks dropped even further, yet most private equity funds in the energy sector remained marked at 1x.
 
This is dangerous thinking, though. The flood of money into private equity means that institutional investors now pay higher prices to buy companies in private markets than in public markets. The S&P 500 trades at just over 12x EBITDA today, whereas the average private equity deal in 2017 was done at 13.7x EBITDA. These higher prices could reduce expected returns and add to the risk of the asset class.
 
Welch shows in his paper that if private equity firms adopted fair value accounting standards, then the reported volatility of private equity would double. We can also see this in the private equity secondary market, where investors trade their stakes in different private equity funds. Marking the reported returns of private equity to market by using these secondary transactions would bring the volatility of private equity higher than the public markets.
 
Figure 1: Private Equity Secondary Pricing

Source: Greenhill Cogent
 
Market pricing demonstrate that private equity is far riskier than the marks suggest.  For example, as shown in the graph above, private equity funds traded at 59% of their NAV at the depths of the financial crisis. 
 
Only “phony” accounting could transmogrify portfolios of highly leveraged small-cap companies into an asset class that some institutional investors consider less risky than investing in the S&P 500.