Volatility “Laundering” is a Myth: We’re Measuring the Wrong Price
Private equity is often accused of “volatility laundering.” 1The charge is simple: reported returns are too smooth, so the marks must be stale, smoothed, or just plain wrong. If private assets were marked “honestly,” the argument goes, they would look a lot more like public equities: choppy, volatile, and highly correlated.
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It’s a compelling story, but it is incomplete.
Not because private markets are less risky, they aren’t. And not because volatility doesn’t matter, it does in the right context. The problem is more basic: the critique assumes that there is only one meaningful “mark-to-market” price for an asset, and that it’s the one you see in public markets.
That assumption misses an important concept: there are at least two relevant prices.
Two Prices, Two Processes
First, there’s the price at which an asset trades continuously in a liquid market. Call this “mark-to-public.” It moves fast, incorporates information immediately, and gives you a clean, up-to-the-second read on what markets think.
Second, there’s the price at which the same asset would actually transact in a private market. Call this “mark-to-private.” This price is not formed in a continuous auction. It emerges from a process that involves finding a buyer, negotiating terms, lining up financing, and closing a deal.
These are two different concepts, and there is no reason they should behave the same way.2
When interest rates jump, public market prices adjust instantly. Private transaction prices don’t. Not because private market participants are asleep at the wheel, but because deals don’t reprice in real time.3 Buyers and sellers adjust their expectations gradually, financing conditions reset, and transactions already in motion close at yesterday’s terms. Prices in private markets adjust through a sequence of transactions, not continuous repricing.
An Intuitive Example: Housing Prices
For an intuitive example, consider housing. When mortgage rates rise, homebuilder stocks fall immediately. But house prices don’t reset overnight. Volume drops, deals stall, and prices drift lower over time. No one calls this “volatility laundering” in housing. It’s just how the market works.
Private equity works the same way. The idea that smooth returns must be the result of bad marking comes from taking a public-market lens and applying it where it doesn’t belong.
In private markets, price changes come from discrete events: improving a business, levering it, and eventually selling it. Public information feeds into transaction prices only gradually.
Severing the Link between Short Term Volatility and Long Term Risk
Financial analysts routinely use volatility and risk as interchangeable terms.4 It is easy to forget that the familiar √T linkage of short term volatility and long term risk rests on many of the simplifying assumptions of the ”standard” continuous diffusion pricing models.5
Private prices adjust slowly through a sequence of transactions, incorporate new information only partially, and are prone to jumps. For illiquid assets, the standard continuous trading model breaks down.
That’s why volatility is a poor measure of risk here. You can have low daily volatility and still have a very wide distribution of long term outcomes. In fact, you usually do.
The main concern that private asset volatility is an incorrect measure of risk is dead on. But it’s not because volatility is mis-measured. It’s because for private assets there is no basis for using volatility as a proxy for risk in the first place.
Changing the Question
But what problem did you just solve?
You haven’t discovered the “true” private price. You’ve switched to a different pricing concept, one that answers a counterfactual: what an illiquid asset would be worth if it were liquid. That is not the same as asking what it would transact for in the market that actually exists. Those are different questions.
And this is why the disparaging “laundering” moniker is not justified. It treats the difference between mark-to-private and mark-to-public as evidence of error, when it’s really a difference in what’s being measured.What Actually Needs Fixing
This does not mean that you cannot compare the risk of liquid and illiquid assets. If you measure the dispersion of long-term outcomes directly, the risk will be on an equal footing.7
The fix is not to declare private valuations invalid. The fix is to stop using volatility as a measure of risk for illiquid assets.
The Takeaway
Recognize that for illiquid assets, short term volatility says nothing about long term risk. Then you can stop adjusting volatility to make it look like privates are public. Instead, measure long term risk directly for risk-return comparisons.
And can we please retire the accusatory “laundering” moniker? Why not simply note that “illiquid volatility” is not an appropriate measure of risk. If anything is being laundered here, it’s the distinction between two different pricing regimes.8Footnotes
Disclosures
1The term “volatility laundering” was coined by Cliff Aness, my former boss at AQR. While we differ on the interpretation, we share many of the same conclusions.
2The different price just before and just after an IPO illustrates that the pricing regime itself may affect price.
3Even though the two sides of the transaction are aware of the latest information, they incorporate it gradually rather than instantaneously.
4In this context, we define risk as the dispersion of long term outcomes.
5The standard model assumes that volatility scales with the square root of time.
6Practitioners often approximate this “as-if-public” price using techniques like unsmoothing, Public-Market Equivalent (PME), or factor replication.
7An analogy from physics. Comparing two objects based on mass or weight will give the same answers on earth. But two objects of equal mass will different weights on Mars versus Earth.
8Whether or not private equity marks are appropriate or manipulated is its own question. The claim here is that the low volatility of these marks should not be viewed as prima facie evidence of mis-marking.
The views expressed reflect the current views as of the date hereof. This document has been provided solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments, and may not be construed as such. Any illustrations and views expressed should not be construed as investment advice or a guarantee of future results and can’t account for future economic conditions.
Private market investments involve significant risks, including limited liquidity, reliance on valuation methodologies that incorporate subjective assumptions, and the potential for differences between reported values and realizable transaction prices.