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 change, 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 discontinuous adjustments. For illiquid assets, the standard continuous trading model breaks down.
That’s why volatility is an inadequate proxy for 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
Critics may say: “Fine, but we don’t want to look at mark-to-private prices. Just mark everything to public comparables.” That introduces a third price: “mark-private-as-if-it-were-public.”6
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
None of this is a defense of naïve use of private market statistics. If you take low mark-to-private volatility, plug it into a mean-variance optimizer, and conclude that you should put 80% of your portfolio in private equity, you are doing something crazy.
Traditional Sharpe Ratios are just as misleading for comparing private and public assets. They measure a mechanically computed return-to-volatility ratio, not return-to-risk.
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.
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, observed short-term volatility is an unreliable proxy for 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.7Coda: Finding Common Ground
The placement of the quotation marks in the title is very deliberate.
If by “volatility laundering” you mean “all that stuff about vol understating the risk of PE, practical implications for allocators, potential abuses of private marks, etc.”, then I am your comrade in arms. This is the core of the debate, and I agree with the concerns.
My two key points of divergence are that a) the term “laundering” should be used in a more nuanced way, and b) there a two price-generating processes that should not be conflated. Here are some examples:
GP-controlled marks often lag too much. Probably true on average. But mark-to-private marks by the most honest of Abes will legitimately be smoother.8
Mark-private-as-if-public is the relevant price. Yes, if you insist on using vol for risk-return comparisons. I prefer to mark privates as private while they are private, and use a different measure than vol for risk comparisons.
Private asset prices are “smoothed”. Depends. Mark-to-private prices are legitimately smooth(er), not actively smoothed. If you are looking for mark-as-if-public prices, then yes, you will need to de-smooth.
Even if private prices move slowly, investors still bear economic risk continuously, whether or not trades occur. My point exactly: daily price vol does not capture this risk. Measuring risk over medium to long horizons reveals correlations, economic risk, etc. Also, big jumps in public markets can propagate quickly to private markets, so they aren’t always smooth either.
You have neither a theory nor empirical data to support your assertions. Yes, and that’s one of the reasons for writing this note. I believe that “A Theory of Private Asset Prices” and “An Empirical Study of Actual Private Asset Transactions” would make for fine dissertation topics.
For transparency, my obsession with the “laundering” semantics is driven by the fact that my day job includes marking private assets on a daily basis. The “price theory” angle reflects the musings of a lapsed academic.Disclosures & Footnotes
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.
1The term “volatility laundering” was coined by Cliff Asness, 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.
7Whether 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.
8For transparency, my obsession with the “laundering” semantics is driven by the fact that my day job includes marking private assets on a daily basis. The “price theory” angle reflects the musings of a lapsed academic.