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Parallel Conversations: Private Equity and Used Cars

A: I’ve got a guy who’s getting me into private equity.      
 A: This ad for a used car looks like a good deal.
B: Are you sure that’s a good idea? Valuations in private equity are just made up.      
 B: The ad says it’s being sold as is, and you can’t go see the car. Do you know what you're getting into?
A: That’s one down side, but the low volatility of private equity makes it less risky, and that’s what I’m looking for.      
 A: That’s a down side, but this is the brand I’ve been looking for. This model is highly rated.
B: But the low volatility of returns is just a consequence of the made-up valuations. All the risk is hidden until a knowledgeable buyer evaluates the assets.      
 B: A good rating applies to the average car of this model. That won’t mean much if this particular car has problems.
A: Another plus is high Sharpe ratios.      
 A: The price is good.
B: A high Sharpe ratio comes from the low volatility, and that comes from the made-up valuations.      
 B: Maybe it’s been in an accident or needs some major repairs. The price may not be as good as it seems.
A: I’ve heard of lots of other positives with private equity.      
 A: Experts say buying used cars is better than buying them new.
B: Everything looks good as long as the made-up prices keep rising. Someone will be left holding the bag if the real value of the assets turns out to be much lower. That someone could be you.      
 B: That’s true, but it won’t help you if this car is a lemon. You just don't know if the real value of the car is much lower than the asking price.
A: I don’t know the real value of publicly-traded stocks and ETFs either.      
 A: Won’t I have the same problems with any used car I find?
B: That’s true, but at least their prices are set in competitive public markets by people committing their money. There is much more reason to believe that the prices you pay are fair.      
 B: You could find a used car not being sold as is, and you could take it to a mechanic to check it out. This isn’t foolproof, but it improves your chances of getting a fair deal.


If it sounds like I’m saying that investing in private equity is like buying a used car as is from an ad without ever looking at the car, then you were paying attention.

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