Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Uber is in crisis. But don't worry about its stock.

One of the perks of being a private company is that it can be mired in scandal and not have to watch the market whipsaw its stock around.  

Or in Uber’s case, a spectacular series of scandals. In January, the #DeleteUber movement resulted in at least 500,000 users deleting their accounts. In February, Uber brought in former U.S. Attorney General Eric Holder to investigate accusations of widespread harassment and discrimination. In March, a video went viral showing  CEO Travis Kalanick berating an Uber driver. In April, a string of Uber executives resigned. There’s more, but a full recitation would require a separate column.

The latest bombshell was Kalanick’s announcement this week that he will take indefinite leave. A management committee will replace him and will presumably implement Holder’s 47 recommended changes.

Needless to say, Uber’s stock would be swooning if it were publicly traded. And it ought to be. Surely Uber’s future is less certain than it was before these scandals, which means that its stock is worth less, too. Lucky for Uber, there’s no market quote to say how much less, and so its valuation remains a lofty $69 billion.  

Lucky also for the private equity and venture funds that invest in Uber. While Uber has proved to be a bumpy ride, their performance numbers have remained smooth.   

It’s not just Uber. There’s no way to know whether or how much the value of a private investment has changed from quarter to quarter -- which is typically when private equity and venture funds report to investors -- so they assume it hasn’t. As a result, their risk-adjusted returns look fantastic, at least on paper.

According to Cambridge Associates, its US Private Equity Index generated a pooled internal rate of return (IRR) of 13.4 percent annually over the last 25 years through 2016, while the standard deviation -- or volatility -- was just 10 percent.

Going Private
On paper, private investments have generated higher risk-adjusted returns than publicly traded stocks
Sources: Cambridge Associates, Bloomberg
Note: Returns for venture capital and private equity are pooled internal rates of return.

To put that in perspective, consider that publicly traded stocks generated a lower return with nearly double the volatility over the same period. The S&P 500 returned 9.1 percent annually, including dividends, with a standard deviation of 17.7 percent.

And if you like private equity, then you’ll love venture. Cambridge Associates’ US Venture Capital Index generated an astounding IRR of 25.5 percent annually, with a standard deviation of 23.3 percent. That may seem like a lot of volatility, but most of it is attributable to the gains, not the losses. Separating the positive quarterly returns from the negative ones, the standard deviation of the positive quarters is 22.4 percent, but a mere 11.7 percent for the negative quarters.

Diminishing Returns
With declining absolute returns, private equity funds are trumpeting their risk-adjusted returns
Source: Cambridge Associates
Note: Returns are pooled internal rates of return.

The muted volatility has come in handy for private equity and venture funds. As their returns have trended down over the years, they have increasingly trumpeted their Sharpe Ratios -- a common measure of risk-adjusted return. The Sharpe Ratios of the Private Equity Index and the Venture Capital Index were 1.08 and 0.98, respectively, over the last 25 years, while the Sharpe Ratio of the S&P 500 was a lowly 0.37.  

Venture Out
As with private equity, returns from venture are trending down
Source: Cambridge Associates
Note: Returns are pooled internal rates of return.

Investors, however, should be skeptical of those numbers. It’s nonsensical to believe that an investment in a startup or a leveraged buyout is less risky than one in a large, well-established company. Or that the value of a privately held company isn’t affected by the kind of turmoil that’s roiling Uber. But that’s precisely what the low volatility -- and by extension high Sharpe Ratio -- of private equity and venture funds would have investors believe.  

This isn’t just a harmless sleight of hand. Pensions and endowments are among the big investors in private equity and venture capital. If they were presented with numbers that more realistically reflected the risk of those investments, I suspect they would make different decisions. Those fanciful numbers also bleed into the performance that pensions and endowments report to their stakeholders. The result is that the risk taken by those pensions and endowments is far greater than anyone acknowledges.

The problem is that no one has much incentive to change. Naturally, funds want to show the best possible performance, as do their pension and endowment investors, which explains some of their enthusiasm for private investments.

But delusion isn’t a good basis for making investment decisions. Private equity and venture funds can present more realistic volatilities and Sharpe Ratios by using public market proxies for their private investments. They might assume, for example, that Uber’s volatility is comparable to a publicly traded stock with a market cap of $70 billion and similar leverage. Granted, that wouldn’t fully reflect Uber’s troubles, but it would be better than ignoring them altogether.

In the meantime, Uber’s stockholders can pretend that their investment is unaffected by the turmoil swirling around them. That is, until they can’t.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net