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Private equity

Investment in companies that are not publicly listed, usually through closed-end partnerships with a ten-year life that buy, hold and eventually sell operating businesses.

Capital is committed rather than paid up front and is drawn down over an investment period through capital-call notices. Returns come back as investments are realised, which is why performance is measured with internal-rate-of-return and multiples rather than annual returns.

Value is created through some mix of operational improvement, multiple expansion between entry and exit, and leverage. The proportions matter for judging skill: returns driven by rising valuations across the market are not the same as returns driven by improving a business.

Reported volatility is low because holdings are appraised quarterly rather than traded, a smoothing effect that flatters risk statistics. Adjusting for that smoothing typically raises estimated volatility and lowers estimated sharpe-ratio substantially. See j-curve and illiquidity-premium.

Related: leveraged-buyout, venture-capital, capital-call, j-curve, illiquidity-premium, internal-rate-of-return

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Payoff of a long call at expiryA flat loss equal to the premium below the strike, turning upward at 45 degrees above it.Profit / loss per share08595115125Strike 105Max loss 3 — the premium paidBreakeven 108Profit keeps growingUnderlying price at expiry
Buying a call: payoff at expiry. A 105-strike call bought for 3 loses that whole 3 if the price finishes at or below 105, breaks even at 108, then gains a dollar for every dollar higher. The loss is capped at the premium; the upside is not capped.
A simple and an exponential moving average over the same pricesOne price line with two smoothed lines drawn through it; the exponential average bends away from the simple average as soon as price turns, and sits between price and the simple average all the way down.SAME PRICES, TWO AVERAGES (8 PERIODS)the EMA turns down firstand stays nearer to price8-day SMA8-day EMApriceIllustrative prices. Both averages smooth the same series over the same span.
Simple versus exponential averages. Both lines average the last eight prices, but the exponential version gives the newest prices the most weight while the simple version treats them all alike. That is why the exponential line bends first when price turns and then tracks it more closely.

Educational only, not advice. Spotted an error? Post in Site Feedback.