Strategy
Hedging the real risk of private fund yield.
Private fund returns look smooth on paper. They are not. Each position in the basket carries a sized hedge against a publicly traded counterpart that prices the same underlying risk.
Background
The Cambridge US Private Equity Index reported a 25% max drawdown in 2008. Over the same window, leveraged loans tracking the same credit fell 38%, BDCs holding nearly identical loan portfolios fell 60%, and listed PE manager equity traded at 70 to 88% discounts to reported NAV. Reported NAV smooths losses; the public counterpart prices them in real time. Investors using reported volatility as a measure of true risk understate drawdowns by two to three times.
| Proxy | 2008 (GFC) | 2015 16 | Q4 2018 |
|---|---|---|---|
| Cambridge PE Index (reported) | −25% | −1% | −2% |
| Liquid PE proxy basket | −58% | −28% | n/a |
| PE managers basket | n/a | −36% | −24% |
| BDC / leveraged loan basket | −60% | −33% | n/a |
| S&P 500 (reference) | −53% | −11% | −19% |
Source: Bloomberg, Cambridge Associates, Man Group analysis (van Dooijeweert, 2019).
Three proxy approaches
Three categories of publicly traded proxies are used in combination. No single proxy is the sole point of failure.
1. Liquid public proxies
Regression based baskets that match the factor exposures of the underlying private fund. Industry tilts plus bottom up name selection, avoiding the mega cap, biotech, utility, and REIT weightings that distort general public indices.
2. Manager basket
The publicly traded equity of the private fund managers themselves: Apollo, KKR, Blackstone, Ares, Carlyle, Oaktree, Intermediate Capital. High beta to the underlying cycle. In 2015 the basket fell 36% while the S&P 500 fell 11%; in Q4 2018 it fell 24% versus 19%.
3. BDCs and leveraged loan instruments
For private credit positions, BDCs and leveraged loan ETFs hold the same loans (or close substitutes) and price them daily. The most direct proxy because the underlying obligations are the same.
Hedging instruments
- Outright puts. Direct downside protection. Around 2 to 3% per annum for a 1Y 85% strike on liquid PE proxies. Maximum payoff in tail events.
- Put spreads. Buy closer to money, sell further out. Cuts premium 30 to 40% and caps payoff. The cap is rarely binding because the underlying private fund itself marks slowly.
- Underperformance options. Profit when the proxy underperforms a reference index (typically the S&P 500). Captures private fund specific risk like fee compression that shows up as relative weakness.
Hedging cost reference
| Proxy | 1Y put | Put spread | Notes |
|---|---|---|---|
| S&P 500 | 2.2% | 1.9% | Cheapest. Weakest correlation to PE. |
| Liquid PE proxy | 2.8% | 1.9% | Best correlation / option depth balance. |
| PE managers basket | 3.4% | 2.4% | Highest beta. Thinner option liquidity. |
| Leveraged loan index | 1.5% | 1.0% | Cheapest credit hedge. |
| BDC basket | 2.6% | 2.1% | Largest 2008 payoff. Lower depth. |
1Y 85% strike (puts) and 85/65 (spreads) for liquid PE and managers; 90% and 90/75 for loan and BDC. Source: Man Group, Bloomberg. Reference points; sizing, strike, and tenor tuned per position.
Selection logic
S&P 500 puts are the cheapest equity hedge but the index is a poor match for private fund risk, and layering shorts on it cancels the public yield the basket already holds.
The basket diversifies across all three proxy approaches. Per position weights depend on which proxy historically tracked the underlying best under stress, weighted by option market depth at the required size.
Hedge effectiveness is set by conditional correlation under stress, not historical drawdown. That correlation is unstable. Each pairing is its own regression, refreshed continuously. Pairings whose stress correlation degrades trigger an instrument review.
Why public hedges work
Book value accounting structurally understates drawdowns. The public counterpart hedges what the underlying actually is, not what the smoothed mark says.
The crystallization point is the key mechanic. Mark to market hedges register gains in real time, while the private fund has not yet adjusted its NAV. Those gains fund distributions and redemptions through the cycle without forced sales of the underlying. This is the failure mode that destroys most unhedged private fund allocations: holders forced to test private market liquidity at the worst moment. Per position hedging removes that constraint.