Evaluating the Interplay Between Private and Public Markets

Introduction

Have you ever noticed how some private equity valuations seem to skyrocket—then eventually, they spill over into the public markets, shaping stock price expectations for similar companies? It’s almost like a “ripple effect,” where private deals can send signals about what the next wave of public valuations might look like. Anyway, in this section, we’ll explore that phenomenon in depth, walking through how funds flow between private and public deals, how valuation methods differ, and how all these factors might shape your asset allocation and capital market expectations.

Investors constantly navigate the relative attractiveness of private and public markets. Sometimes, you might see relentless enthusiasm for private equity deals when interest rates are low, and at other times, everyone rushes to IPO or some SPAC structure. This ebb and flow can mean real shifts in the risk/return profiles of each market. And so, we’ll talk about the interplay of these forces from a CFA Level III perspective, highlighting the key drivers—valuation lags, regulatory constraints, performance measurement, and so on—that shape capital flows and asset allocation decisions.

Comparing Valuation Approaches

One big difference in private vs. public markets is the valuation process. Public equities get priced in real time, tick by tick. In private real estate or private equity deals, it’s more of a “wait-and-see” approach.

• In public markets, prices are determined by continuous trading. Stock prices, for instance, reflect the marginal buyer’s and seller’s demand at any moment.
• In private markets, valuations are often appraisal-based or negotiated—think of a real estate investor’s periodic evaluation using recent property sales across the neighborhood, or a private equity firm’s discounted cash flow (DCF) assumptions, validated by sporadic comparable transactions.

Because of this, private valuations might be stickier; they can lag behind broader macro changes. Picture a scenario: real estate cap rates haven’t adjusted yet to new interest rate environments, though the Fed has raised rates multiple times. By the time the next appraisal cycle rolls around, the gap between “expected price” and “market clearing price” could become quite obvious.

Practical Example

Let’s say a real estate private equity fund invests in commercial properties in a city that’s recently experienced a surge in technology company layoffs (leading to office vacancies). However, the appraisals might still reflect last year’s occupant-friendly environment. Public REITs (Real Estate Investment Trusts), on the other hand, might already have taken a hit as soon as the news reached the market, dropping 10% in a matter of weeks. Private investors only see the degree of that downturn once new appraisals come in, which may be quarterly or even annually.

Capital Flows and Market Sentiment

Capital flows can switch between private and public opportunities depending on interest rates, appetite for illiquidity, and general market sentiment. There are times when investors say, “Well, maybe we can’t get enough return in the public market right now—where else can we go?” That question can push them to private infrastructure, private debt, or venture capital.

Low-Rate Environment

When interest rates are low, financing deals through debt becomes more attractive. A private equity sponsor, for instance, might load up on leverage for a leveraged buyout (LBO). Because the required debt servicing costs are lower, the cost of capital can appear more favorable in private markets, luring capital away from public equities or bonds. That can simultaneously drive up valuations in private transactions and compress expected returns—yet ironically, it might still look relatively more appealing than what’s happening in the traditional stock or bond market.

Shifting Sentiment Between Markets

There are cases when public markets seem clearly overvalued—maybe technology stocks in certain bull markets—while private markets appear more disciplined (or vice versa). In such cases, sophisticated investors might rotate allocations, looking for better value. This phenomenon is relevant when building capital market expectations for multi-asset portfolios (see also “2.9 Forecasting Commodity Markets and Real Assets” for how some managers might shift from public to real assets).

Below is a simple diagram illustrating how money can flow back and forth between private and public arenas:

    graph LR
	    A["Private Markets <br/>(PE, Real Estate, Infrastructure)"] --> B["Capital Flows Out"]
	    B["Capital Flows Out"] --> C["Public Markets <br/>(Listed Equities, Bonds)"]
	    C["Public Markets <br/>(Listed Equities, Bonds)"] --> D["Exits <br/>(IPOs, SPACs)"]
	    D["Exits <br/>(IPOs, SPACs)"] --> A["Private Markets <br/>(PE, Real Estate, Infrastructure)"]

Notice how the arrows form a cycle of interactions: private capital flows into public markets (for instance, if private equity sponsors sell holdings via IPO), and in turn, the public domain can supply new capital (when public investors buy into a SPAC, the money flows back into a private operating company).

Liquidity and Time Horizons

Let’s talk about liquidity. Public markets are generally liquid—an investor in a large-cap stock can usually sell within seconds. Private assets aren’t so friendly in that regard; you’re often locked in for several years, especially in private equity or private real estate funds.

• Public Markets: Frequent trading, daily or intraday pricing, typically less complex to buy or sell.
• Private Markets: Lock-up periods of 5–10 years for private equity or venture capital; exit windows often hinge on an IPO, acquisition, or recapitalization event.

There’s an interesting anecdote I recall from a fellow portfolio manager who found himself over-allocated to private investments in a tough market environment. He basically said, “I couldn’t move. Public markets crashed, so my private allocations became a bigger slice of the overall portfolio. But I couldn’t exactly fix that overnight.” This phenomenon—commonly known as the denominator effect—can cause real headaches when you do your strategic rebalancing (see “3.10 Strategic Rebalancing Considerations and Best Practices”).

Cost of Capital and the Leverage Factor

The cost of debt is a major variable. In private equity, a lot of deals rely on significant leverage. If interest rates remain low, that cost of capital remains attractive, fueling more transactions. When money is cheap, it’s easier to justify a higher purchase multiple because you can use financing to enhance your internal rate of return (IRR). But let rates rise, and suddenly, fewer deals pencil out.

An elevated cost of capital in private markets can make publicly traded equities look relatively cheap—or the other way around. If private equity sponsors have trouble loading up on leverage at a decent rate, they might reduce their volume of buyouts, and you might see less upward pressure on valuations in the relevant public industries.

Exit Strategies and Market Sentiment

Another dimension is how private deals exit into public markets. IPOs or SPAC listings can create a surge of hype, especially if the sector is already popular (like biotech or green tech). Sometimes, early-stage investors earn enormous multiples, fueling a sense that “private markets are the place to be.” Other times, high-profile flops (perhaps the most famous ones are over-hyped unicorns that disappointed on the public stage) show that the interplay can go sour. If a big private name lists on the stock market and then tumbles 30% in the first week, it may cast doubt on the entire domain of private valuations.

Structural and Regulatory Factors

Regulatory restrictions on accredited investors, leverage caps, or foreign ownership rules also shape how easily assets can move between private and public. For instance, in some emerging markets, local regulation might severely limit foreign direct investment in private deals, effectively pushing offshore investors to listed securities.

• Accredited Investors: In many jurisdictions, regulations require that private placements only be open to accredited investors—those meeting certain net worth or income thresholds.
• Reporting Requirements: Once a private company goes public, it must comply with extensive disclosures. Some founders and sponsors might avoid IPOs to retain confidentiality or limit regulatory overhead.
• Leverage Availability: Banking regulations (like Basel standards) and capital requirements can, in certain climates, discourage or encourage large-scale financing of LBOs.

Performance Measurement Differences

Measuring performance in private markets differs from the time-weighted return (TWR) measure standard in public markets. In a public equity portfolio, we typically use TWR to track how the portfolio value changes day by day—factoring in external cash flows consistently.

In private equity or real estate, you’ll see IRR used more often. The IRR metric captures the internal rate at which the net present value of all future cash flows is zero. It’s sensitive to both the magnitude and timing of cash flows. That can sometimes create illusions of “threading the needle” if you exit at the perfect time or if the capital calls and distributions line up nicely.

Take a look at a simple table that summarizes some differences:

Implications for Asset Allocation

From a capital market expectations angle, you need to consider how private valuations and public prices might converge or diverge over time. If private asset valuations linger at historical multiples while public markets have already repriced downward, it’s possible that a wave of reappraisals in private funds is right around the corner. This dynamic can significantly influence a multi-asset portfolio’s risk profile.

Moreover, the relative attractiveness of public vs. private investments will shape where new capital flows. If your strategic or tactical asset allocation calls for, say, a 20% weighting to alternatives, you might pick from direct private equity, real estate limited partnerships, or listed alternatives like REITs—each path having different liquidity, risk, and cost of capital dynamics.

Practical Case Study: Tech Company Exits

Let’s suppose you have a hypothetical private equity sponsor, Growth Horizons Partners, that invests in early-stage e-commerce startups. Over the past three years, they’ve enjoyed a low-rate borrowing environment, fueling growth. They’ve also had robust valuations in the private market as big technology IPOs soared. Suddenly, interest rates rise, public tech stocks crash, and new IPOs falter. Growth Horizons finds it harder to sell its portfolio companies at the lofty multiples that were normal just a year ago.

Public multiples are down 25%. However, private deals haven’t fully caught up; the official valuations might still only reflect a 5–10% pullback. Growth Horizons tries to exit one of its star companies via a SPAC, but the market is suspicious of new listings at high valuations. The sponsor has to accept a lower price or wait longer, hoping sentiment recovers, locking up capital in the meantime.

This situation highlights the interplay:

• Delayed Valuation: Private “paper” valuations do not immediately reflect the change.
• Capital Flow Impact: As public valuations drop, some investors might move their money away from new private deals, focusing on “cheap” public equities.
• Liquidity Constraints: Growth Horizons can’t easily pivot in and out as a hedge fund might do with public equities.
• Cost of Capital: Rising interest rates hurt leveraged deals, reducing the sponsor’s capacity to bid aggressively on new targets.

Best Practices and Pitfalls

• Best Practices

• Regularly stress-test your portfolio’s exposure to private market valuations.
• Use scenario analysis to see how changes in interest rates can shift relative attractiveness.
• Keep discipline: avoid chasing hype-driven private deals without rigorous due diligence.

• Common Pitfalls

• Overestimating “safe” returns from private assets just because they show lower reported volatility.
• Failing to account for the denominator effect, leaving you stuck with a suboptimal overall mix.
• Confusing IRR success in short time frames with sustained, long-term outperformance.

Strategies to Overcome Challenges

• Thoughtful Portfolio Construction: Integrate both public and private assets in the context of your broader risk/return objectives. Consider correlation structures (see “3.13 Analyzing Cross-Asset Correlations in Strategic Asset Allocation”) and how liquidity constraints might affect your rebalancing.
• Dynamic Rebalancing: Acknowledge that private markets have lagged revaluation. Keep an eye on public proxies—like listed REITs or publicly traded private equity firms—to gauge potential shifts in private valuations.
• Due Diligence and Manager Selection: In private markets, manager selection is critical. IRRs can vary significantly based on expertise, sector focus, and the timing of capital calls.

Concluding Thoughts

Integrating private and public assets within a single portfolio demands a nuanced perspective on valuation, liquidity, and performance measurement. The interplay between these two arenas can seem complicated—maybe even frustrating at times—because it’s not as straightforward as checking yesterday’s closing price on a public stock. But it’s also full of opportunity: robust private markets can offer uncorrelated growth drivers, while public markets provide immediate liquidity and transparent price discovery.

In the grand scheme of capital market expectations for multi-asset portfolios, be prepared. Understand that the forces in the private domain could affect public sentiment and vice versa, especially when big “unicorns” go public or when interest rate policy suddenly changes the math on leveraged deals. Bridging that gap is crucial for any Level III candidate aspiring to truly master asset allocation.

Final Exam Tips

• When you see a scenario-based question about portfolio rebalancing in the context of a large private equity holding, think about liquidity constraints, potential lags in valuation, and how cost of capital might shift.
• Practice short-answer or constructed-response formats discussing how private equity IRRs differ from time-weighted returns—and why that matters in a multi-asset portfolio.
• Remember to highlight due diligence aspects of private market deals: if the exam prompts mention high leverage or hazy exit strategies, that’s your cue to discuss risk management.
• Don’t forget the denominator effect. It often appears in item set questions dealing with portfolio weights that get skewed after a public market decline.

References and Further Exploration

• Lerner, J., Hardymon, F., & Leamon, A. (2021). Venture Capital, Private Equity, and the Financing of Entrepreneurship. Wiley.
• CFA Institute. (2025). CFA Program Curriculum, Level III – Interplay of Public and Private Market Returns.
• Kaplan, S. N., & Strömberg, P. (2009). Leveraged Buyouts and Private Equity. Journal of Economic Perspectives.
• For further study on private market risk assessment, see “4.7 Absolute and Relative Risk Budgets for Determining/Implementing an Asset Allocation.”

Test Your Knowledge: Private vs. Public Market Interplay