Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

Which risk may be considered a potential drawback of private equity investments?

1. High market volatility

2. Limited liquidity

3. Lower potential returns

4. Standardized performance evaluations

The correct answer is: Limited liquidity

Limited liquidity is indeed a significant drawback of private equity investments. Unlike publicly traded assets that can be bought and sold with relative ease on stock exchanges, private equity investments typically involve capital that is locked up for extended periods, often ranging from several years to a decade. This illiquid nature arises because private equity funds focus on acquiring stakes in private companies, many of which do not have a market for their shares, making it challenging for investors to exit their positions before the fund’s predetermined lifespan. Furthermore, the process of selling a private equity investment usually requires finding a buyer through a longer and more complex sales process, or it may involve an IPO, both of which are not guaranteed and can take considerable time. This limited liquidity can make it difficult for investors to respond quickly to changes in market conditions or personal financial situations, potentially leading to missed opportunities elsewhere in their investment portfolios. While other options mention relevant risks associated with investments, like market volatility or concerns about performance evaluation standardization, they do not align with the inherent nature of private equity, which is better characterized by its illiquidity compared to traditional securities.