Building a Diversified Portfolio with Private Equity

To determine whether private equity investments add value to a diversified portfolio, we maximize portfolio value over five asset classes: large-capitalization stocks, small-capitalization stocks, investment-grade bonds, cash, and private equity. For large-cap stocks we use the S&P 500 total return index, for small-cap stocks we use the NASDAQ total return index, for long-term bonds we use the Salomon Smith Barney Broad Investment Grade (BIG) Bond Index, and for cash we use the 3-month U.S. Treasury bill rate.

We use the term "private equity" generally to describe the four forms of private investing we have previously discussed: venture capital, leveraged buyouts, mezzanine financing, and distressed debt investing. We obtain information on the historical returns for these four sources of private equity from Venture Economics and Hedge Fund Research Inc.11

8 See Gompers and Lerner, "The Challenge of Performance Assessment."

9 See Gompers and Lerner, "Money Chasing Deals?"

10 See Gompers, "Grandstanding in the Venture Capital Industry."

11 Venture Economics is a Thomson Financial company. It offers information on the private equity industry, including conferences, market statistics, journals, and databases. It has been in business since 1961. Hedge Fund Research Inc. is a database that contains information on many different types of investment styles for hedge funds. Unfortunately, it is not possible to measure the diversification potential of every individual private equity fund on a stock and bond portfolio. Therefore, we use an index of returns for each of the four private equity categories to determine the impact on expected utility

3Mo T-Bill

SBBIG

Nasdaq

S&P 500

Venture Capital

Buyouts

Mezzanine

Distressed

3Mo T-Bill

1.000

0.232

-0.148

-0.052

-0.094

-0.282

-0.243

-0.163

SBBIG

0.232

1.000

-0.026

0.158

-0.228

-0.180

-0.003

-0.098

Nasdaq

-0.148

-0.026

1.000

0.841

0.681

0.408

-0.090

0.504

S&P 500

-0.052

0.158

0.841

1.000

0.427

0.352

0.047

0.499

Venture Capital

-0.094

-0.228

0.681

0.427

1.000

0.384

-0.129

0.243

Buyouts

-0.282

-0.180

0.408

0.352

0.384

1.000

0.114

0.380

Mezzanine

-0.243

-0.003

-0.090

0.047

-0.129

0.114

1.000

0.106

Distressed

-0.163

-0.098

0.504

0.499

0.243

0.380

0.106

1.000

There are several caveats associated with an index of private equity returns. First, private equity managers tend to use conservative assumptions in the computation of their returns. As a result, private equity values tend to lag the rest of the financial markets because fund managers usually wait until there is a realizable event associated with a private equity investment that provides a measure of market value. This event could be an initial public offering, a second round of

financing, or a third-party follow-on investment.12

Second, private equity managers tend to report the net asset value of their funds on a quarterly basis. Monthly return data are rare. Quarterly reporting can mask month-to-month fluctuations in value.

Last, there is usually some source of bias associated with a database. In Chapter 7 we described the data biases associated with hedge fund data. The same biases apply with respect to private equity databases.

In Exhibits 5 through 9, the Sharpe ratios for the four categories of private equity are higher than those for the S&P 500. On a stand-alone basis, it would appear that private equity funds are a superior investment choice. However, private equity should not be considered in isolation because this ignores its diversification potential with respect to other asset classes.

The diversification potential of private equity is demonstrated in Exhibit 10, which presents a correlation matrix of the quarterly returns of the four classes of

private equity compared to the traditional stock and bond asset classes.13 For instance, the returns to all four classes of private equity are negatively correlated with investment-grade bonds and U.S. Treasury bills, and have low correlation with the returns to large-cap and small-cap stocks. In conclusion, the less than perfect correlation (and, in some cases, negative correlation) of private equity returns with the returns to stocks, bonds, and cash indicate excellent diversification potential.

12 We also note that private equity indices are not fully investable due to issues of capacity, minimum net worth requirements imposed by the private equity managers, and regulatory restrictions as to the number of investors that may invest in a private investment vehicle.

13 In Exhibit 10 we use quarterly data from 1990-2000 to ensure consistency of the data, and we convert the monthly returns for distressed debt into quarterly returns to be comparable with those for the other classes of private equity.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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