Private Equity Within A Diversified Portfolio

The popularity of private equity investments has led to many studies on the value of investing in these vehicles.7 However, the amount of assets committed to private equity investments will depend on the value of portfolio diversification to the investor. In other words, the utility of investing in private equity will be different depending upon an investor's level of risk aversion. In this section, we examine the utility of investing in private equity funds within a diversified portfolio context.

Prior research has demonstrated that private equity has good diversification properties. Gompers and Lerner examine the correlation of the returns to private

7 See, Alon Brav and Paul Gompers. "Myth or Reality? The Long-Run Underperformance of Initial Public Offerings: Evidence from Venture and Non-Venture Capital-Backed Companies," Journal of Finance (December 1997), pp. 1791-1821; Paul Gompers and Josh Lerner, "Money Chasing Deals? The Impact of Fund Inflows on the Valuation of Private Equity Investments," Journal of Financial Economics (2000), pp. 281-325; Paul Gompers and Josh Lerner, "The Challenge of Performance Assessment," in Private Equity and Venture Capital, Rick Lake and Ronald Lake (eds.) (London: Euromoney Books, 2000); and Paul Gompers, "Grandstanding in the Venture Capital Industry," The Journal of Financial Economics (1996), pp. 131-156.

o equity with that of several asset classes.8 Using information reported by Warburg, Pincus, they find that the correlation of private equity returns with that of corporate and Treasury bonds to be 10% and 7%, respectively. With the S&P 500 and small cap stocks, the correlation with private equity returns was 60% and 68%, respectively. However, when Gompers and Lerner adjust the Warburg, Pincus private equity returns with estimated marks to market, they find that the correlations with corporate bonds, Treasury bonds, large cap stocks, and small cap stocks, increases to 19%, 14%, 74%, and 78%, respectively. Nonetheless, the less than perfect correlation of private equity with major asset classes indicates it has useful properties of diversification.

There are, however, concerns about the returns to private equity. First, Gompers and Lerner conclude that inflows to private equity funds have a substantial impact on the pricing of private equity investments.9 The implication is that there is too much money chasing too few deals, and that the positive valuations associated with private equity investments may be due to new capital inflows instead of real economic value.

Second, Gompers demonstrates that young venture capital firms bring private companies to the public market earlier than older venture capital firms in order to establish a positive reputation.10 He concludes that this type of signaling causes real wealth losses in the form of underpriced IPOs and lower-valued equity stakes, and that this loss is borne by the limited partners in the venture fund.

Despite these potential caveats, empirical research indicates that private equity has favorable risk and return characteristics. We examine these properties within a portfolio framework.

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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