Private Equity versus Stocks

Abstract

In this article the risk and return characteristics and diversification benefits when private equity is used as a portfolio component are investigated. The analysis is based on actual cash flows to and from portfolio companies. Using a dataset that provides complete information for 3620 investments made by 123 funds from 37 investment managers the authors find a dramatic increase in the extent to which private equity outperforms stock investment during the late 1990s. Within the overall class of private equity, returns on earlier private equity investment categories, including venture capital, show on average higher variations and even higher rates of failure. However, by selecting a few extremely well-performing companies, one can achieve high average returns, thus compensating for lost investments. An analysis of various private equity subcategories shows that there is a wide range of optimal allocations to this asset class that minimizes mixed-asset portfolio variance or maximizes performance ratios.

TOPICS: Private equity, security analysis and valuation, portfolio construction, performance measurement