Private equity provides diversification benefits in portfolios with at least 60
percent equity. Illiquidity, risk, and inefficient markets cause some investors
to consider private equity unsuitable for their portfolios. It is most
appropriate for moderately sized funds with special skills, strong board
support, and limited need for liquidity and confidentiality.
This paper analyzes private equity investment within the context of portfolio
optimization and special variables related to an investor's compatibility with private
equity. Data show total investable capital to be $71.2 trillion, including cash
equivalents, U.S. and non-U.S. stocks and bonds, emerging market debt, high-yield bonds,
real estate, and private equity. About 94 percent of total investable capital consists
of publicly traded stocks, and real estate accounts for most of the rest. Private
equity, venture capital, and leveraged buyouts account for only 0.7 percent.
The relatively small amount of private equity constrains investors' collective ability to
allocate assets to it. If some allocate substantially more than 0.7 percent of their
portfolios, others must allocate less. Mean–variance analysis provides a framework
for determining optimum allocations. Data are from the Wilshire 5000 Index, the Morgan
Stanley All-Country World (ex U.S.) Index, the Lehman Brothers' Aggregate Bond Index,
the Wilshire Real Estate Securities Index, and the CSFB Warburg Pincus/Venture Economics
Post-Venture Capital Index (PVCI), which is used to proxy private equity risk.
A pricing framework such as the capital asset pricing model provides returns, standard
deviations, and correlations for the asset classes. The correlation between private
equity and the broad U.S. equity market is 0.90. The equilibrium expected return for
private equity, based on systematic risk only, is 11.3 percent, and the standard
deviation is the highest among the asset classes. This expected return does not take
into account other factors entering into the required return for private equity such as
illiquidity, asymmetric information, and difficulty in diversifying private equity
investments, but these are not needed for the present analysis. Diversification benefits
of private equity occur primarily in equity portfolios, and private equity enters only
those efficient portfolios with 60 percent or more equity. Portfolios with 100 percent
equity allocate 5 percent to private equity.
An inefficient market means that success in private equity investment requires highly
skilled professionals with special abilities, as evidenced by the large variation in
private equity returns. Fifty percentage points separate the highest quartile of past
returns from the lowest. The median returns for both venture capital and leveraged
buyouts are several percentage points below the return on the Wilshire 5000. Investor
risk tolerance suggests that private equity is not appropriate for portfolios with 30
percent or more in bonds.
Successful private equity investors likely have moderately sized portfolios, internal
resources needed to supervise the investment, boards with experience in private equity,
and the ability to accept the information confidentiality that is normal among private
equity managers. In recent years, large pension funds have invested an average of about
3 percent of assets in private equity and large endowments have invested about 8
percent, but more than half have no allocations to private equity.
The authors conclude that some investors appropriately invest a few percentage points in
private equity while others invest none. Portfolio allocations as large as 10 percent
are appropriate only for equity-oriented funds that are moderately sized, with private
equity investment skills and staff resources, and with support from a knowledgeable
board.