Diversifying Private Equity

Abstract

Most institutional investors in private equity (PE) invest in just one or two PE funds per year. For these investors, it is overly optimistic to judge the value of PE as an asset class by its average performance, as prior literature does, because it does not adjust for idiosyncratic risk. This paper proposes a new framework for private equity performance evaluation that permits a fund selection scheme to capture diversification constraints, allows for high-moment characteristics in fund returns, and can be adapted to a variety of utility functions. We use the framework to evaluate the utility costs to imperfectly diversified PE investors relative to a fully diversified benchmark. When calibrated to the data on institutional allocations to PE and plausible risk aversion, our analysis reveals that certainty equivalent returns in PE fund investing are 2-to-8% lower than if inferred from average fund performance levels. Funds-of-funds are generally worth their fees-on-fees for small, constrained investors that would otherwise bear substantial idiosyncratic risk from small numbers of PE funds. Chasing managers with high past performance increases idiosyncratic risk which for most investors outweighs the incremental improvement in returns. Historical commitments by public pension funds are consistent with a neglect of underdiversification costs.