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Private Equity and Strategic Asset Allocation
Private equity is both an asset class and an investment strategy. Distinguishing between the private equity asset class and the private equity investment strategy can be confusing and creates challenges for the traditional approach to asset allocation. Asset allocation decisions should be based on the risk and return characteristics of the asset class, although in reality, most private equity decisions are based on the perceived risk and return characters of the available private equity vehicles.
Public companies collectively form the public equity asset class. Investors can gain exposure to the public equity asset class by purchasing shares of publicly traded companies or shares of investment vehicles, such as mutual funds, that purchase the public shares.
Private (non-public) companies collectively form the private equity asset class. Investors can gain exposure to the private equity asset class by purchasing shares of privately held companies or shares of investment vehicles, such as private equity funds, that purchase the non-public shares.
A large number of private corporations are generally assumed to be public corporations, including Dunkin Donuts, Hertz, Linens-N-Things, Neiman-Marcus, and Toys-R-Us. Common reasons for being private include family owned businesses that have always been private, leverage buyouts, and venture start-ups still waiting to go public.
From a modern portfolio perspective, ideally, one could invest in a basket of all private corporations in which the weights of the companies in the basket are based on their true values. Such a basket with real-time pricing would include thousands of constituents and would be a true representation of the private equity asset class. In such a world, all value-weighted benchmarks would lead to very similar conclusions on the performance of the asset class. Unfortunately, this is not possible and, philosophically, not how most people conceptualize a private equity investment. When investors make an allocation to private equity, it is not a passive investment
in the basket of all (or most) private companies that form the private equity asset class. Rather, for most investors, the allocation to private equity is an investment in a skill-based strategy, in which the two primary sub-strategies are leveraged buyouts and venture capital. One can carry out such strategies directly or through an investment vehicle that carries out the investments on their behalf. Two primary investment 5 vehicles are engaged in these strategies – traditional private equity funds and publicly listed companies.
Traditional private equity funds are typically pure plays in the private equity strategies, while publicly listed companies offer a spectrum of private equity-like exposure. Most private equity funds are organized as limited partnerships with a finite life (e.g.10 years). The limited partners invest in (or commit capital to) the funds which are then managed by the general partners. The industry appears to be moving toward the creation of more perpetual investment vehicles. If one assumes that traditional private equity funds and publicly listed companies engaged in private equity strategies own all of the private companies, the collective performance associated with these investments would perfectly match the performance of a basket of all private companies representing the private equity asset class. The implication is that the weighted average performance of private equity funds would be the same as the investment in the private equity asset class. On an asset weighted-basis, half of the investors will do better and half will do worse than the asset class as a 6whole. This return relationship is straightforward, but not always recognized.
Unlike the straightforward return relationship, the risk relationship between the asset class and the investment vehicle is not straightforward. The standard deviation of private equity “asset class” returns is not the same as the standard deviation of private equity “fund” returns, as individual funds have high amounts of idiosyncratic (investment specific) risk. For example, for the universe of large cap U.S. mutual funds, the average standard deviation of their returns is very similar to the standard deviation of the S&P 500, which is a byproduct of the tendency of most mutual funds to create portfolios with characteristics that mimic those of the benchmark. For the universe of private equity funds, the average standard deviation of their returns should
be considerably higher than the standard deviation of the private equity asset class due to the concentrated nature of private equity funds. This phenomenon of a wide dispersion of returns among private equity funds is documented in Lerner, Schoar, and Wongsunwai [2007].
Public equity investments often involve exposure to more than 1,000 public companies. While thousands of private companies collectively form the private equity asset class, private equity funds are more concentrated and often involve exposure to fewer than 15 private companies. The fragmented structure of the private equity market is such that private equity investors cannot fully diversify away private company specific risk; thus, all private equity investments are a mixture of systematic risk exposure to the private equity asset class and private company specific risk.
Asset allocation decisions are largely based on the expected return and standard deviation of the asset class. For most asset classes, it is relatively easy to invest in a passive – or beta – representation of the asset class. When it comes to the private equity asset class, a passive investment with risk and return characteristics that mimic the risk and return characteristics of the total private equity asset class does not exist! Thus, as advocates of separating the beta (asset allocation) decision from the alpha (product) decision, we face a rather large dilemma – should we base the beta decision on risk and return characteristics associated with the average private equity investment or the private equity asset class? We are forced to muddy the alpha-beta separation waters and use the risk and return characteristics that reflect the beta characteristics that an investor could obtain through a particular method of private equity exposure. Fortunately for us, the type of private equity exposure used in this study – listed private equity exposure – provides exposure to thousands of private equity companies and moving forward as more private equity investments are securitized should be more reflective of the private equity asset class.
As asset allocators contemplating the role of private equity in a strategic asset allocation, two strands of research are of particular interest: research on strategic asset allocations to private equity and research on the risk and return characteristics of private equity. Phalippou [2007a] provides an excellent literature review and
私人股本和战略资产配置文献翻译
