PDF Ebook Private Equity Investment
This thesis aims to answer the question of how to invest in Private Equity and to provide guidelines for an investor who considers allocating a part of his wealth in this asset class. First, we describe the Private Equity industry, its structure and its return characteristics. Second, we review Modern Portfolio Theory, Behavioral Portfolio Theory and the liquidity issue. Third, we review some portfolio allocations studies and we finally look at the investment styles of the major Private Equity investors, banks, insurance companies, family offices, endowments, foundations and pension funds and explain them considering portfolio theories.
The Private Equity industry can be divided into two main segments: Venture Capital and Buyout. There are different stages of investment within the Venture Capital industry, going from the business idea to the need to raise cash to grow. These stages are called Seed, Startup, Expansion and Replacement Capital. The Buyout industry deals with mature firms and has the objective of taking control. The most well-known and publicized forms are Leveraged Buyouts and Management Buyouts.
There are three major ways to invest in Private Equity: direct investment, Private Equity funds or funds of funds. The funds of funds provide a good way of diversifying the risk for individual investors at a fee p.a. between 0.75% and 1.25%.
The Internet bubble had a significant impact on the Private Equity industry in the recent years. The number of Private Equity funds and the total committed capital doubled from 1997 to 2000, and were then followed by a strong reduction. The impact was more pronounced for the Venture industry than for Buyouts.
The Private Equity asset class has approximately a market capitalisation of $470 billions, which represents only 0.7% of the world total investable assets. It is a long term and illiquid investment, since it provides a positive return only after 8 years of investing and excess return after 10 years on average. According to Venture Economics, we had a 10-year average return of 9.8% for Private Equity as of the end of year 2004.
Private Equity is an inefficient market because information is not public but limited to fund managers who conduct due diligence and monitor their investments. This inefficiency is translated with a difference of 28% between the lower and upper quartile in Private Equity funds returns. Investment in Private Equity thus depends on one's access to this information.
To be able to understand how we should invest in Private Equity, we compare Modern Portfolio Theory (Markowitz (1952)) to Behavioral Portfolio Theory (Kahneman and Tversky 1979)). The former assumes rational individuals and perfect arbitrage, which lead to efficient markets where each investor holds a portion in a risk free asset and another in the market portfolio. The latter assumes non rational investors, showing behavioral biases due to the psychological nature of human beings, and limited arbitrage on the market because of financial constraints. We also consider the liquidity issue and give a simplified model of Amihud and Mendelson (1986) to be able to approach this problem.
We do a literature review of asset allocation with Private Equity. We consider several portfolios and see whether Private Equity can improve the initial position in terms of risk and return. We start with an equity-only portfolio, then a diversified one, and finally we look if Post Venture Private Equity, which refers to firms after their IPO, has the same properties in improving a portfolio. One of our conclusions is that introducing Venture Capital and Buyout in a portfolio undoubtedly brings diversification benefits.
In the last part, we examine Private Equity largest investors which are banks, pension funds and insurance companies. We also take a look at family offices, endowments and foundations which invest relatively more in Private Equity than other investors. All of these investors have in common a long term horizon so that the illiquidity of Private Equity has less impact.
Our main conclusion is that different allocations to Private Equity could be explained by the ability of the investor to access the relevant information. A recent study, Lerner (2005), finds a positive correlation between American University endowments' performance in Private Equity investments and the quality and loyalty of the student body. This suggests that the top performing schools use their information obtained through their alumni network to select the appropriate investments.
In the case of family offices, we can observe behavioral biases like long-term investment benchmarks or a tradition in investing in some asset classes. Pension funds must respect benefit plans and thus may require cash suddenly from their investments. This reduces the attractiveness of Private Equity for them and we observe a lower average allocation than for family offices and endowments.
Contents
1. Introduction
2. Private Equity
- 2.1. Definition
2.2. Structure
2.3. Facts
2.4. Risk and return
2.5. Other considerations
3. Theories of asset allocation
- 3.1. Markowitz model
- The two fund separation theorem
Issues with the Markowitz approach
3.2. Behavioral Portfolio Theory
- Heuristic-driven bias
Frame dependence
Inefficient markets
Portfolio selection in behavioral finance
3.3. Other issues
- Liquidity
The role of information
4. How much should we allocate to Private Equity?
- 4.1. Equity-only portfolio
4.2. Traditional portfolio consisting of equity and bonds
4.3. Post Venture portfolio
5. Private Equity Investors
- 5.1. Banks and insurance companies
5.2. Family offices
- Definition
Structure
Facts
Investment style
5.3. Endowments and foundations
- Definition
Investment Style
5.4. Pension funds
- Definition
Investment Style
6. Conclusion
7. References
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PDF Ebook Private Equity Investment
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