Show me the money

Are private equity investments worth the risk?

Question: Do private equity returns and diversification benefits adequately compensate investors?

This is the debate swirling in investment circles, and it’s the question that researchers Berk A. Sensoy from The Ohio State University Fisher College of Business and Nicholas P.B. Bollen from Vanderbilt University work toward answering in their paper, “How much for a haircut? Illiquidity, secondary markets and the value of private equity.”

Private equity investments have illiquidity and market risks related to the timing of capital flows and require management fees that are usually two percent of investors’ capital commitments per year, plus performance fees typically equal to 20 percent of the profits. According to the researchers, the returns and diversification benefits do justify the risks and costs borne by investors.

The drawback is that secondary sales could result in discounts from fund net asset values of as much as 50 percent during financial crises. During other times, the discount could be 20 percent. Despite these discounts, the study finds that the historical performance and diversification benefits of venture capital and buyout funds, the main types of private equity firms, are sufficient to justify their risks and fees. For example, buyout funds have on average outperformed public equities by about 3% per year.

So what percentage of your portfolio should you allocate to private equity?

If you’re an extremely conservative investor with an extreme risk aversion, the researchers recommend that you should allocate no more than about 10 percent of your portfolio to private equity investments.

If you’re an investor with low to moderate risk aversion, you can comfortably allocate up to 40 percent of your portfolio.

To set yourself up for the best chance of success, the study notes that you should be particularly willing to take the risk of private equity investments if you can access average-performing funds.

While this study will certainly not end the debate, Bollen and Sensoy’s study shows that the returns and diversification benefits of private equity appear sufficient to compensate for the risks and costs for limited partners who have a broad range of risk preferences at portfolio allocations typically observed in practice. The findings offer limited partners a guide in making their portfolio allocation decisions.