Human Capital and the Private Equity Premium

Abstract:     
In imperfect capital markets, an entrepreneur has to invest substantial personal funds to start a private firm and is forced to bear large firm-specific risk. Furthermore, if the entrepreneur is risk averse, one would expect the private equity to earn a premium for idiosyncratic risk. In this paper I explore how human capital interacts with the decision to invest in a private business and calibrate a model of entrepreneurial choice to illustrate a significant attenuating effect of human capital on the premium for firm-specific risk. When the entrepreneur can quit the business and work for hire, the firm-specific risk premium is order of magnitude lower than without this option. The main point of the model is to recognize how human capital interacts with the decision to invest in a private firm. While the entrepreneur risks a substantial fraction of her financial wealth, she does not commit all human capital to the current business. At risk is only the labor income forgone while managing the business and the rest of human capital is unaffected by the business risk. The empirical evidence suggests that private equity does not earn any significant premium over the public equity. The model with human capital is consistent with that, assuming typical entrepreneur forgoes a small return of about 1% in lieu of intangible benefits of entrepreneurship.

Keywords: Human capital, private equity, entrepreneurhsip

JEL Classifications: G00, M13, J24

Working Paper Series