The Benefits of Private Equity

Abstract

Private equity is a widely encompassing term for any equity-type investment in a company that generally is not listed on a stock exchange. Private equity investment strategies represent an increasingly significant component of institutional portfolios.

According to the Russell Survey on Alternative Investing (2005) of 327 large organizations responsible for managing tax-exempt assets, strategic allocations to private equity are forecast to grow across all regions (North America, Europe, Australia, and Japan). In North America, allocations to private equity are expected to grow to more than 7.5 percent of total traditional and alternative asset allocations. While generally regarded as strategies that provide higher return opportunities relative to traditional asset classes, primarily through their ability to participate in the vast marketplace of privately held companies, the sector has undergone dramatic transformations in recent years. In February 2007, Fortress Investment Group, a leading global alternative asset manager with significant assets in private equity, went public on the New York Stock Exchange, and Blackstone Group, L.P., went public in June 2007.

The increased interest in this sector is largely driven by its superior long-term returns compared with the performance of public equities. The primary sources of these superior returns are twofold: Private equity is able to access the vast and growing marketplace of privately held companies that are not available in traditional investment products. In addition, private equity can create value by proactively influencing invested companies’ management and operations, thereby generating excess returns over conventional stock and bond investments.

This paper reviews the risk-and-return characteristics of various forms of private equity investments as well as the risk-and-return implications of adding private equity to traditional stock and bond portfolios. The results suggest that traditional private equity indexes may provide diversification and return benefits when added to an existing stock and bond portfolio or to an existing mixed traditional (stock and bond) and alternative (hedge funds, commodity trading advisors, real estate, and commodity) portfolio. In addition, we discuss the impact of the use of alternative private equity indexes on our empirical results.

Keywords: Private Equity

JEL Classification: E21, G11, G23, G24