Private Equity's Diversification Illusion: Evidence From Fair Value Accounting

Abstract

Private equity fund managers, pension fund managers, and investment advisers assert that private equity investments diversify investors’ portfolios. We show that cost-based methods of accounting understate the systematic risk of private equity, creating an illusion of diversification. After European private equity funds switched to fair value accounting following their adoption of IAS 39, correlations between accounting-based private equity returns and those of public equity markets increased and private equity funds’ access to capital decreased. Our results are consistent with an illusion of diversification that (1) affected investors’ perceptions of risk and investment in private equity and (2) was corrected when private equity firms’ change to fair value accounting more accurately conveyed the true risk of PE investments to investors.

Keywords: private equity, diversification, fair value accounting, IAS 39

JEL Classification: G11, G15, G23, M41