Diversifying Private Equity

58 Pages Posted: 18 Feb 2020 Last revised: 24 Jan 2025

See all articles by Oleg Gredil

Oleg Gredil

Tulane University - A.B. Freeman School of Business

Yan Liu

Purdue University

Berk A. Sensoy

Vanderbilt University - Finance

Date Written: January 13, 2021

Abstract

The vast majority of institutional investors in private equity (PE) invest in fewer than three PE funds per year. We propose an expected utility framework to account for underdiversification costs. For plausible portfolio choices and risk preferences, certainty equivalent returns from PE are up to 5% lower than if inferred from average PE fund performance. Chasing PE managers with high past performance increases idiosyncratic risk, which outweighs improvements in expected return for risk-averse investors. However, investing in as few as five funds per year likely sufficiently diversifies most investors. Funds-of-funds create value through diversification even with average performance, especially for highly risk-averse investors. Consistent with learning, investors diversify more after encountering negative performance shocks.

Keywords: Private Equity, Venture Capital, Fund of Funds, Fund Performance, Portfolio Choice

JEL Classification: C11, D83, G11, G23, G24

Suggested Citation

Gredil, Oleg and Liu, Yan and Sensoy, Berk A., Diversifying Private Equity (January 13, 2021). Available at SSRN: https://ssrn.com/abstract=3535677 or http://dx.doi.org/10.2139/ssrn.3535677

Oleg Gredil (Contact Author)

Tulane University - A.B. Freeman School of Business ( email )

7 McAlister Drive
New Orleans, LA 70118
United States

Yan Liu

Purdue University ( email )

West Lafayette, IN 47907-1310
United States

HOME PAGE: http://yliu1.com

Berk A. Sensoy

Vanderbilt University - Finance ( email )

401 21st Avenue South
Nashville, TN 37203
United States

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