Diversifying Private Equity
58 Pages Posted: 18 Feb 2020 Last revised: 24 Jan 2025
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: Suggested Citation