Managing Diversifiable Risk in Private Equity
43 Pages Posted: 7 Nov 2020
Date Written: April 04, 2020
Risk models commonly used in practice disregard the diversifiable risk of LP's PE portfolios. Based on a unique data set we find evidence that the relevance of idiosyncratic portfolio risk might be underrated. Our simulation results show that diversification across the number deals significantly mitigates idiosyncratic portfolio risk in large LP portfolios. Especially for buyout investments, syndicated deals reduce idiosyncratic portfolio risk, whereas deals shared by several partners within the same LP portfolio increase this risk. Looking at a sample of real LPs, our findings indicate that some investors have particularly high skills in identifying the most diversified GPs and selecting the most diversified funds. Additionally, we find that certain LPs are simultaneously invested in several deal partners of a syndicated deal, more frequently than luck would have it, and that these deals show a favorable risk-return profile.
Keywords: Private Equity, Risk Management, Idiosyncratic Risk, Limited Partners
JEL Classification: G24
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