Private Equity for Pension Plans? Evaluating Private Equity Performance from an Investor's Perspective

Abstract

We propose a methodology to evaluate private equity investments by using investor-specific stochastic discount factors. The methodology allows a direct way of decomposing an investor's private-equity return into a risk-compensation and an "alpha". It also helps determine whether a given investor could benefit from investing (more) in private equity. Applying our metrics to U.S. public pension plans, our key results are that: a) during our sample period, pension plan allocations to private equity funds were optimal overall, although the average plan was underexposed to buyout; b) plans invest in PE funds that have higher risk-adjusted performance, but this is because of some pension plans' superior access to successful private equity funds, c) the higher returns obtained by some pension plans in their private equity investments appear to be the result of a higher willingness to take risk rather than a manifestation of timing or selection: Differences in governance structure and funding ratios tend to correlate with the risk-compensation component of the private-equity return rather than the alpha component.

Keywords: Private Equity, Performance Evaluation, Public Pension Plans

JEL Classification: G10, G11, G23, G24