Jul 7, 2010
Should investors expect higher returns from private equity investments as compensation for the lack of liquidity? Does private equity offer a useful diversification benefit in a balanced portfolio?

EFF/KRF: Asset pricing theory suggests that less liquid assets should have higher expected returns to compensate for lower liquidity. Whether there is in fact a liquidity premium in the returns to private equity is, however, difficult to document. The problem is lack of data on private equity returns that does not suffer from survival bias. The existing evidence, such as it is, says the returns have not been high, given the risks. But in truth, because private equity investments are risky, good estimates of expected returns are not possible with the limited data that are available.

We are probably on safer ground in concluding that private equity is not a diversification tool. Estimates of market betas for private equity are 1.0 or higher. The intuition is that the firms that get private equity (or venture capital) are typically small, and the stocks of small firms have high market sensitivity that cannot be diversified away.

We also emphasize that if private equity managers have skill in choosing good investment projects and bringing them to fruition, the result is a return due to the human capital of the private equity managers. Labor economists would argue that this return goes to the human capital, that is, the managers. Talented private equity managers are the scarce resource here, not investors' capital. As a result, the fees of managers should be set so that private equity investors just get expected returns that compensate them for the high risks of the investments.

Finally, because the returns to private equity investments have large idiosyncratic random components (in addition to high market sensitivity), a wide range of outcomes is likely purely by chance. It is then predictable that the lucky managers are anointed by investors and the media, and they are flooded with new money from investors, even when past performance is due to luck. In other words, the message of our post on Luck Versus Skill in Mutual Fund Returns surely carries over to private equity where the range of chance outcomes is likely to be even more extreme.

Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
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Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.