Chapter 4 - Private equity in diversified investment portfolios

Abstract

The recent financial crisis has revived the debate about the role of alternative investments in diversified portfolios. A wholesale shift back to traditional public markets in portfolios where private equity and other alternatives represent a sizeable share of total assets under management is not anticipated. Instead, a key lesson for investors with substantial exposures to illiquid investments is to hold a complementary part of the portfolio in liquid assets to avoid cash-flow distress and to retain flexibility in adjusting their asset allocation. Nor does one see signs that the share of private equity in portfolios with a moderate exposure to alternatives will progressively converge toward levels seen in some endowment portfolios, as some had predicted before the crisis. There are good reasons why allocations to private equity vary substantially, both across and within different investor classes. Individual investors have different utility functions, they operate under different regulatory requirements, the size of their portfolios varies, and their access to top-performing funds may be sufficiently heterogeneous. Despite these fundamental differences, overall private equity has gained substantial importance over the last few decades. Having emerged into a trillion-dollar industry, today private equity funds manage around 1 percent of the world's financial assets under management.