Mastering Illiquidity: Risk management for portfolios of limited partnership funds

Foreword

Over the last three decades, private equity has established itself as one of the most important asset classes for institutional investors. Despite going through boom and bust periods, investments in private equity have grown steadily over time. Two important economic forces have helped drive this growth.

First, illiquid assets, such as private equity, comprise an important part of the overall market portfolio and thus provide investors with important diversification benefits. The vast majority of assets around the world are private, and despite the recent growth of private equity these assets are still underrepresented in the portfolios of institutional investors.

Second, as institutional investors have grown larger and more diversified, it is becoming harder for institutions to exercise active ownership and governance in all the companies they own. This is a serious problem, since active ownership and governance are crucial in order to realize the full value potential of a firm. By investing part of their assets in private equity funds, large institutions can delegate their active ownership to skilled intermediaries, which in turn can acquire large ownership stakes in companies and act as active owners, while still allowing the institutional investors to maintain a high degree of diversification in their overall portfolios.

Recent research has confirmed that this model seems to work: firms seem to be run more efficiently under private equity ownership, and private equity ...