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Dynamic Portfolio Management with Private Equity Funds PDF
By:Joo Hyung Lee
Published on 2012 by

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Private equity investments have become an increasingly significant portion of many institutional portfolios because of their attractive return characteristics. However, despite being illiquid and having inherently multi-period cashflow characteristics, portfolio management techniques involving private equity asset classes are still dominated by traditional but largely inadequate single period approaches. In this work, I propose a quantitative modeling approach and a portfolio optimization framework to handle funds with significant private equity investments. Driven by the demands of practical application, the key features of this approach are that it captures the unique illiquid and multi-period characteristics of private equity while remaining computationally simple. In fact, the computation required is not significantly more difficult than that required for single period mean-variance portfolio optimization. I use a state space model to capture the aggregate dynamics of each private equity asset class. If desired, the number of states in this model can be increased to more accurately reflect the cashflow characteristics of the asset class. Using the model, a multi-period mean-variance portfolio optimization problem is formulated, and a suboptimal open-loop approach is employed for its computational simplicity. Based on this open-loop problem, I also propose a shrinking horizon implementation that is provably superior to the open-loop solution that it is based on. Numerical examples are used to compare the open-loop approach to other commonly used heuristic approaches. An example using statistics reflective of a large university endowment fund is solved and insight into portfolio management with private equity asset classes is highlighted. Finally, using the developed multi-period open loop approach, I develop a heuristic method that utilizes the single-period methods that most investors still rely on. The heuristic method is derived by adjusting the mean and variance of the returns of the private equity asset classes, and can be interpreted in the context of a liquidity premium.

This Book was ranked at 2 by Google Books for keyword Private Equity.

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