Handbook of Alternative Assets Ch 20 - Private Equity

Question 1

Based on the author’s analysis of returns from 1991 - 2005, state the main takeaways
regarding performance.

Answer 1

VC and LBO earned risk premiums above the public stock market

Mezzanine finance and distressed debt underperformed compared to the S&P
500

Sharpe ratios for VC, LBO and mezzanine debt exceeded that of the public stock
market while distressed debt had a lower Sharpe ratio

Question 2

Summarize key characteristics of the return distributions of the four strategies for
private market investing.

Answer 2

VC had a large positive skew and large positive value for kurtosis, indicating a
large fat tail to the upside
Ÿ Consistent with the view of VC as a call option on the success of a startup company
Ÿ VC is exposed to positive event risk

Distressed debt had a large negative skew and large kurtosis, indicating a fat
downside tail
Ÿ Distressed debt is exposed to negative event risk (e.g. defaults, bankruptcies)

LBOs / Mezzanine debt had more symmetrical returns

Question 3

State the three main risks driving the VC risk premium.

Answer 3

1. Business risk of the startup company
2. Lack of liquidity
3. Lack of diversification

Question 4

Describe positive/negative skewness.

Answer 4

A negative skew indicates that the mean of the distribution is less than the median
of the distribution
Ÿ There are more frequent large return observations to the left of the distribution
(negative returns)
Ÿ In this case, large negative outlying returns occur more frequently than large positive
returns

Positive skew indicates upside bias – the mean of the distribution is to the right of
the median
Ÿ There are more frequent large positive returns than there are large negative returns
Ÿ Upside bias

Question 5

Describe positive/negative kurtosis.

Answer 5

If a distribution has kurtosis greater than a normal distribution, it has fatter tails
than a normal distribution (called “leptokurtosis”)

If a distribution has kurtosis less than a normal distribution, it has thinner tails than
a normal distribution (called “platykurtosis”)

Question 6

Describe the correlations of private equity returns.

Answer 6

The different classes of private equity investing have low correlations with each
other

Returns to private equity have low correlations with traditional asset classes
Ÿ Appears that private equity is a very good diversifier for a traditional portfolio of
stocks and bonds