A Simple Question?
A fund manager enters their favorite investment boutique and asks: How to replicate private equity fund cash flows by public market trading strategies?
Despite the continued popularity of private equity funds among institutional investors, with evermore capital committed to these illiquid investment vehicles, the question about liquid alternatives to private equity funds remains largely unanswered by the academic literature. Particularly the identification of feasible traded-factor based replication strategies for the cash flow streams associated with private equity funds seems appealing from various risk management and performance evaluation perspectives: They can be readily used as:
- (1. replication) easy to execute investment alternative to a private equity fund commitment,
- (2. hedging) hedging instrument for committed private equity fund investors, and
- (3. benchmarking) advanced public market equivalent methodology for benchmarking purposes.
A Sophisticated Answer
To better understand the relation between public markets and private equity, we consider quadratic hedging strategies to replicate the typical payment stream pattern associated with private equity funds by traded factors. Our methodology is inspired by the risk-minimization framework developed in financial mathematics and applies the componentwise L2Boosting machine learning technique to empirically identify feasible replication strategies. The application to US venture capital fund data further draws on a stability selection procedure to enhance model sparsity. Interestingly a natural connect to the famous Kaplan and Schoar (2005) public market equivalent approach can be established.
The article can be found in the Journal of Finance and Data Science. The R code can be found on GitHub. The presentation slides for additional context are here.
Example: US Venture Capital Cashflows
Ex-post model
The picture below visualizes a perfect ex-post hedge for the cash flows of all US Venture Capital funds of vintage year 1992 by trading the NASDAQ.Composite Minus MSCI.World factor.
2019-02-06SingleVintage-eps-converted-toEx-ante model
The final model ready for a real world hedging/replication application is obtained by componentwise L2Boosting in combination with a stability selection like procedure. The corresponding sparse ex-ante hedging result for US Venture Capital funds of vintage 1992 is depicted below.
2019-03-12SingleVintageStabilitySelection-eps-converted-to