Although the risk reduction benefits may be modest, the expertise required to invest in private equity usually results in a higher return on investments. Therefore, a modest inclusion in the portfolio may still be merited.

Cambridge Associates and Thomson Venture Economics provide overall indices for VC and buyout funds. They typically calculate the internal rate of return based on cash flows since fund inception. Often firms are compared by vintage year for comparability across the stage of financing and any macroeconomic influences.

Since the venture capital must provide appraisals of some assets, stale valuations can result in a smoother return appearance than is actually realized.

Input uncertainty relates to whether the inputs fed to a model are accurate.

Input and model uncertainties make it difficult to evaluate potential inefficiencies or market anomalies.

In the March/April 2008 Financial Analysts Journal Waring and Ramkumar write that the expected alpha from active fund managers can be forecasted, as long as investors pay heed to the rules of zero-sum-game investing.

The forecasts are based on two equations derived from the fundamental law of active management. Variables for the equation are estimates of the manager’s skill, estimates of the sponsor’s assessment of its own skill in identifying skilled managers, the cross-sectional standard deviation of manager skill, portfolio breadth, implementation efficiency, expected active risk, and fees.

• No double taxation (profits taxed at limited partner or shareholder level)
• No liability beyond the initial investment

Typically private equity funds will be structured to have a 7-10 year life, with options to extend this for an additional 1-5 years. The objective is to realize the full value of investments by the liquidation date. Rather than manage pools of uninvested capital, private equity managers typically require commitments that are drawn down as the funds are needed to make investments or cover expenses.

Fees for private equity managers typically include a management fee of 1.5% – 2.0% of assets under management, plus an incentive fee of 15%-20% of the profits retained after capital is returned to the limited partners. The incentive fee may include a hurdle rate of return that must be met before the fee is earned, and also may include a claw-back provision in case later investments do poorly.

Anchoring refers to giving disproportionate weight to the first information received about a topic.

Status quo bias is the tendency to perpetuate recent observations in forecasts.

Confirming evidence is the tendency to give more weight to information that supports existing or preferred points of view than to information that contradicts the preferred view.

Overconfidence is having too much faith in the accuracy of one’s forecasts.

Recallability is when forecasts are overly influenced by events that left a strong impression on the forecaster’s memory.

Studies have shown that high volatility index scores are positively related to future stock market returns. In an efficient market, an observable variable such as the VIX should not have predictive power. The authors confirm that the predictive power exists, and offer support for both the market inefficiency and the priced risk arguments.

Liquidity can be defined a number of ways:

• Tightness (low bid/ask spread)
• Depth (limited price impact from large trades)
• Resiliency (rapid adjustments for discrepancies between market price and intrinsic value)

Transparency means access to quotes is quick, easy and inexpensive. It also requires that trade details (size and price) are rapidly disseminated to the public.

Assurity of completion simply means that the counterparties of a trade can be trusted to honor the trade.

Typically the preferred investors must see a return of capital and also some investment return (often a total of 2x the capital contributed) before any cash can be returned to common shareholders. This provides the founders with an incentive to earn the return required by their investors so they can reap their own rewards.

The preferred shares are also convertible to common shares, which is typically done when a corporate action (merger or IPO) creates liquidity for the common shares and an opportunity to cash out.

1. Higher semiconductor sales result in a need for more semiconductor equipment (A predicts B)
2. Having more equipment to make semiconductors results in higher sales (B predicts A)
3. Some other factor (such as economic conditions) results in higher need for both semiconductors and semiconductor equipment (C predicts A and B)

Without investigating and modeling the underlying linkages, using correlations relationships in a prediction model can lead to significant errors.

Equally important, suppose that no correlation is found between semiconductors and semiconductor equipment. They may still have a strong (but nonlinear) relationship that should be considered. Such relationships may be found by using multiple regression techniques.