Building on previous work we analyze the option-like characteristics of investment in private equity. While the main academic focus has been on the disputed ability of this asset class to produce above-average risk-adjusted returns, our focus is on the underappreciated role played by volatility in private equity (PE) performance. Our conclusion is that PE is a much more attractive asset class (lower risk) than commonly believed.

In contrast to most approaches, we focus on the influence of the options built into the private-equity investment business model primarily from the perspective of the fund manager, or General Partner (GP). As the owner of call options on the underlying investors’ capital commitments initially and later of complex put options as assets can be retained before being sold, the GP is well placed to take advantage of market volatility, particularly during bad times.

We posit the existence of “negative beta” as a reason for large investors to make much bigger allocations to PE than are typical.