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Human Capital and the Private Equity Premium

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  • Valery Polkovnichenko

    (University of Minnesota)

Abstract

When capital market is imperfect, an entrepreneur has to invest substantial personal funds to start a firm and has to bear large firm-specific risk. Furthermore, if a typical entrepreneur is risk averse, private equity should earn a premium for idiosyncratic risk. In this paper I explore the interaction of human capital with the decision to become an entrepreneur. I calibrate a model of entrepreneurial choice to illustrate a significant attenuating effect of human capital on the premium for firm-specific risk. When an entrepreneur can quit the business and work for hire, the firm-specific risk premium is order of magnitude lower than without this option. While an entrepreneur puts at risk a substantial fraction of financial wealth, she does not commit all human capital to the current business. At stake is only the labor income forgone while managing the firm and the rest of human capital is unaffected by the business risk. Empirical evidence suggests that private equity does not earn any significant premium over publicly traded equity. The model with human capital is consistent with this observation, assuming typical entrepreneur forgoes a small expected return (1.5%) in lieu of intangible benefits of entrepreneurship. (Copyright: Elsevier)

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Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 6 (2003)
Issue (Month): 4 (October)
Pages: 831-845

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Handle: RePEc:red:issued:v:6:y:2003:i:4:p:831-845

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References

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Cited by:
  1. Hugo A. Hopenhayn & Galina Vereshchagina, 2003. "Risk Taking by Entrepreneurs," RCER Working Papers, University of Rochester - Center for Economic Research (RCER) 500, University of Rochester - Center for Economic Research (RCER).
  2. Jason DeBacker & Bradley Heim & Vasia Panousi & Shanthi Ramnath & Ivan Vidangos, 2012. "The properties of income risk in privately held businesses," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2012-69, Board of Governors of the Federal Reserve System (U.S.).
  3. Frank M. Fossen, 2012. "Risk Attitudes and Private Business Equity," Discussion Papers of DIW Berlin 1209, DIW Berlin, German Institute for Economic Research.
  4. Ander Pérez Orive, 2010. "Credit constraints, firms' precautionary investment and the business cycle," Economics Working Papers, Department of Economics and Business, Universitat Pompeu Fabra 1237, Department of Economics and Business, Universitat Pompeu Fabra, revised Nov 2012.
  5. Akyol, Ahmet & Athreya, Kartik, 2011. "Credit and self-employment," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 35(3), pages 363-385, March.
  6. Nikolai Roussanov, 2010. "Diversification and Its Discontents: Idiosyncratic and Entrepreneurial Risk in the Quest for Social Status," Journal of Finance, American Finance Association, American Finance Association, vol. 65(5), pages 1755-1788, October.
  7. Christian Roessler & Philipp Koellinger, 2009. "Firm Formation with Complementarities: The Role of the Entrepreneur," Tinbergen Institute Discussion Papers, Tinbergen Institute 09-003/3, Tinbergen Institute, revised 26 Jul 2011.
  8. Ander Pérez Orive, 2010. "Credit Constraints, Firms' Precautionary Investment, and the Business Cycle," Working Papers 506, Barcelona Graduate School of Economics.
  9. Simon Parker & Mirjam van Praag, 2004. "Schooling, Capital Constraints and Entrepreneurial Performance," Tinbergen Institute Discussion Papers, Tinbergen Institute 04-106/3, Tinbergen Institute, revised 07 Mar 2005.
  10. Simon C. Parker & C. Mirjam van Praag, 2006. "The Entrepreneur's Mode of Entry: Business Takeover or New Venture Start?," Tinbergen Institute Discussion Papers, Tinbergen Institute 06-089/3, Tinbergen Institute.
  11. Ahmet Akyol & Kartik Athreya, 2009. "Self-employment rates and business size: the roles of occupational choice and credit market frictions," Annals of Finance, Springer, Springer, vol. 5(3), pages 495-519, June.
  12. Roessler, Christian & Koellinger, Philipp, 2012. "Entrepreneurship and organization design," European Economic Review, Elsevier, Elsevier, vol. 56(4), pages 888-902.
  13. Hintermaier, Thomas & Steinberger, Thomas, 2002. "Occupational Choice and the Private Equity Premium Puzzle," Economics Series, Institute for Advanced Studies 122, Institute for Advanced Studies.
  14. Kartik Athreya & Ahmet Akyol, 2007. "Unsecured Credit and Self-Employment," 2007 Meeting Papers, Society for Economic Dynamics 49, Society for Economic Dynamics.
  15. Claudio Campanale, 2006. "Leraning, life-cycle and entrepreneurial investment," Working Papers. Serie AD, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie) 2006-29, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).

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