Private Equity Returns in a Model of Entrepreneurial Choice with Learning
Entrepreneurs invest a large share of their financial wealth in a single business that they personally manage. Despite the large risk implied by this undiversified investment they do not seem to require any extra return on a diversified public equity index. In light of the large public equity premium, this fact poses a new asset pricing puzzle. In the present paper, I use a quantitative model to explore the issue and find that the choice to become entrepreneur can be rationalized even with a negative private equity premium when the full return on entrepreneurial investment is properly accounted for. The key assumption is that the quality of a business project is not precisely known upon entry and is learned over time. As long as it is possible to switch back to paid-employment, it is worth experimenting with entrepreneurship to find out if the project is good even if initially the expected return is low.
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Volume (Year): 10 (2010)
Issue (Month): 1 (July)
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