We study private equity in a dynamic general equilibrium model and ask two questions: (i) Why does the investment of venture funds respond more strongly to the business cycle than that of buyout funds? (ii) Why are venture funds returns higher than those of buyout? On (i), venture brings in new capital whereas buyout largely reorganizes existing capital; this can explain the stronger co-movement of venture with aggregate Tobin's Q. Regarding (ii), venture returns co-move more strongly with aggregate consumption and therefore pay a higher premium. Our model embodies this logic and fits the data on investment and returns well. At the estimated parameters, the two PE sectors together contribute between 14 and 21 percent of observed growth, relative to the extreme case where private equity is absent.
We thank Yakov Amihud, Christian Opp, and Stijn Van Nieuwerburgh for comments, Zahin Haque and Angelo Orane for research assistance, the National Science Foundation and C.V. Starr Center for financial assistance, and seminar participants at the Federal Reserve Bank of Chicago, the Federal Reserve Board, NYU Stern, and The Ohio State University for helpful comments. The views expressed are those of the authors and do not necessarily reflect those of the Federal Reserve Board, the Federal Reserve System, or the National Bureau of Economic Research.