"Valuing Private Equity"

Morten Sorensen, Neng Wang, Jinqiang Yang

Working paper, 2012

Publication type: Working paper

Research Archive Topic: Business Economics and Public Policy, Corporate Finance

Abstract

To evaluate the performance of private equity (PE) investments, we solve a portfolio-choice model for a risk-averse institutional investor (LP). In addition to public equity and bonds, the LP invests in a PE fund, managed by a general partner (GP). Our model captures key features of PE: (1) illiquidity; (2) non-diversifi able risk and incomplete markets; (3) GP compensation, including management fees and carried interest; (4) GPs' ability to create value (alpha); and (5) leverage. We derive tractable formulas for the LP's portfolio weights and certainty-equivalent valuation of the PE investment. Importantly, we show that the cost of illiquidity and non-diversifiable risk is substantial. We also fi nd that the cost of GP compensation is large and comparable to the cost of illiquidity and non-diversifiable risk. Interestingly, increasing leverage reduces these costs. Our analysis suggests that conventional interpretations of empirical PE performance measures may be optimistic. On average, LPs may just break even.

Download PDF

 

Each author name for a Columbia Business School faculty member is linked to a faculty research page, which lists additional publications by that faculty member.

Each topic is linked to an index of publications on that topic.