"Valuing Private Equity"
Publication type: Working paper
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-diversifiable 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 find 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.
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