Valuing Private Equity
Columbia Business School; National Bureau of Economic Research (NBER); Swedish Institute for Financial Research (SIFR)
Columbia Business School - Finance and Economics
Shanghai University of Finance and Economics
June 13, 2013
Netspar Discussion Paper No. 04/2012-041
We develop a dynamic valuation model of private equity (PE) investments by solving the portfolio-choice problem for a risk-averse investor (LP), who invests in a PE fund, managed by a general partner (GP). Key features are illiquidity, leverage, GP value-adding skills (alpha), and compensation, including management fees and carried interest. We find that the costs of management fees, carried interest, and illiquidity are high, and the GP needs to generate substantial value to cover these costs. Leverage substantially reduces these costs. Finally, we find that conventional interpretations of PE performance measures are optimistic. On average, LPs may just break even.
Number of Pages in PDF File: 58
Keywords: Private equity, LP portfolio choice, certainty-equivalent valuation, incomplete markets, illiquidity, non-diversiable risk, alpha, GP compensation, management fees, carried interest
JEL Classification: G11, G23, G24working papers series
Date posted: November 27, 2012 ; Last revised: June 14, 2013
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