Private Equity Funds: Valuation, Systematic Risk and Illiquidity
61 Pages Posted: 6 Mar 2008 Last revised: 15 Jan 2015
Date Written: September 30, 2014
We derive a novel model of the cash flow dynamics and equilibrium values of private equity funds. Based on intertemporal capital asset pricing results for an investor with logarithmic utility, the model explains a life cycle of systematic fund risk and fund value. The closed form solution allows us to predict the typical dynamics of fund values, time varying systematic risk as well as expected returns, and considers market illiquidity. Our model calibration illustrates that a European sample of funds has an average risk adjusted excess value of 14 percent relative to committed capital, which amounts to average illiquidity costs of 1.4 percent annually. We show how equilibrium expected fund returns, systematic risk, and illiquidity discounts decrease over fund lifetime. As compared to venture capital funds, buyout funds on average exhibit lower systematic risk, faster payback, lower life cycle maximum values, but higher initial excess values.
Keywords: private equity, venture capital, buyout, fund life cycle, equilibrium fund values, illiquidity and expected returns, time-varying systematic risk
JEL Classification: G24, G12
Suggested Citation: Suggested Citation