Explaining Returns in Private Equity Investments
Posted: 8 May 2010
Date Written: October 22, 2009
Exploiting a unique opportunity offered by the Italian private equity (PE) market, we examine the hitherto largely unexplored internal rate of return (IRR) of PE investments. Our database covers the entire universe of transactions sponsored by Italian PE investors in Italy up to 2007 and offers rarely accessible information about IRR, covenants and governance at the investment level. We show that IRR is mainly driven by growth in sales, ROA and ROE of the invested firm. IRR also depends on how contractual covenants distribute cash-flows between different classes of investors. For the same level of firm growth, IRR increases when covenants distribute cash-flows more than proportionally to PE investors. We then explore the determinants of growth of invested firms. Growth depends on the intensity of monitoring by PE investors, on firm characteristics and on the incentive alignment effect of contractual covenants, which ultimately affect the quality of firm governance.
Keywords: Private equity, venture capital, internal rate of return, covenants
JEL Classification: G11, G23, G24
Suggested Citation: Suggested Citation