Valuing Private Equity
58 Pages Posted: 18 Apr 2012 Last revised: 14 Jun 2013
Date Written: June 13, 2013
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.
Keywords: Private equity, LP portfolio choice, certainty-equivalent valuation, incomplete markets, illiquidity, non-diversiﬁable risk, alpha, GP compensation, management fees, carried interest
JEL Classification: G11, G23, G24
Suggested Citation: Suggested Citation