Valuing Private Equity

58 Pages Posted: 18 Apr 2012 Last revised: 14 Jun 2013

See all articles by Morten Sorensen

Morten Sorensen

Copenhagen Business School; Columbia Business School; Centre for Economic Policy Research (CEPR)

Neng Wang

Columbia University; National Bureau of Economic Research (NBER); Asian Bureau of Finance and Economic Research (ABFER)

Jinqiang Yang

Shanghai University of Finance and Economics

Multiple version iconThere are 4 versions of this paper

Date Written: June 13, 2013

Abstract

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

Sørensen, Morten and Wang, Neng and Yang, Jinqiang, Valuing Private Equity (June 13, 2013). Available at SSRN: https://ssrn.com/abstract=2041715 or http://dx.doi.org/10.2139/ssrn.2041715

Morten Sørensen (Contact Author)

Copenhagen Business School ( email )

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Neng Wang

Columbia University ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Asian Bureau of Finance and Economic Research (ABFER) ( email )

BIZ 2 Storey 4, 04-05
1 Business Link
Singapore, 117592
Singapore

Jinqiang Yang

Shanghai University of Finance and Economics ( email )

777 Guoding Road
Shanghai, AK Shanghai 200433
China

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