Valuing Private Equity

59 Pages Posted: 27 Nov 2012 Last revised: 15 Jul 2013

Morten Sorensen

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

Neng Wang

Columbia Business School - Finance and Economics

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, alternative investments, illiquidity, portfolio choice, asset allocation, management fees, carried interest, incomplete markets

JEL Classification: G11, G23, G24

Suggested Citation

Sorensen, Morten and Wang, Neng and Yang, Jinqiang, Valuing Private Equity (June 13, 2013). Netspar Discussion Paper No. 04/2012-041. Available at SSRN: https://ssrn.com/abstract=2180789 or http://dx.doi.org/10.2139/ssrn.2180789

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 )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Neng Wang

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Jinqiang Yang

Shanghai University of Finance and Economics ( email )

777 Guoding Road
Shanghai, Shanghai 200433
China

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