The Systematic Risk of Private Equity
55 Pages Posted: 2 Apr 2014
Date Written: March 24, 2014
This paper introduces a novel econometric approach to estimate the systematic risk and abnormal returns of illiquid assets based only on their observable cash flows. Our model assumes that the returns of a private equity investment are generated by the standard market model, and that the dividends from the investment occur at a stochastic, yet increasing rate from its unobservable interim values until the investment finally liquidates. Using the Generalized Method of Moments (GMM), we then estimate the systematic risk and abnormal returns of private equity by minimizing the distance between the model expected dividends and the cross-section of observed dividends over time. Our methodology generates asymptotically consistent estimates and we confirm its validity via a detailed Monte Carlo simulation in which all model parameters are randomly distributed, and the individual dividend rates of each investment are further correlated with the market returns and dependent on the individual risk and return profile of each investment. We apply our model to two research-quality datasets containing the net cash flows of over 1,000 mature buyout and venture capital funds, and the gross cash flows of almost 15,000 portfolio company investments. This allows us to study the risk and return characteristics at each level individually. Our estimations show that that the exposure to systematic risk is notably higher than previously estimated and widely assumed, with beta coefficients ranging from 2.5 to 3.1. While carried interest provisions reduce the exposure to systematic risk, we find that management fees effectively offset this effect. Our estimations also suggest that buyout deals have generated gross alphas of around 5% per annum, relative to the total returns of the S&P 500, whereas venture capital investments have generated alphas of more than 10%. As expected, both management fees and carried interests have a negative effect on the abnormal returns delivered to institutional investors. For buyout funds, annual alphas are slightly negative but statistically insignificantly different from zero. Net alphas of venture capital funds remain positive and range from 2% to 5%. Relative to the total returns of the Fama-French all U.S. stock market index, we find slightly lower market betas around 2.4 and consistently positive net alphas for both buyout and venture capital funds. In all estimations, our model shows excellent goodness-of-fit properties, explaining up to 95% of the cross-sectional variation in the observed monthly dividends.
Keywords: private equity, venture capital, systematic risk, abnormal return
JEL Classification: C51, G12, G23, G24
Suggested Citation: Suggested Citation