Evaluating Private Equity Performance Using Stochastic Discount Factors

Abstract

We examine the performance of 2,790 private equity (PE) funds incepted during 1979-2008 using Stochastic Discount Factors (SDFs) implied by the two leading consumption-based asset pricing models (CBAPMs) — external habit and long-run risks — as their assumptions appear consistent with investment objectives of avid PE investors. In contrast to CAPM-based inference, venture funds did not destroy value under these CBAPMs in post-2000 vintages and may even have outperformed buyouts and generalists in the full sample. We find that 2007-08 venture vintages provide a better hedge for post-crises consumption shocks than other types of PE, and that the temporal variation in PE excess returns is significantly smaller under CBAPMs. Our contribution is also methodological. We extend the realized risk premia matching insight of Korteweg and Nagel (2016) to a more general class of SDFs, namely portfolio-specific discount factors that reflect non-tradeable assets unspanned by standard benchmarks. To this end, we propose a more efficient estimation of SDF parameters in this context and develop a finite sample bias correction for NPV-based inference with long-duration assets.

Keywords: Private Equity, Venture Capital, Institutional Investors, Consumption-based Asset Pricing, University endowments, Pension plans

JEL Classification: C11, G12, G14, G23, G24, G32, G34