A Theory of Liquidity in Private Equity
60 Pages Posted: 25 Feb 2020 Last revised: 15 Oct 2020
Date Written: August 10, 2020
We develop a model of private equity in which many empirical patterns arise endogenously. Our model rests solely on two critical features of this market: moral hazard for General partners (GPs) and illiquidity risk for Limited Partners (LPs). The equilibrium fund structure incentivizes GPs with a share in the fund and compensates LPs with an illiquidity premium. GPs may inefficiently accelerate drawdowns to avoid default by LPs on capital commitments. LPs with higher tolerance to illiquidity then realize higher returns. With a secondary market, return persistence decreases at the GP level but persists at the LP level.
Keywords: Private Equity, Fund Structure, Return Persistence, Liquidity Premium, Secondary Markets
JEL Classification: G11, G23, G30
Suggested Citation: Suggested Citation