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Valuing Private Equity

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  • Morten Sorensen
  • Neng Wang
  • Jinqiang Yang

Abstract

We investigate whether the performance of private equity (PE) investments is sufficient to compensate investors (LPs) for risk, long-term illiquidity, management, and incentive fees charged by the general partner (GP). We analyze the LPs' portfolio-choice problem and find that management fees, carried interest, and illiquidity are costly, and GPs must generate substantial alpha to compensate LPs for bearing these costs. Debt is cheap and reduces these costs, potentially explaining the high leverage of buyout transactions. Conventional interpretations of PE performance measures appear optimistic. On average, LPs may just break even, net of management fees, carry, risk, and costs of illiquidity.

Suggested Citation

  • Morten Sorensen & Neng Wang & Jinqiang Yang, 2014. "Valuing Private Equity," Review of Financial Studies, Society for Financial Studies, vol. 27(7), pages 1977-2021.
  • Handle: RePEc:oup:rfinst:v:27:y:2014:i:7:p:1977-2021.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhu013
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    Cited by:

    1. Buchner, Axel, 2016. "How much can lack of marketability affect private equity fund values?," Review of Financial Economics, Elsevier, vol. 28(C), pages 35-45.
    2. Nadauld, Taylor D. & Sensoy, Berk A. & Vorkink, Keith & Weisbach, Michael S., 2019. "The liquidity cost of private equity investments: Evidence from secondary market transactions," Journal of Financial Economics, Elsevier, vol. 132(3), pages 158-181.
    3. Eric Luxenberg & Stephen Boyd & Mykel Kochenderfer & Misha van Beek & Wen Cao & Steven Diamond & Alex Ulitsky & Kunal Menda & Vidy Vairavamurthy, 2022. "Strategic Asset Allocation with Illiquid Alternatives," Papers 2207.07767, arXiv.org.
    4. Yingjie Niu & Jinqiang Yang & Zhentao Zou, 2021. "Investment decisions under incomplete markets in the presence of wealth effects," Journal of Economics, Springer, vol. 133(2), pages 167-189, July.
    5. Boyan Jovanovic & Peter L. Rousseau, 2014. "Extensive and Intensive Investment over the Business Cycle," Journal of Political Economy, University of Chicago Press, vol. 122(4), pages 863-908.
    6. Lan, Yingcong & Wang, Neng & Yang, Jinqiang, 2013. "The economics of hedge funds," Journal of Financial Economics, Elsevier, vol. 110(2), pages 300-323.
    7. Boyan Jovanovic & Sai Ma & Peter L. Rousseau, 2022. "Private equity and growth," Journal of Economic Growth, Springer, vol. 27(3), pages 315-363, September.
    8. Liu, Yang & Yang, Jinqiang, 2015. "Optimal investment of private equity," Finance Research Letters, Elsevier, vol. 14(C), pages 76-86.
    9. Ljungqvist, Alexander & Bircan, Cagatay & Biesinger, Markus, 2020. "Value Creation in Private Equity," CEPR Discussion Papers 14676, C.E.P.R. Discussion Papers.
    10. Stephen G. Dimmock & Neng Wang & Jinqiang Yang, 2019. "The Endowment Model and Modern Portfolio Theory," NBER Working Papers 25559, National Bureau of Economic Research, Inc.
    11. Arthur Korteweg & Stefan Nagel, 2016. "Risk‐Adjusting the Returns to Venture Capital," Journal of Finance, American Finance Association, vol. 71(3), pages 1437-1470, June.
    12. Tereza Tykvová, 2018. "Venture capital and private equity financing: an overview of recent literature and an agenda for future research," Journal of Business Economics, Springer, vol. 88(3), pages 325-362, May.
    13. Buchner, Axel, 2016. "Dealing with non-normality when estimating abnormal returns and systematic risk of private equity: A closed-form solution," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 45(C), pages 60-78.
    14. Bian, Yuxiang & Chen, Lin & Xiong, Xiong & Yang, Jinqiang, 2023. "Private equity valuation under time-inconsistent preferences," Research in International Business and Finance, Elsevier, vol. 65(C).
    15. Robinson, David T. & Sensoy, Berk A., 2016. "Cyclicality, performance measurement, and cash flow liquidity in private equity," Journal of Financial Economics, Elsevier, vol. 122(3), pages 521-543.
    16. Fan Hu & Yaoyao Wu, 2023. "R&D investment under incomplete markets," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 44(2), pages 858-861, March.
    17. Fang, Dawei, 2019. "Dry powder and short fuses: Private equity funds in emerging markets," Journal of Corporate Finance, Elsevier, vol. 59(C), pages 48-71.
    18. Valentin Haddad & Erik Loualiche & Matthew Plosser, 2017. "Buyout Activity: The Impact of Aggregate Discount Rates," Journal of Finance, American Finance Association, vol. 72(1), pages 371-414, February.
    19. Van Nieuwerburgh, Stijn & Gupta, Arpit, 2019. "Valuing Private Equity Strip by Strip," CEPR Discussion Papers 14241, C.E.P.R. Discussion Papers.
    20. Axel Buchner, 2016. "How much can lack of marketability affect private equity fund values?," Review of Financial Economics, John Wiley & Sons, vol. 28(1), pages 35-45, January.
    21. Andrew Ang & Morten Sorensen, 2012. "Risks, Returns, and Optimal Holdings of Private Equity: A Survey of Existing Approaches," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 2(03), pages 1-27.
    22. Bo Liu & Yang Liu & Jinqiang Yang, 2018. "Optimal ownership structure in private equity," European Financial Management, European Financial Management Association, vol. 24(1), pages 113-135, January.
    23. Barber, Brad M. & Morse, Adair & Yasuda, Ayako, 2021. "Impact investing," Journal of Financial Economics, Elsevier, vol. 139(1), pages 162-185.
    24. Nicolas P. B. Bollen & Berk A. Sensoy, 2022. "How much for a haircut? Illiquidity, secondary markets, and the value of private equity," Financial Management, Financial Management Association International, vol. 51(2), pages 501-538, June.
    25. Luo, Deqing & Wu, Xiaoping & Xu, Jiawen & Yan, Jingzhou, 2022. "Robust leverage decision under locked wealth and high-water mark contract," Finance Research Letters, Elsevier, vol. 46(PB).

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    More about this item

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G2 - Financial Economics - - Financial Institutions and Services
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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