Equilibrium Liquidity Premia of Private Equity Funds

Abstract

This paper proposes a theory of the equilibrium liquidity premia of private equity funds and explores its asset-pricing implications. The theory is based on the notion that investors are exposed to the risk of facing surprise liquidity shocks, which upon arrival force them to liquidate their positions on the secondary private equity markets at some stochastic discount to the fund’s current net asset value. Assuming a competitive market where fund managers capture all rents from managing the funds and investors just break even, equilibrium liquidity premia are defined as the risk-adjusted excess returns that fund managers must generate in order to compensate investors for the costs of illiquidity. The model is calibrated such that parameters closely match data of buyout funds and is illustrated by using numerical simulations. The theory generates a rich set of novel implications. These concern (i) how fund characteristics (i.e., systematic risk, and the drawdown and distribution dynamics of a fund) affect liquidity premia, (ii) the role of the investors’ propensities of liquidity shocks and secondary market discount dynamics in determining liquidity premia, and (iii) the impact of market conditions and cycles on liquidity premia.