Measuring the Performance of Illiquid Equity Investments: What Can We Learn from the Loan Market?

Abstract

The recent financial crisis has shown the limits of a valuation based on market values. If markets become illiquid due to the absence of buyers, market-based valuation approaches can lead to a severe underestimation of the true economic value of an asset. Auditors and regulators agree that in this situation model-based valuation techniques should supplement or even replace market-based approaches. For retail loans, the prototype of an illiquid asset, RAROC is an established measure to relate the revenues of a loan to its risk. This measure is based on interest rates, default probabilities, and recovery rates, risk parameters that are well known among market participants. This article shows how the RAROC concept can be used for illiquid equity investments and demonstrates that it can be applied easily in practice. This allows investors and also regulators to measure and compare the performance of illiquid equity investments where no market values exist or where market values are not reliable.