Valuing Private Equity Strip by Strip

Abstract

We propose a new valuation method for private equity investments. It first constructs a cash-flow replicating portfolio using cash-flows on various listed equity and fixed income instruments (strips). It then values the listed strips using a flexible asset pricing model that accurately captures the systematic risk in bonds of different maturities and a broad cross-section of equity factors. The method delivers a risk-adjusted profit on each PE investment and a time series for the expected return on each PE fund category. It avoids using realized discount rates and has good small-sample properties. We apply the method to the universe of PE funds. Under our more comprehensive risk model, we find negative risk-adjusted profits for the average fund in most PE categories. Substantial cross-sectional variation and persistence in performance suggests some funds outperform. Expected returns and risk-adjusted profit decline in the later part of the sample.