What Really Drives Risk Premium and Abnormal Returns in Private Equity Funds? A New Perspective

Abstract

In the last two decades, a number of private equity scholars have attempted to assess the ex-post returns (performance) of private equity funds (PEs). Such studies have produced both contradictory conclusions that have included a wide spread of abnormal realized returns ranging from -6% (Phalippou & Gottschalg, [2009]) to 32% (Cochrane, [2005]). Moreover, this research has been concerned with assessing realized returns instead of the required risk-premium. In addition, research in the last two decades has found a set of phenomena unique to the PE sector that influence performance and recent research suggests that illiquidity is the only additional factor to include in asset pricing models. This article seeks to help practitioners understand the drivers and determinants of risk-premium in PE investments and expected abnormal returns by critiquing extant research and explaining why contradictions persist in its results. We then propose a model which will allow practitioners to identify the nature of the drivers involved in PE investments thus enabling them to adopt a more rational approach in defining portfolios and assessing deals.