Using a unique and comprehensive dataset containing the detailed cash-flows generated by 4,403 liquidated private equity investments, we show that innovations in aggregate liquidity are a major driver of private equity returns. The investments held during the worst liquidity conditions defined as the bottom decile of Pastor and Stambaugh’s (2003) innovations in aggregate liquidity have an average annual return of -12%. At the opposite end, investments held during the best liquidity conditions have an average return of 31% (see Figure 1). This result also holds in regression analysis and is robust to the inclusion of a number of control variables.
To our knowledge, this is the first study to test and document the role played by liquidity risk in the cross-section of private equity returns. The literature has focused on drivers of returns across funds (e.g., Kaplan and Schoar (2005)). Having returns that are disaggregated at the investment level provides us with a unique opportunity to measure the influence on private equity performance of macro-economic conditions, including aggregate liquidity.
In addition, this is the first study to provide an estimate of the cost of capital for private equity in a large sample. We find that the total risk premium for private equity is about 18% annually. Of this, 3% is attributable to a premium for liquidity risk. Recent literature finds that liquidity risk is priced in public equity (e.g., Pastor and Stambaugh (2003), Acharya and Pedersen (2005), Sadka (2006), and Bekaert, Harvey, and Lundblad (2007)). This means that stocks whose returns are more sensitive to aggregate liquidity have higher average returns. Pastor and Stambaugh (2003, p.683) argue that “[...] it would also be useful to explore whether some form of systematic liquidity risk is priced in other financial markets”. We believe that private equity is a particularly interesting market to investigate liquidity risk, because liquidity effects are probably magnified in this asset class.
We conjecture three channels for liquidity risk in private equity. First, Acharya and Pedersen (2005) argue that liquidity risk originates from uncertainty over transaction costs. As private equity funds often sell entire corporations, they may face larger uncertainty over transaction costs than public equity investors undertaking a trade of similar size. Second, private equity investors may have a higher tolerance for liquidity risk. Catering to these investors, a private equity fund may tilt its portfolio towards companies with larger exposure to this source of risk. As a result, private equity returns are likely to load on liquidity risk more heavily. Third, private equity investments are highly levered and often need to be refinanced. Providers of debt to private equity – mainly banks and hedge funds are sensitive to changes in funding liquidity (Brunnermeier and Pedersen (2009)). When aggregate liquidity is low, creditors may choose to force private equity investments into bankruptcy rather than providing new finance. Hence, returns may be lower in times of low liquidity (all else equal).
Anecdotal evidence from the recent financial crisis is consistent with the view that private equity returns are particularly sensitive to liquidity. Harvard university’s endowment initially planned to sell part of its private equity portfolio to raise cash, but realizing that the cost was substantial, it issued $1.5 billion of bonds instead while the market for debt issuance was at a record low. In this paper, we provide a systematic study of the importance of market-wide liquidity shocks for private equity returns in a large pre-crisis sample.
