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Risk and Expected Returns of Private Equity Investments: Evidence Based on Market Prices

Private equity (PE) refers to equity securities in private companies that are not publicly traded. Private equity funds that specialize in PE investments opened up this asset class to institutional investors and other capital market participants. The early successes of some large PE funds led to a rapid growth of this asset class. Capital commitment to private equity in the U.S. has grown rapidly from around $20 billion in 1990 to over $496 billion in 2007.

Although PE has experienced rapid growth, the risk and return profile of this asset class is not well understood. Many news stories in the media suggest that PE investments yield higher returns than traditional asset classes. A recent news release by Thomson Financial and the National Venture Capital Association announced that Thomson Reuters' US Private Equity Performance Index (PEPI)2 “across all horizons outperformed public market indices, NASDAQ and the S&P 500, through 9/30/2008.” For example, for the 20-year period ending in September 2008, PEPI earned annualized return of 15.4% after fees, which is more than twice the return of 7.5% earned by S&P 500.

A number of academic papers also report superior returns for private equity investments. Ljungqvist and Richardson (2003) find that private equity investments outperformed the S&P 500 by more than 5%. Cochrane (2005), Kaplan and Schoar (2005), Peng (2003) and others also find that private equity funds outperform the S&P 500. However, these papers use databases that suffer from potential selection bias. Performance information is usually compiled from self-reported data provided by large private equity investors. It is quite likely that investors who do not have good experiences with their PE investments exit those investments or choose not to report their performance. Hence, PE funds that performed poorly are less likely to be included in these databases.

Moreover, the estimated performance of PE funds depends critically on the valuation of non-exited investments at the end of the sample period. For instance, Kaplan and Schoar use funds’ self-reported values of such non-exited investments and find that the value-weighted performance of PE funds exceeds S&P 500 return by five percent over the life of the fund. This cumulative estimate is equivalent to out performance of about 1% per year according the approximation provided by Phalippou and Gottschalg (2009). However, Phalippou and Gottschalg argue that it is more reasonable to write-off non-exited investments after a certain period of time and they find that PE funds under perform the market by 3% to 6% per year. Even if we set such disagreements aside, these estimates of PE performance are not based on market prices.

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Risk and Expected Returns of Private Equity Investments: Evidence Based on Market Prices