Valuing Private Equity Investments Strip by Strip

Institutional investors have steadily increased their allocation to asset classes that do not trade on public securities markets — such as private equity, which now accounts for $5.8 trillion in assets under management. However, traditional asset pricing methods are not well suited to value investments that do not trade on securities markets due to the absence of frequent price and return information. These limitations make it difficult to understand the risk and return characteristics of the private investments and how they affect investors’ portfolios. As the fraction of overall wealth that is held in the form of private investment grows, so does the importance of developing appropriate valuation methods. In “Valuing Private Equity Strip by Strip” we propose a new valuation method for private investments, with a focus on private equity. 

The method proceeds in two steps. In a first step, we estimate a flexible no-arbitrage asset pricing model. The model accurately prices government bonds of various maturities, the aggregate stock market, as well as the cross section of stocks in a variety of categories (small, value, growth, real estate, natural resources, and infrastructure stocks). The asset pricing model extracts the prices of risk on systematic risk factors; they measure how much compensation investors demand for exposure to the various sources of risk that are relevant for valuing private equity. The model decomposes security prices into the claims to cash flows at each point in time. For bonds, this results in price estimates of zero coupon bonds, and for equities the resulting strip corresponds to the price of a security that pays off the claim to a risky cash flow at a particular maturity, but at no other time. For equity factors, we consider both dividend strips (which pay off one risky dividend as of a certain period) as well as capital gains strips (which pay off the realized price gain over a certain horizon).

Second, we construct the replicating portfolio for the cash flow distributions from private equity investments. The building blocks of the replicating portfolio are bond, dividend, and capital gains strips. We use both OLS and Machine Learning methods to estimate the portfolio of these strips that best replicates the systematic risk exposure of the private equity fund. We allow for the risk exposures (the portfolio weights) to differ by investment horizon (fund age) and to depend on the overall investment climate at the time of fund inception, as proxied by the price-to-dividend ratio on the stock market. 

Our approach allows for a novel measurement of cash-flow betas from private equity against a variety of cross-sectional factors. We find that private equity does in fact take cross-sectional equity exposure beyond just the aggregate stock market index, which is the state-of-the-art risk adjustment in the PE literature. The pattern of risk factor exposures generally reflects the risks associated with the underlying business strategy. Buyout funds, for instance, take on considerable small and value stock exposure early in fund life, and growth gain exposure later in fund life. This payoff pattern corresponds to Buyout activity which consists of purchasing companies, harvesting some initial cash flows, and then selling the firms. For Venture Capital funds, we find the payoffs are largely related to growth gains strips; corresponding to selling growth companies. In real estate, infrastructure, and natural resources: we find that these fund categories take on sector-specific factor exposure in terms of REITs, listed infrastructure stocks, and listed natural resource stocks, respectively. Our findings suggest that private equity is exposed to a richer cross-section of factor exposure than has been previously recognized. 

Given cash flow loadings from the PE data and strip prices and expected returns from the asset pricing model, we develop novel measures of fund performance.  We introduce a new performance metric, the Risk-Adjusted Profit (RAP), which simply measures how many dollars LPs get back after accounting for risk on a $1 PE investment. RAP subtracts from the realized profit on the PE investment the realized profit on the replicating portfolio. While the replicating portfolio is constructed to produce the same amount of systematic risk as private equity funds, on average, it may cost more or less than the private equity fund. A PE fund with a RAP of 10% returns $0.10 in profits to the investor for every $1 invested after accounting for the time value of money and, most importantly, after accounting for risk. Our RAP measure is positively correlated with existing IRR and Kaplan-Schoar PME measures but contains substantial independent information. We find that our risk-adjustment methodology generates much lower average risk-adjusted profits across all fund categories. We estimate positive RAPs for many Buyout and Venture Capital funds with vintage years in the 1990s, but generally estimate negative RAPs for more recent fund vintages across all categories. 

The asset pricing model is also used to compute the expected return on the private equity investment, which equals the expected return of the replicating portfolio, a linear combination of expected returns on bond and equity dividend and capital gains strips. Expected returns on PE investments average around 10-15% per year but with substantial variation across categories and over time. The time variation in risk premia arises from two sources. The first one is differences over time in the cost of the replicating portfolio, which in turn reflects time variation in risk premia on the stocks and bonds that make up the replicating portfolio. The second one is time variation in the quantity of risk across PE vintages, which we capture by allowing the PE cash flow exposures to depend on the state of overall investment sentiment, as captured by the price-dividend ratio on the stock market. We find lower expected returns for private equity funds in more recent periods

Our new method makes it possible to apply standard portfolio and risk management techniques when combining alternative investments with traditional investments in stocks and bonds; and can be used to value any privately-held asset that generates cash flows, such as individual real estate assets, oil wells, or infrastructure projects.