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1 January 2014 CFA Institute Journal Review

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

  1. Thomas M. Arnold, CFA

Given that private equity investment takes place in nonpublic markets, previous work using public-market techniques appears to be incomplete and inconsistent. The use of an illiquidity factor attached to models used for publicly traded firms does not capture how private equity investors view investments and can also potentially hide a number of other pertinent factors. So, the authors suggest a conceptual framework for understanding private equity returns.

What’s Inside?

The authors demonstrate that private equity investments are different from investments in public firms. There is inefficiency in the private equity market that can be beneficial to the general partner (GP) of a fund who can acquire specialized information. Furthermore, the decision to invest is not based on achieving a particular risk premium to compensate for risk, but on an assessment of the GP’s expected internal rate of return (IRR) being higher than the targeted IRR of the investment opportunity (i.e., the GP sees a better return than what is forecasted).

How Is This Research Useful to Practitioners?

Previous research suffers from the use of inconsistent databases and the use of techniques that work with publicly traded firms (implicitly assuming market efficiency). The authors note that when there is inefficiency in a market, such as in private equity, idiosyncratic risk can generate returns and counterintuitive ideas relative to efficient markets can be beneficial, such as less diversification and less competition.

The authors list a number of phenomena based on prior research as potential factors that can influence private equity returns. Based on these factors, they develop a conceptual model for the IRR on a private equity investment: One portion is from risk factors that the capital asset pricing model associates with public markets, and the other portion is potential gains associated with inefficiency/opportunities. The gains from inefficiency/opportunities can be subdivided into rational nonrisk factors, nonrational/behavioral nonrisk factors, and costs. (Note that a nonrisk factor is a risk factor associated with the investor/fund rather than the risk associated with the investment.)

This research is useful because it explains how private equity investment is viewed by private equity investors, unlike the prevailing research that uses public market techniques. The whole idea of what is beneficial in an inefficient market is very counterintuitive to what exists in an efficient public market. To see how idiosyncratic risk leads to returns within private equity investment, despite using an inexact conceptual framework, is very beneficial for practitioners and academics to understand.

How Did the Authors Conduct This Research?

The authors survey prior empirical research to demonstrate how it does not really capture what private equity investors are trying to accomplish with illiquid investments. By introducing the idea that the private equity market is inefficient, a great deal of additional research enters as factors that can potentially affect the return within a private equity investment. The conceptual model the authors develop captures all of these effects. The conceptual model is intended to help academics and practitioners develop intuition relative to this type of investing and is not readily applicable in an empirical setting.

Abstractor’s Viewpoint

I like how the conceptual model is developed from the prevailing literature and the intuition it generates relative to private equity investing. Although I think this model is beneficial, what I am really looking for is a model that can be applied empirically. The great difficulty in this instance is the lack of credible data, which may also be part of the reason why existing empirical studies are found to be lacking.

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