CHASING THE DEAL WITH THE MONEY: MEASURING THE REQUIRED RISK PREMIUM AND EXPECTED ABNORMAL RETURNS OF PRIVATE EQUITY FUNDS TO MAXIMIZE THEIR INTERNAL RATE OF RETURN

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Abstract

A number of scholars of private equity (“PE”) have attempted to assess the ex-post returns, or performance, of PEs by adopting an ex-post perspective of asset pricing. In doing so a set of phenomena has been recognized that is thought to be specific to the PE sector, such as “money-chasing deal phenomenon” (Gompers and Lerner, 2000) and “performance persistence” (Lerner and Schoar, 2005). However, based on their continuing use of an ex-post perspective, few scholars have paid attention to the possible extent to which these and other PE phenomena may affect expected returns from PE investments. To address this problem this article draws on an ex-ante perspective of investment decision-making in suggesting how a number of drivers and factors of PE phenomena may produce “abnormal returns”, and that each of those drivers and factors should therefore be considered
in accurately assessing the required risk premium and expected abnormal returns of PE investments. In making these contributions we examined a private equity investment of a regional PE in Italy and administered a telephone questionnaire to 40 PEs in Italy and the UK and found principally that while size is the most important driver in producing abnormal returns illiquidity alone cannot explain the expected returns of PE investments (cf. Franzoni et al., 2012). Based on our findings we developed a predictive model of PE decision-making that draws on an ex-ante perspective of asset pricing and takes into account PE phenomena and abnormal returns. This model extends the work of Franzoni et al. (2012), Jegadeesh et al. (2009), and Korteweg and Sorensen (2010) who did not consider the possible influence of PE phenomena in decision-making and will also help PE managers in making
better-informed decisions.

Keywords: Risk Premium; Abnormal Returns; Private Equity Funds; Internal Rate of Return

How to cite this paper: Scarpati, F., & Ng, W. (2013). Chasing the deal with the money: Measuring the required risk premium and expected abnormal returns of private equity funds to maximize their internal rate of return. Risk Governance and Control: Financial Markets & Institutions, 3(3), 56-69.https://doi.org/10.22495/rgcv3i3art6