The determinants of the risk premium required by Italian private equity funds
Year: 2011
Type: dissertation
Abstract: This research aims to identify the determinants of the ex-ante risk premium \nrequired by Italian private equity funds (PEFs) when valuing privately-held \ntarget companies. In theory, perceived risk is a key driver of expected returns \nand anticipated value, but: ¿Although PE (private equity) has experienced \nrapid growth, the risk and return profile of this asset class is not well \nunderstood.¿ (Jegadeesh et al., 2009). \nSome papers have attempted to assess the ex post returns pioneered by \nLerner & Gompers (1997). Yet such studies reveal both contradictory \nconclusions and hitherto inexplicable phenomena: what some authors call \nthe ¿private equity premium puzzle¿ (Moskowitz & Jorgensen, 2000). Such \ncontradictory conclusions include a wide spread of abnormal realized returns \nranging from -6% (Phalippou & Gottschalg, 2009) to +32% (Cochrane, 2005). \nIn this research, the perceived risk and expected return drivers refer not to \nthe ex-post realized return that PEF investors actually achieve, but to the \nrequired return the PEF hopes to gain from the target investment. At this \nstage, two important indicators adopted in PEF parlance have to be \ndifferentiated: (i) the Expected IRR (E.IRR) and (ii) the Threshold IRR \n(T.IRR). The first is the IRR as an output of a business plan, and the second assesses the return expected by PEFs according to the risk perceived in the \nbusiness plan. Put simply, these are respectively, the anticipated return and \nthe (risk-adjusted) required return. \nThe study of the T.IRR is one of the main contributions of this thesis since it \nhas never been studied before by academia as an indicator of the ex-ante \nperceived risk of a PEF target company. This is partly due to two important \nreasons. First, most previous papers examine ex-post performance, and only \na few (e.g. Manigart et al., 2002), try to assess return expectations and risk \nperceptions using an ex-ante perspective. Second, most of the prior studies \nare quantitative and try to measure statistical effects captured by the ex-post \nIRR. \nBy studying 26 deals (in 13 Italian PEFs) in detail (qualitatively and \nquantitatively), this research project has been able to observe how PEFs \nassess risk and estimate the T.IRR. The research project reveals that PEFs \napply neither rational-based models nor explicit formulae to assess risk exante. \nBy observing a set of phenomena unique to the PEF sector (fees effect, \ninvestment speed effect, persistence effect, money-chasing deal \nphenomenon, illiquidity effect, etc) whose existence has been suggested by \nmany recent papers, this thesis has been able to propose an adjusted \nversion of the three-factor model of Fama and French (1993, 1995) to assess \nrisk. \nThe application of a quasi-rational-based asset pricing model to guide PEFs \nassessments is also an important contribution of this thesis. In fact, Franzoni, Nowak and Phalippou (2010), claim to be the first to calculate the PEFs¿ cost \nof capital by applying asset pricing models. \nHowever, their approaches are not only based on the observations of \nrealized returns, but also consider only one additional factor to the standard \nFama & French three-factor model (1993), the liquidity factor. \nIn contrast, the results and the model proposed by this thesis are based on \nqualitative and quantitative ex-ante information and include not only the \nclassical factors of that model, but also some other factors intended to \nexplain some of the phenomena listed above which might also drive the risk \npremium in private equity funds. Based, therefore, on explaining the behavior \nof PEFs, the research develops a framework that can be applied by Italian \nPEFs and perhaps other PEFs in a more rational manner than their past \nbehavior suggests.
Author: Fernando Scarpati
Language: English
Subfield: Finance
Domain: Social Sciences
Open Access status: green
OpenAlex ID: W781493538