CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

CHAPTER 13

Private Equity Fund Discount Rates

Discount rates are particularly difficult to estimate in the case of private equity (PE), but they are important. As with any financial asset, it is worth investing in a private equity fund only if its expected rate of return is at least equal to the investors' required rate of return or cost of capital. Moreover, when cash flows can be projected, the discount rate allows for estimating the economic value of a fund, as we saw in the previous chapter. Therefore, the question of how to set this rate is of high interest for private equity investors. Finance theory postulates that the risk in an investment should be the risk borne by a well-diversified investor, and that the return to be expected should be commensurate with this risk.

13.1 THE CAPITAL ASSET PRICING MODEL (CAPM)

The capital asset pricing model (CAPM) defines the relationship between risk and return using the following equation:

Here, E(RA) is the expected return of asset A; Rf is the risk-free rate of return; βA is the beta, or the systematic risk of asset A; and the term [E(RM) − Rf] is the market risk premium. If we know an asset's systematic risk, the risk-free rate, and the market risk premium, we can use the CAPM to estimate its expected return.

Even though in theory the CAPM holds whether we are dealing with financial assets or real (physical) assets, it is not clear ...