The Private Equity Model

As the name suggests, private equity assets are not exchange-traded shares. The fact that there are no closing prices, trading volume, bids or asks, or any other publicly available information poses several challenges to investors, foremost of which is pricing and risk assessment. With no trading, there are no observed closing prices, and therefore no frequency of observable returns and therefore no volatility. The tasks related to return and risk attribution are quite different for this asset class, as we shall see further on.

There are several subclasses of private equity investments, including, for example, the two main ones—venture and leveraged buyout, along with distressed, growth, subordinated debt, and energy. According to Phalippou, private equity managers had over $1 trillion under management in 2006, roughly two-thirds of which was in leveraged buyout funds. Funds are organized as limited partnerships with the LPs as primary investors generally drawn from the ranks of large institutional investors like pension funds. Limited partners commit funds to general partners (GPs) who manage the funds and whose compensation is determined by an agreed-upon fee structure. Funds are typically organized with a specific strategy (venture or buyout), target for committed capital, and life (typically 10 years). For example, the GPs might announce the formation of a new fund with targeted committed capital to be, say, $1 billion and then solicit LPs (investors) ...

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