Evaluating Private Equity performance using Stochastic Discount Factors

We examine the performance of 2,750 private equity (PE) funds incepted during 19792008 using Stochastic Discount Factors (SDFs) implied by the two leading consumptionbased asset pricing models (CBAPMs): Habit Formation and Long-run Risks. Our approach is motivated by the observation that investment mandates and cash flow patterns of university endowments and public pension funds are strongly consistent with the preferences of a representative investor per these models. Under CBAPM SDFs, venture capital funds did not destroy value in post-2000 vintages and has outperformed buyouts and generalists in the full sample, in contrast to the CAPM-based evidence. Also, we find that 2007-08 venture vintages are on track to provide a relatively good hedge for consumption shocks during and post crisis in comparison to buyout funds. Moreover, there is virtually no spike in PE excess returns in late 90s according to CBAPMs. Our contribution is also methodical: (i) we develop a finite sample bias correction method for the NPV-based inference which is highly relevant in PE-context whereby fund cash flows span a decade and yet the panel of funds is relatively short; (ii) we propose a more effcient estimation of SDF parameters that adopts the realized risk premia matching insight per Korteweg and Nagel (2016) while supporting a more general class of SDFs. Broadly, our methodology enables a construction and calibration of portfolio-specic discount factors for PE performance evaluation that may reflect nontradeable assets and liabilities which risks are not spanned by standard benchmarks.