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Biases in Private Equity Returns

Hayley, S. & Sefiloglu, O. (2022). Biases in Private Equity Returns. .


Private Equity (PE) has grown into a substantial asset class, but there remain major problems with measuring PE fund returns. Investors continue to use the internal rate of return (IRR) as a key measure of fund performance. It is well known that early returns of cash can have a substantial impact on fund IRRs, but the magnitude and causes of this effect have not previously been systematically analysed. We demonstrate that the IRR is affected by two biases: a convexity bias, and a “quit-whilst-ahead” bias arising because the returns on PE projects tend to covary with their durations. Both bias the IRRs of PE funds upwards. Using a range of parametric and non-parametric estimation techniques, we show that these biases boost fund IRRs by an average of around 3% per annum, which is a very significant proportion of the average net PE fund IRR (around 12% per annum). Fund cash multiples and PMEs become similarly biased if they are annualized to try to make them comparable with other assets. We further demonstrate that alternative performance measures which have been suggested by practitioners are also biased, which confirms how poorly understood these effects are. Failure to take proper account of these biases is likely to lead investors into badly misinformed investment decisions.

Publication Type: Monograph (Working Paper)
Publisher Keywords: private equity; internal rate of return; bias
Subjects: H Social Sciences > HG Finance
Departments: Bayes Business School > Finance
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