Equilibrium Asset Prices and Manager's Contracts: An Application to Private Equity Fund

Posted: 29 Nov 2016

See all articles by Byeong-Je An

Byeong-Je An

San Diego State University - Finance Department

Date Written: October 14, 2016

Abstract

In this paper, I examine the joint determination of the contract for a private equity (PE) fund manager and the equilibrium risk premium of the PE fund. My model relies on two realistic features of PE funds. First, I model agency frictions between PE fund's investors and manager. Second, I model the illiquidity of PE fund investments. To alleviate agency frictions, compensation to the manager becomes sensitive to the PE fund performance, which makes investors excessively demand the PE fund to match the target exposure to a PE fund specific risk. This induces a negative effect on the risk premium in equilibrium. For the second feature, I add search frictions in the secondary market for PE fund's shares. PE fund returns also contain a positive illiquidity premium since investors internalize the possibility of holding sub-optimal positions in the PE fund. Thus, my model delivers a plausible explanation for the inconclusive findings of the empirical literature regarding PE funds' performance. Agency conflicts deliver a lower risk-adjusted performance of PE funds, while illiquidity risk can raise it.

Keywords: Private Equity Premium, Agency Conflicts, Search Frictions

JEL Classification: G11, G12, G23

Suggested Citation

An, Byeong-Je, Equilibrium Asset Prices and Manager's Contracts: An Application to Private Equity Fund (October 14, 2016). Available at SSRN: https://ssrn.com/abstract=2876418 or http://dx.doi.org/10.2139/ssrn.2876418

Byeong-Je An (Contact Author)

San Diego State University - Finance Department ( email )

5500 Campanile Drive
San Diego, CA 92182-8236
United States

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