The Valuation of Illiquid Assets: A Focus on Private Equity and Real Estate

Abstract

This article reviews methods that can be used to value illiquid investments, focusing on private equity and real estate. The authors discuss the traditional valuation methods, particularly the net present value (NPV) rule, and show in what circumstances these can lead to suboptimal investment decisions. Emphasis is placed on a real option valuation framework that can alleviate some of the drawbacks of traditional approaches. A new jump-diffusion option pricing model and a numerical example are presented to show the usefulness of such a framework in valuing illiquid assets, in particular venture capital funds. They maintain that, under harmonized parameter estimation techniques, the NPV rule can be viewed as the lower bound in a competitive market and the real option exercise criteria and valuation models as providing the upper bound to value and time investments in illiquid assets. The knowledge of such bounds should enhance the decision-making process concerning allocating funds to alternative investments.