How much for a haircut? Illiquidity, secondary markets, and the value of private equity

Limited partners (LPs) of private equity funds commit to invest with extreme levels of illiquidity and significant uncertainty regarding the timing of capital flows, often exacerbated by the LPs’ spending requirements and portfolio rebalancing needs. Secondary markets have emerged that alleviate some of the associated cost. This paper develops a valuation model incorporating these institutional features. Model-implied breakeven returns match empirically observed average fund returns for moderately risk-tolerant LPs with private equity allocations up to 40%. In contrast, when earning average returns in private equity, highly risk-averse LPs optimally allocate only a few percent to the asset class.