The return profile for private equity is one of the critical investment issues for many institutional investors. This will also become a crucial issue for retail investors if many of the large PE firms have it their way. We need to go back to basics and look at the pay-off structure for private equity, and the graph below provides valuable insight. This chart is from the new paper "Analytic Valuation of Private Equity Investments".
Notice that four distinct pay-offs form a real option. If you cannot pay the borrowing costs, the investor makes nothing. Once the costs are covered, the investors make money until the invested capital is returned, and the GP then receives his fees. Afterward, the investor receives the excess. You have to clear hurdles to receive the next set of cash flows. There are failures which impact this pay-off, and the investments are illiquid and take, on average, 5-7 years to return capital. This is a long-term option on the quality of management to provide a return above the cost of capital.
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