Understanding the Firm Specific Risk Premium
-
Stan Feldman
and
Todd Feldman
Abstract
We seek to determine whether a firm specific risk premium (FSRP) exists for private firms. We show that private equity investors price firm specific risk as part of establishing the expected rate of return hurdle rate. Our research is based on survey data constructed by the Private Capital Markets Project. We decompose the rate of return into its component parts-market risk premium, size premium, liquidity premium and firm specific risk premium (FSRP). We find that on average PE FSRP varies between zero and six percent. These findings indicate that the cost of capital buildup used in valuing private firms should include a premium for firm specific risk unless facts and circumstances suggest otherwise.
References
Ang, A., B. Chen, W. Goetzmann, and L. Phalippou. 2013. Estimating Private Equity Returns from Limited Partner Cash Flows. Working Paper. Columbia University.10.2139/ssrn.2356553Search in Google Scholar
Axelson, U., M. Sorensen, and P. Stromberg. 2013. The Alpha and Beta Of Buyout Deals. Working Paper. Columbia.Search in Google Scholar
Berger, A. N., and G. F. Udell. 1998. “The Economics of Small Business Finance: The Roles of Private Equity and Debt Markets in the Financial Growth Cycle.” Journal of Banking & Finance 22 (6–8): 613–73, https://doi.org/10.17016/feds.1998.15.Search in Google Scholar
Buchner, A. 2014. The Alpha and Beta Of Private Equity Investments. Passau: Working Paper, University of Passau.10.2139/ssrn.2549705Search in Google Scholar
Chen, H., J. Miao, and N. Wang. 2010. The Review of Financial Studies, Vol. 23, 4348–88. Oxford: Oxford University Press.10.1093/rfs/hhq122Search in Google Scholar
Cochrane, J. 2005. “The Risk and Return on Venture Capital.” Journal of Financial Economics 75: 3–52. https://doi.org/10.1016/j.jfineco.2004.03.006.Search in Google Scholar
Cole, R. A., J. D. Wolken, and R. L. Woodburn. 1996. “Bank and Nonbank Competition for Small Business Credit: Evidence from the 1987 and 1993 National Surveys of Small Business Finances.” Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.) 82 (Nov): 983–95, https://doi.org/10.17016/bulletin.1996.82-11.Search in Google Scholar
Ewens, M. 2009. A New Model of Venture Capital Risk and Return. Working Paper. San Diego: University of California.10.2139/ssrn.1356322Search in Google Scholar
Franzoni, F., E. Nowak, and L. Phalippou. 2012. “Private Equity Performance and Liquidity Risk.” The Journal of Finance 67 (6): 23412373. https://doi.org/10.1111/j.1540-6261.2012.01788.x.Search in Google Scholar
Fugazy, D. 2017. Special Report On Private Equity: 7 Ways PE Firms are Evolving, Vol. 1. New York: Mergers and Acquisitions.Search in Google Scholar
Gentry, W. M., and R. G. Hubbard. 2004. “Entrepreneurship and Household Saving.” Advances in Economic Analysis and Policy 4 No. 1, Article. https://doi.org/10.2202/1538-0637.1053.Search in Google Scholar
Gupta, A., and S. V. Nieuwerburgh. 2019. Valuing Private Equity Investments Strip by Strip, CBS, NBER, and CEPR.10.3386/w26514Search in Google Scholar
Heaton, J. C., and D. J. Lucas. 2004. Capital Structure: Hurdle Rates, and Portfolio Choice Interactions in an Entrepreneurial Firm. Working Paper. Northwestern University.Search in Google Scholar
Korteweg, A., and M. Sorensen. 2010. “Risk and Return Characteristics of Venture Capital Backed Entrepreneurial Companies.” Review of Financial Studies 23 (10): 37383772. https://doi.org/10.1093/rfs/hhq050.Search in Google Scholar
Lehmann, B. 1990. “Residual Risk Revisited.” Journal of Econometrics 45: 71–97. https://doi.org/10.1016/0304-4076(90)90094-a.Search in Google Scholar
Liu, W. 2004. “Liquidity Premium and a Two-Factor Model.” In EFA 2004 Maastricht Meetings Paper No. 2678. Also available at https://ssrn.com/abstract=559407.10.2139/ssrn.559407Search in Google Scholar
Merton, R. 1987. “A Simple Model of Capital Market Equilibrium with Incomplete Information.” The Journal of Finance 42 (3): 483–510. https://doi.org/10.1111/j.1540-6261.1987.tb04565.x.Search in Google Scholar
Moskowitz, T., and A. Vissing-Jrgensen. 2002. “The Returns to Entrepreneurial Investment: A Private Equity Premium Puzzle?” The American Economic Review 92 (4): 745–78. https://doi.org/10.1257/00028280260344452.Search in Google Scholar
Novak, N. 2016. Measuring the Discount for Lack Of Marketability for Noncontrolling, Nonmarketable Ownership Interests, 37–51. Willamette: Insights, Winter.Search in Google Scholar
Petersen, M. A., and R. G. Rajan. 1994. “The Benefits of Lending Relationships: Evidence from Small Business Data.” The Journal of Finance 49: 3–37. https://doi.org/10.1111/j.1540-6261.1994.tb04418.x.Search in Google Scholar
The Kroll (Duff & Phelps). 2022. Valuation Handbook Cost of Capital. New York: Kroll.Search in Google Scholar
Tinic, S., and R. West. 1986. “Risk, Return, and Equilibrium: A Revisit.” Journal of Political Economy 94 (1): 126–47.10.1086/261365Search in Google Scholar
US PE Breakdown. 2019. Annual Report. Pitchbook.Search in Google Scholar
© 2023 Walter de Gruyter GmbH, Berlin/Boston
Articles in the same Issue
- Frontmatter
- Research Article
- Understanding the Firm Specific Risk Premium
Articles in the same Issue
- Frontmatter
- Research Article
- Understanding the Firm Specific Risk Premium
