What Really Drives Risk Premium and Abnormal Returns
in Private Equity Funds? A New Perspective

Abstract

Private equity (PE) scholars have attempted to assess the ex post returns (performance) of PE funds. Such studies have produced both contradictory conclusions and abnormal realized returns ranging from –6% (Phalippou and Gottschalg [2009]) to +32% (Cochrane [2005]). Research has focused on assessing realized returns instead of the required risk premium. This research has found a set of phenomena unique to the PE sector that influences performance and suggests that illiquidity is the only additional factor to include in asset pricing models. This article explains the drivers and determinants of the risk premium and expected abnormal returns by critiquing extant research and explaining why contradictions persist in its results. A model is proposed enabling practitioners to adopt a more rational approach to defining portfolios and assessing deals.