Risk, Uncertainty, and Valuation in Private Equity: A Multifaceted Approach via Investor Beliefs, Priors, Benchmarking, and Fund Characteristics

I show that investors’ beliefs can explain the undervaluation of private equity (PE) funds. The value of PE funds, in accordance with finance principles, is determined by the expected cash flows discounted for time and risk. Therefore, the undervaluation may stem from either an incorrect stochastic discount factor (SDF) or a discrepancy between investors’ beliefs and the true distribution of cash flows. I propose an estimation method based on Empirical Likelihood (EL) to back out investors’ beliefs from funds’ cash flows. I validate estimated beliefs using investors’ sentiment surveys. I find that investors’ pessimism about PE cash flows and overoptimism about public market cash flows, rather than SDF misspecification, offer a potential explanation for the undervaluation of PE funds.