Credit Market Equivalents and the Valuation of Private Firms

We propose to value leveraged buyout investments by credit market equivalents (CME). Our method relies on the observation that portfolio companies held by private equity funds have loans traded in secondary markets. Motivated by Merton's insight that debt and equity are claims on the same asset, we back out equity valuations from debt prices by constructing a stochastic discount factor that prices secondary market loan returns of private equity portfolios from deal-level data. We identify a credit factor model to price buyout cash flows to derive their CME valuation. We find no evidence for buyout outperformance after controlling for credit market factors. In contrast, funds raised during favorable credit conditions underperform. Our method works whenever credit and private equity markets are sufficiently integrated, for which we provide evidence.