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Business Tax School | Building a Better Model for Private Equity

A conversation with Morten Sorensen, Associate Professor of Finance, about his research on private equity risk and return and his education at Tuck.

Ten years ago, Morten Sorensen presented at Columbia University about his research on how to measure risk and return in private equity investing.

He joked that the inclusion of his name in the 1.5 papers seemed to designate him as an expert, as there was little research on private equity risks at the time. His sheer humility aside, Sorensen says he has been with Tuck since 2020 and is a true expert in the field, not only in his private equity investments, but also in his venture capital and entrepreneurial finance. We continue to study the impact of those investments on trades in general and on individual trades. wider economy.

Has anyone solved the problem of how to definitively measure the risk and return of private equity investments?

No, the issue is not resolved. Our first study, published in 2010, is very good at developing models that can estimate risk and return on investment. However, this is a very complex model with many complex analyses.

Why is private equity risk and return difficult to measure?

Because private equity is private, there isn’t a lot of quantitative information, and you can’t really know the value of a private company unless you buy, sell, or refinance it. This complicates the quantitative analysis and naturally the approach becomes more qualitative. I think this is unique to private equity. That is, the analysis is more qualitative, empirical, and based on more subjective assessments of trends and strengths and weaknesses. As we move into the study of larger, more established publicly traded companies, the analysis becomes progressively more quantitative as we have the data to do the analysis.c

“No matter how much data we get, private equity has its idiosyncratic qualities. I doubt we will ever be able to talk about private equity with the same precision as we talk about public equities.”

In short, it’s all about data.

exactly. Much less data is available for private companies, a challenge for researchers studying private equity. Private he is also a challenge for those who manage equity. This is because we need to work with the data we can get, even if the data is not perfect.

Given a sufficiently large data set for research, is it possible that there are more definitive models of risk and return, or are there still too many intangibles?

I used to think that private equity analysis would become more and more quantitative as more data became available and the investment structures used in private equity became more standardized. But now, I’m starting to think that private equity has an idiosyncratic quality, no matter how much data you get. This means that there is a limit to the amount of knowledge that can be quantified. Because the structure and circumstances surrounding private equity are unique and constantly changing. I don’t think we’ll ever be able to talk about private equity with the same precision that we can when we talk about publicly traded stocks.

Do you see private equity as a growing part of the market?

Private equity has experienced tremendous growth over the last 10-15 years. I see no reason for it to stop. I think institutional investors are becoming more and more comfortable investing in private companies and private equity his funds, and are becoming more comfortable dealing with illiquidity. Private equity ownership is an efficient form of governance, and you may find that these companies tend to perform just as well as publicly traded companies.

You write about skill and luck in private equity investing, how much do they affect risk?

There is an enormous amount of risk and I think people underestimate it. When a company has been doing well for a while, people like to attribute it to their skill and call themselves good. In the research you allude to about skill and luck, we try to distinguish between these two things. that even companies that have raised money and made maybe 10 or 20 investments still have too short a history to clearly show whether they are good or not. . In our research, we refer to persistence that can be identified in real time and used to guide investment decisions as “investable persistence”. Unfortunately, investable sustainability is modest, as it’s all luck involved. It shows that there are persistent differences in performance among private equity firms, but it’s almost impossible to see those differences in real time when looking at company performance. So even if a private equity firm appears to be doing well, it is largely just luck and does not predict how subsequent future investments will perform.

“Even if a private equity firm appears to be doing well, it is largely just luck and does not predict how subsequent future investments will perform.”

How do you teach the idiosyncrasies and intangibles of private equity?

First, tell students that these decisions are based on experience and more qualitative evaluations and trade-offs—there is more than one correct answer. I can’t say that management counts in 5.5 and business plan counts in 4.7. There is no mathematical way to calculate it. While he can lay a technical foundation and teach you various structures such as legal contracts and valuation models, that’s the easy part and a good private he won’t be an equity investor. So instead of trying to tell you, “This is how you do it,” I tell them more, “These are the factors you should consider and this is what experience shows is important.” Private Equity is largely based on business experience. That is, an understanding of the industry, its challenges, and the dynamics of how people react and how companies evolve.

It seems to require critical thinking skills and general management knowledge.

I absolutely believe it. Today, quantitative modeling skills are a commodity and can be purchased on the market. Running numbers and complex statistical models do not stand out in this business. What sets you apart and makes you a great investor in both the venture capital and buyout aspects is managing people, understanding strategy at a higher level, communicating and laying out that strategy clearly and effectively. Ability. A foundation for people to follow. These skills are proving to be more important, even if they are more difficult to define and quantify. We teach them to our students and I really think it’s a great part of tuck culture.

I’m a math/economics guy — I grew up on math.All the math you want.As I get older, I realize that quantitative analysis is great for research, but it’s not enough for business . Business requires an entirely different level, an entirely different layer of skill.

Any special thoughts on teaching at Tuck? Any advice for MBA’s who want to work in private equity?

I am very impressed with the MBA students here in Tuck. They are smart, very friendly, very serious, but serious in a good way. One thing I particularly like is that the students here are very balanced. They understand the value of interpersonal communication, relationships and networking. And I think that’s incredibly important. I think you should know that the MBA students we teach here at Tuck today are some of the best in the world.

My advice to students is that working in private equity or venture capital should not be considered the next step on the career ladder. They should think of it as an end point and a way to build their careers. A relevant experience that can finally get them there.

This story originally appeared in the Summer 2022 issue. today’s tuck.