Building a Better Model for Private Equity

A conversation with Morten Sorensen, associate professor of finance, about his research into private equity risk and return and about teaching at Tuck.

He joked then that there was so little research about private equity risk that having his name on one-and-a-half papers seemed to designate him an expert. His genuine humility aside, Sorensen, at Tuck since 2020, truly is an expert in the field, and he continues his research into private equity investments—as well as venture capital and entrepreneurial finance overall—and the effects of those investments in individual transactions and the broader economy.

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

No, the problem hasn’t been solved. Our original study came out in 2010, and it does a pretty good job of developing a model that can estimate the risk and return on investment. But it is a very complex model involving a lot of complex analysis.

Why are risk and return in private equity so 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 it’s been bought, sold, or refinanced. That complicates any quantitative analysis, and naturally the approach becomes more qualitative. I think that’s inherent in private equity—that an analysis is more qualitative and based on experience, on a more subjective assessment of trends and strengths and weaknesses. As you move into studying more-established, larger public companies, the analysis gradually becomes more quantitative because then you have the data to do it.c

So it’s all about the data.

Exactly. There is much less data available about private companies, which is a challenge for researchers studying private equity. It’s also a challenge for the people managing private equity because they have to work with the data they can get, even if it is less complete.

If you had a large enough data set for your research, could there be a more definitive model for 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 we got more data and because the investment structures that we use in private equity have become more and more standardized. But now I am starting to think that, regardless of how much data we get, there is an idiosyncratic nature to private equity—a limit to the amount of knowledge we can quantify—because the structures and circumstances around it are idiosyncratic and always changing. I doubt that we will ever be able to talk about private equity with the same kind of precision we do when we talk about publicly traded stocks.

Do you see private equity continuing to grow as a portion of the market?

Private equity has been growing tremendously over the past 10 to 15 years, and I don’t see any reason for that to stop. I think institutional investors are increasingly comfortable investing in private companies and private equity funds, and they are growing more comfortable managing the illiquidity. I think we’re seeing that the private equity ownership form is an efficient governance form and that these companies tend to do as well as publicly traded companies.

You’ve written about skill and luck in private equity investing—how much do they affect risk?

I think there is an enormous amount of risk, and people underestimate it. When a firm has done well for a while, people want to attribute that to skill and say they are good, when in reality they’ve just been lucky some times in a row. In the study you’re alluding to about skill and luck, we’re trying to tell these two things apart. And what we found is that if you look at the histories of most private equity firms today, even a firm that has raised a number of funds and made maybe 10, 20 investments, it’s still too short a history to definitively show whether they are better or worse or whether they’ve just been lucky or unlucky. In our study, we call the persistence that you can identify in real time and use to guide investment decisions “investable persistence.” Unfortunately, due to all the luck involved, the investable persistence is modest. We do show that there is a persistent difference in performance across private equity firms, but that it’s almost impossible to pick up that difference in real time when you’re looking at a firm’s track record. So even if a private equity firm looks like it’s been doing great, to a large extent it’s really just luck, and it’s not very predictive of how their future investments will perform afterwards.

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

First, we tell students that these decisions are based on experience and more qualitative valuations and tradeoffs—that there is no single right answer. I can’t tell you that the management counts for 5.5 and the business plan counts for 4.7—there’s no mathematical way to do that. I can lay the technical foundation and teach you the various structures, like legal contracts and valuation models, but that’s the easy part—it’s not going to make you a great private equity investor. So instead of trying to teach “this is how you do it,” we teach more “these are the factors that you should consider, and this is what experience has shown is important.” To a large extent, private equity is based on business experience—your understanding of the industry, of its challenges, and the dynamics of how people respond and how companies evolve.

That sounds like a push for critical-thinking skills and general-management knowledge.

I absolutely believe that. Today, quantitative modeling skills are a commodity—you can buy them in the market. Running numbers and complicated statistical models isn’t going to set you apart in this business. What is going to set you apart and make you a great investor, both on the venture capital and the buyout sides, is the ability to manage people, to understand strategy at a greater level, to communicate that strategy clearly and effectively, and to lay a foundation for people to follow. These skills turn out 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 the Tuck culture.

I’m a math/econ guy—I grew up with math, all the math you’d ever want. And the older I become, the more I realize that quantitative analysis is great for research, but in business it only takes you so far. In business, there’s a whole other level, a whole other layer of skills that you need to have.

Do you have any particular thoughts about teaching at Tuck? Any advice for MBAs who want to work in private equity?

I am incredibly impressed with the MBA students here at Tuck. They are smart, very friendly, and very serious, but serious in a good way. One thing I particularly like is how students here are so well rounded—they have an understanding of the value of interpersonal communication and relationships and networking. And I think that’s incredibly important. I think that people out there should know that the MBA students we are teaching here at Tuck today are amongst the best in the world, bar none.

My advice to students is that they shouldn’t think of working in private equity or venture capital work as the next rung on their career ladder: they should think of it as being the end station and think of their career as a way of building up the relevant experience that can eventually take them there.

This story originally appeared in print in the Summer 2022 issue of Tuck Today.