Capital commitment and illiquidity risks in private equity

  • Ludovic Phalippou Ludovic Phalippou
  • Mark Westerfield Mark Westerfield

Investing in real estate, infrastructure, leveraged buyouts, or venture capital typically involves committing capital to a fund several years before the capital is actually used. Once the capital is called and invested, the asset is untradable until the fund exitsthe project. We present a model of capital commitment and allocation that captures this type of illiquidity along with realistic features like strategic default and liquidity cycles. With one illiquid asset, the welfare premiums associated with commitment risk are small because of the ease of adjusting liquid risky asset exposure. The presence of multiple illiquid assets allows the investor to diversify across liquidity events, increasing welfare, but generates a costly funding mismatch: some funds may call early while others return capital late. With many funds, the welfare premium associatedwith commitment risk actually increases and, in the limit, is equivalent to increasing investment returns by 1:63% per annum.

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