Total Beta: Free lunch for Private Equity

Abstract

In Private Equity transactions rather often, the seller is not completely diversified. When there is a difference between the levels of diversification of sellers and buyers, this translates different risk exposure between the two parties while holding the same assets. Risk-returns models such as the CAPM account only for the systemic risk when valuing investments, but an undiversified investor should also consider the specific risk component. To estimate the expected return for these investors, academic literature has developed the Total Beta which can substitute it to the original Beta in the CAPM to calculate the expected return for this type of investor. My claim is that Private Equity funds might be able to extract value when buying stakes of a private company directly from the undiversified funder of that company, and they can do so by paying a price that lies within these the value perceived by an undiversified investor and the one perceived by a diversified one. If that is the case, this difference should result on average in lower entry multiples or higher IRR for Buyout funds (that buy from individual entrepreneurs) compared to Secondaries funds (that buy from institutional investors) when purchasing stakes in private companies. This work focuses on assessing this difference and trying to seek a correlation between the expected returns and the empirical results for these two types of transactions.