Podcast: Lipton and Lopez de Prado on a quant approach to private equity

The pair introduce analytical methods to valuing and allocating private asset investments

Alex Lipton photo by Steven Sullivan

Gigantic IPOs are capturing global attention, and a large chunk of investor dollar. But many of these recently listed companies were previously private-equity owned – an asset class that is notable for its complex fee structures and absence of accessible market prices. The lack of reliable valuation method means that portfolio managers are often left guessing whether they should invest in private markets and if so, how much should be allocated.

Alexander Lipton and Marcos Lopez de Prado, global heads of research and development at Abu Dhabi Investment Authority and founding advisory board members of Adia Lab, set out to tackle this. Their paper aims to address the current gap in literature, introducing the first quantitative approach to adequately value private equity investments and help investors to better understand the risk/return dynamics involved.

“The main question that we are trying to answer is what is private equity investment worth to a specific investor, given that the asset is illiquid, difficult to hedge and tied to the investor’s own risk tolerance and allocation size,” says Lopez de Prado (pictured above, right). “The paper is not trying to replace judgment or discretionary views. It’s trying to discipline that judgment with a coherent mathematical framework.”

Typically, private asset investments are valued with methods borrowed from public markets. This becomes a problem as private assets are not traded continuously as they would be in a complete public market. Arbitrage pricing theory relies on instantaneous trading to move the price up or down. Without a set unique price to identify assets with identical payoff, the asset cannot be replicated and perfectly hedged.

The pair’s proposed framework encompasses a three-asset model and two-stage approach, involving a risk-free investment, a public investment (such as an index) and an illiquid private investment. In place of arbitrage-based pricing, their method integrates utility maximisation frameworks, which is based on individual investor preferences. As such, their approach results in indifference pricing - for holding and not holding a private asset - moving away from the single universal fair market value in complete markets. This method catches the non-linearity often missed in traditional valuation methods.

Quantcast – a Risk.net Cutting Edge podcast · Lipton and Lopez de Prado 15/06/26

 

Stage one of the two-stage approach determines how much should be allocated to non-tradable private assets. Stage two sets appropriate sub-allocations to best balance what has been allocated to the liquid tradable assets. 

“You can think of this model as a quantitative tool to answer qualitative questions,” says Lipton.

Lipton outlines how increased activity in private equity and recent IPOs aids a better understanding of the dynamics of private companies and their underlying assets, resulting in better predictions of how they will evolve. 

The pair previously won the Risk buy-side quants of the year award in 2021 for their paper on using heat potentials for optimal trading and while both have their own extensive amount of literature in different areas of financial research, they state their work on private equity is far from over. Lipton explains plans to combine digitisation, tokenisation and quantitative methods for private equity valuations. Lopez De Prado highlights the importance of “disentangling risk” with allocation dependent on three dimensions: market risk, model risk and uncertainty.

Index: 

00:00 Introduction

02:28 Motivation and the three-asset model structure

08:25 Valuations using utility functions

12:00 Private equity in practice

21:15 Sensitivity to volatility

30:42 Future research on private assets and next projects

To hear the full interview, listen in the player above, or download. Future podcasts in our Quantcast series will be uploaded to Risk.net. You can also visit the main page to access all tracks, or go to Spotify, Amazon Music or Apple Podcasts to listen and subscribe.