We investigate whether the performance of private equity (PE) investments is sufficient to compensate investors (LPs) for risk, long-term illiquidity, management, and incentive fees charged by the general partner (GP).We analyze the LPs’ portfolio-choice problem and find that management fees, carried interest, and illiquidity are costly, and GPs must generate substantial alpha to compensate LPs for bearing these costs. Debt is cheap and reduces these costs, potentially explaining the high leverage of buyout transactions. Conventional interpretations of PE performance measures appear optimistic. On average, LPs may just break even, net of management fees, carry, risk, and costs of illiquidity.

We develop a dynamic incomplete-markets model of entrepreneurial firms, and demonstrate the implications of nondiversifiable risks for entrepreneurs' interdependent consumption, portfolio allocation, financing, investment, and business exit decisions. We characterize the optimal capital structure via a generalized tradeoff model where risky debt provides significant diversification benefits. Nondiversifiable risks have several important implications: More risk-averse entrepreneurs default earlier, but choose higher leverage; lack of diversification causes entrepreneurial firms to underinvest relative to public firms, and risky debt partially alleviates this problem; and entrepreneurial risk aversion can overturn the risk-shifting incentives induced by risky debt. We also analytically characterize the idiosyncratic risk premium.

The presence of a well designed bankruptcy code is an important part of the financial architecture in developed economies. By allowing the creditors to seize the assets of the borrowers who fail to make contractual payments, the code generates beneficial ex ante effects on debt capacity and firm value. By giving the borrowers options to renegotiate their debt obligations and seek bankruptcy protection, the code increases the likelihood that borrowers may avoid inefficient ex post liquidation. As Hart (1999) notes, the code should balance ex ante firm value maximization with ex post efficiency. The bankruptcy codes in different countries weight this tradeoff differently and hence vary in terms of the distribution of rights and powers between borrowers and lenders. In this paper, we provide an inter-temporal framework to examine how the creditors’ liquidation rights and the distribution of ex post bargaining powers influence the firm’s investment and financing decisions, and affect ex ante firm value. We show that stronger equityholders ’ bargaining power lowers debt capacity, reduces firm value, and discourages growth option exercising. Our calibration suggests that the quantitative effects of ex post strategic renegotiation on ex ante firm value may be large.

The 2008 financial crisis exemplifies significant uncertainties in corporate financing conditions. We develop a unified dynamic q-theoretic framework where firms have both a precautionary-savings motive and a market-timing motive for external financing and payout decisions, induced by stochastic financing conditions. The model predicts (1) cuts in investment and payouts in bad times and equity issues in good times even without immediate financing needs; (2) a positive correlation between equity issuance and stock repurchase waves. We show quantitatively that real effects of financing shocks may be substantially smoothed out as a result of firms' adjustments in anticipation of future financial crises.

We develop an incomplete-markets q-theoretic model to study entrepreneurship dynamics. Precautionary motive, borrowing constraints, and capital illiquidity lead to underinvestment, conservative debt use, under-consumption, and less risky portfolio allocation. The endogenous liquid wealth-illiquid capital ratio w measures time-varying financial constraint. The option to accumulate wealth before entry is critical for entrepreneurship. Flexible exit option is important for risk management purposes. Investment increases and the private marginal value of liquidity decreases as w decreases and exit becomes more likely, contrary to predictions of standard financial constraint models. We show that the idiosyncratic risk premium is quantitatively significant, especially for low w.

ABSTRACT We propose a model of sovereign debt in which countries vary in their level of financial development, defined as the extent to which they can issue debt denominated in domestic currency in international capital markets. We show that low levels of financial development generate the “debt intolerance” phenomenon that plagues emerging markets: it reduces overall debt capacity, increases credit spreads, and limits the country's ability to smooth consumption.

We model the welfare consequences of mandates that restrict investors to hold firms with net-zero carbon emissions. To qualify for these mandates, value-maximizing firms have to accumulate decarbonization capital. Qualification lowers a firm’s required return by its decarbonization investments divided by Tobin’s q, that is, the greenium or the dividend yield shareholders forgo to address the global-warming externality. The welfare-maximizing mandate approximates the first-best solution, yielding welfare gains compared to laissez-faire by mitigating the weather disaster risks resulting from carbon emissions. Our model generates optimal transition paths for decarbonization that we use to evaluate proposed net-zero targets. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online

We introduce aggregate transmission shocks to an epidemic model and link firm valuations to infections via an asset pricing framework with vaccines. Infections lower earnings growth but firms can mitigate damages. We estimate a large reproduction number $\mathcal R_0$ and transmission volatility for COVID-19. Using these estimates, we quantify the bias of deterministic approximations based on $\mathcal R_0$. Our model generates predictions consistent with the data: unexpected infection resurgence, nonmonotonic mitigation policies, and higher price-to-earnings ratios during a pandemic. Valuations would be significantly lower absent mitigation and a high vaccine arrival rate.

We develop a dynamic model of a platform economy where tokens serve as a means of payment among platform users and are issued to finance investment in platform productivity. Tokens are optimally rewarded to platform owners when token supply (normalized by productivity) is low and burnt to boost franchise value when the normalized supply is high. Although token price is determined in a liquid market, the platform’s financial constraint generates an endogenous token issuance cost that causes underinvestment through the conflict of interest between insiders (owners) and outsiders (users). Blockchain technology mitigates underinvestment by addressing the owners’ time inconsistency problem.

We develop a dynamic asset pricing model of cryptocurrencies/tokens that allow users to conduct peer-to-peer transactions on digital platforms. The equilibrium price of tokens is determined by aggregating heterogeneous users’ transactional demand, rather than discounting cash flows as is done in standard valuations models. Endogenous platform adoption builds on user network externality and exhibits an -curve: it starts slow, becomes volatile, and eventually tapers off. The introduction of tokens lowers users’ transaction costs on the platform by allowing users to capitalize on platform growth. The resultant intertemporal feedback between user adoption and token price accelerates adoption and dampens user-base volatility.