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Credit Market Equivalents and the Valuation of Private Firms

We propose to value private equity investments by credit market equivalents (CME). Our method relies on the observation that many portfolio companies held by private equity funds have loans and bonds traded in secondary markets. We exploit the market valuations embedded in these prices by constructing a stochastic discount factor that prices loan and bond returns of private equity portfolio company portfolios. To that end, we construct a dataset that carefully matches loan and bond price data with a proprietary data on cash flows of private equity companies at the portfolio company level. With our credit market implied stochastic discount factor, we can value the cash flows of the private equity companies to derive their CME valuation. Using machine learning variable selection techniques, we identify a five-factor model for credit market returns. Our method works as long as credit and private equity markets are sufficiently integrated, for which we provide supportive empirical evidence.