Real Options and Private Equity Investment Decisions: Awareness, Importance, and Application

Abstract

The purpose of this research project was to explore whether an emerging valuation methodology in academic finance has gained acceptance by practitioners. Specifically, the primary research questions were concerned with the importance of real options in the investment decisions of private equity firms and whether principals of these firms were familiar with real options theory and if it was applied in evaluating investment opportunities. The key conclusions of this study are that real options are important factors in the investment decisions of private equity firms. However, less than half of the principals surveyed are familiar with the theory, and only one applied it explicitly in evaluating investment opportunities. These findings suggest that these firms are unable to value quantitatively crucial factors relating to their investment decisions. It is evident that proponents of the theory in academia must advocate its use more effectively, to address the awareness issue. Additionally, academicians must work with practitioners to develop a real options model that is both accurate yet relatively easy to apply, to address the application issue. Overall, real options play an important role in unlocking shareholder value for private equity firms, and the firms need to be better informed as to the best tools to measure and unlock this strategic value.