Private Equity Funds and Real Options

This chapter introduces the concept of real options in private equity funds. The real options concept applies financial option theory to real-life investments. It recognizes the value of deferring investment decisions and of learning over time. The real option methodology is particularly useful when there is a high degree of uncertainty, some managerial flexibility, and not all the information is known ex ante. The chapter defines a real option as the right, but not the obligation, to take an action at a pre-determined cost, for a predetermined period of time. Comparable to mutations in biological evolution, real options are costly on one side but have a value in situations where changes are unpredictable. Generally options to expand, extend or defer the start of a project can be classified as call options, whereas options to abandon, contract or switch between different modes of operation are seen as put options. The chapter highlights that some real options, such as to abandon, are inherent in the investment decision, but others can be created in their own turn.