Beyond the J Curve E-Book

Thomas Meyer

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Series
• Sprache: Englisch
• Veröffentlichungsjahr: 2011

Seitenzahl: 741

Beschreibung

In recent times, venture capital and private equity funds havebecome household names, but so far little has been written for theinvestors in such funds, the so-called limited partners. There isfar more to the management of a portfolio of venture capital andprivate equity funds than usually perceived. Beyond the JCurve describes an innovative toolset for such limited partnersto design and manage portfolios tailored to the dynamics of thismarket place, going far beyond the typical and often-simplisticrecipe to 'go for top quartile funds'. Beyond the J Curve provides the answers to key questions,including: * Why 'top-quartile' promises should be taken with a huge pinchof salt and what it takes to select superior fund managers? * What do limited partners need to consider when designing andmanaging portfolios? * How one can determine the funds' economic value to helpaddressing the questions of 'fair value' under IAS 39 and 'risk'under Basel II or Solvency II? * Why is monitoring important, and how does a limited partnermanage his portfolio? * How the portfolio's returns can be improved through properliquidity management and what to consider whenover-committing? * And, why uncertainty rather than risk is an issue and how alimited partner can address and benefit from the fast changingprivate equity environment? Beyond the J Curve takes the practitioner's view andoffers private equity and venture capital professionals acomprehensive guide making high return targets more realistic andsustainable. This book is a must have for all parties involved inthis market, as well as academic and students.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

List of Boxes

Acknowledgements

Disclaimer

Part I - Private Equity Environment

Chapter 1 - Introduction

1.1 ROUTES INTO PRIVATE EQUITY

1.2 THE LIMITED PARTNER’S VIEWPOINT

1.3 THE CHALLENGE OF VENTURE CAPITAL FUND VALUATION

1.4 HARD FIGURES OR GUT INSTINCT?

1.5 MANAGING WITH FUZZY FIGURES

1.6 MAKING THE GRADES

1.7 OUTLINE

Chapter 2 - Private Equity Market

2.1 FUNDS AS INTERMEDIARIES

2.2 THE PROBLEM OF PREDICTING SUCCESS

2.3 BROAD SEGMENTATION OF INVESTMENT UNIVERSE

2.4 PRIVATE EQUITY MARKET DYNAMICS

2.5 CONCLUSION

Chapter 3 - Private Equity Fund Structure

3.1 KEY FEATURES

3.2 CONFLICTS OF INTEREST

3.3 FINDING THE BALANCE

Chapter 4 - Buyout and Venture Capital Fund Differences

4.1 VALUATION

4.2 BUSINESS MODEL

4.3 DEAL STRUCTURING

4.4 ROLE OF GENERAL PARTNERS

Chapter 5 - Funds-of-funds

5.1 STRUCTURE

5.2 VALUE ADDED

5.3 COSTS

5.4 PRIVATE EQUITY INVESTMENT PROGRAMME

APPENDIX 5A

Part II - Investment Process

Chapter 6 - Investment Process

6.1 KEY PERFORMANCE DRIVERS

6.2 PROCESS DESCRIPTION

6.3 RISK MANAGEMENT

6.4 TACKLING UNCERTAINTY

Chapter 7 - Risk Framework

7.1 MARKET VALUE

7.2 MARKET OR CREDIT RISK?

7.3 CONCLUSION

APPENDIX 7A: INCORPORATING PRIVATE EQUITY INTO THE TRADITIONAL VaR FRAMEWORK

Chapter 8 - Portfolio Design

8.1 PORTFOLIO DESIGN FRAMEWORK

8.2 PORTFOLIO CONSTRUCTION TECHNIQUES

8.3 RISK-RETURN MANAGEMENT APPROACHES

Chapter 9 - Case Study: Taking the Long-term View—Strategic Approaches to the ...

9.1 LOOKING FOR THE OPTIMAL PROGRAMME SIZE

9.2 OVERCOMING ENTRY BARRIERS: LONG-TERM STRATEGIES

APPENDIX 9A: FORMULAE

APPENDIX 9B: SKEWNESS AND KURTOSIS

APPENDIX 9C: EXPECTED UTILITY

Chapter 10 - The Management of Liquidity

10.1 LIQUIDITY MANAGEMENT PROBLEM

10.2 LIQUIDITY MANAGEMENT APPROACHES

10.3 INVESTMENT STRATEGIES FOR UNDRAWN CAPITAL

10.4 CASH FLOW PROJECTIONS

10.5 CONCLUSION

APPENDIX 10A: CASH FLOW ESTIMATION TECHNIQUE

APPENDIX 10B: CUMULATIVE NET CASH FLOW STATISTICS

APPENDIX 10C: LIQUIDITY MANAGEMENT TESTS

Part III - Design Tools

Chapter 11 - Established Approaches to Fund Valuation

11.1 BOTTOM-UP APPROACH TO PRIVATE EQUITY FUND VALUATION

11.2 INCONSISTENCY OF VALUATIONS

11.3 NAVS DO NOT TELL THE FULL PICTURE

11.4 PORTFOLIO COMPANIES CANNOT BE VALUED IN ISOLATION

11.5 CONCLUSION

Chapter 12 - Benchmarking

12.1 SPECIFIC ISSUES

12.2 INDIVIDUAL FUNDS

12.3 PORTFOLIO OF FUNDS

Chapter 13 - A Prototype Internal Grading System

13.1 GRADING OF PRIVATE EQUITY FUNDS

13.2 THE NAV IS NOT ENOUGH

13.3 EXISTING APPROACHES

13.4 NEW APPROACH TO INTERNAL FUND-GRADING SYSTEM

13.5 SUMMARY—NAV- AND GRADING-BASED VALUATION

13.6 CONCLUSION

APPENDIX 13A

Chapter 14 - Fund Manager Selection Process

14.1 RELEVANCE OF FUND MANAGER SELECTION

14.2 WHY DUE DILIGENCE?

14.3 THE DUE DILIGENCE PROCESS

14.4 FUND MANAGER SELECTION PROCESS

14.5 DECISION AND COMMITMENT

APPENDIX 14A: ILLUSTRATIVE DUE DILIGENCE QUESTIONNAIRE—VENTURE CAPITAL FUNDS

Chapter 15 - Qualitative Fund Scoring

15.1 SCORING APPROACH

15.2 SCORING DIMENSIONS

Chapter 16 - Grading-based Economic Model

16.1 APPROACH

16.2 INTERNAL AGE ADJUSTMENT

16.3 PRIVATE EQUITY FUND IRR PROJECTIONS

16.4 EXPECTED PORTFOLIO RETURNS

16.5 DISCUSSION

16.6 CONCLUSION

APPENDIX 16A

APPENDIX 16B

APPENDIX 16C: GRADING-BASED PRIVATE EQUITY FUND VALUATION—HOW FAIR IS MY VALUATION?

Chapter 17 - Private Equity Fund Discount Rate

17.1 THE CAPITAL ASSET PRICING MODEL

17.2 PRIVATE EQUITY FUND BETAS

17.3 THE ALTERNATIVES TO THE CAPITAL ASSET PRICING MODEL

17.4 SUMMARY AND CONCLUSION

Part IV - Management Tools

Chapter 18 - Monitoring

18.1 APPROACH TO MONITORING

18.2 THE MONITORING OBJECTIVES

18.3 INFORMATION GATHERING

18.4 EVALUATION

18.5 ACTIONS

Chapter 19 - Case Study: Saving Your Investments—Approaches to Restructuring

19.1 THE VALLEY OF TEARS

19.2 THE REPORT TO THE BOARD

19.3 THE TERMS OF THE RESTRUCTURING

19.4 EPILOGUE

APPENDIX 19A: INVESTMENT PROPOSAL

APPENDIX 19B: TRACK RECORD

Chapter 20 - Secondary Transactions

20.1 SELLERS AND THEIR MOTIVATIONS

20.2 BUYERS AND THEIR MOTIVATIONS

20.3 SECONDARY MARKET PRICES

20.4 TRANSACTIONAL ISSUES

20.5 THE FUND MANAGER PERSPECTIVE

Part V - Embracing Uncertainty

Chapter 21 - Deviating from Top Funds

21.1 STRATEGIC INVESTMENTS

21.2 POLICY OBJECTIVES

Chapter 22 - Real Options

22.1 REAL OPTIONS IN PRIVATE EQUITY

22.2 REAL OPTION ANALYSIS

22.3 AN EXPANDED STRATEGY AND DECISION FRAMEWORK

APPENDIX 22A: A REAL OPTION EXAMPLE

Chapter 23 - Beyond the J-curve

23.1 SOME DO IT BETTER

23.2 DEADLY SINS

23.3 STRUCTURE INSTEAD OF “GUT INSTINCT”

23.4 PATIENCE IS A VIRTUE

23.5 TURNING WATER INTO WINE

Glossary

Bibliography

Abbreviations

Index

This is the first work that I have seen that comprehensively covers the important subject of valuing, evaluating and measuring the performance of private equity funds. Much has been published in journals and papers on individual aspects of this controversial subject by various segments of the stakeholder universe - usually putting forward partisan viewpoints. This is the first time that a holistic, integrated and disciplined framework has been adopted. The approach taken has yielded a rich crop of useful results including an innovative methodology for determining fair value for private equity funds during the course of their long lives; portfolio design and benchmarking methods; a prototype grading and fund scoring system. Essential reading for investors and a useful state-of-the-art reference manual for private equity managers.

Christopher K.B. Brotchie, Formerly Chief Executive of the Baring Private Equity Group and Member of the ING Management Council

This book goes a long way to filling the vacuum of digestible thought and writing about private equity fund investing. It provides structure and rigour to all aspects of the investment process and will be an invaluable reference for the limited partner community. But more than anything else, it provides a platform on which to build greater understanding as the asset class evolves and the role of fund investors becomes more demanding.

Chris Davison, Associate Director, Almeida Capital

The transactions, size and stories of private equity and venture capital investment activity are the focus of many news publications today. It is not quite the same situation in the area of academic and technical publications, where much remains to be researched and published. The authors of Beyond the J Curve have taken on the ambitious project of analysing the difficult and controversial area of valuing fund portfolios. Their innovative and integrated approach aims at opening up the framework within which these valuations are practised by investors, and offers alternatives. This is a welcome angle to the current debate among investors, private equity and venture capital practitioners. The subject is likely to spur substantial discussions and additional technical publications. Beyond the J Curve is certainly a thorough and pioneering contribution to that debate.

Javier Echarri, Secretary General, European Private Equity & Venture Capital Association

Congratulations to both Thomas Meyer and Pierre-Yves Mathonet for their publication Beyond the J curve. They should be highly commended for breaking a long-standing taboo–investing in private equity can now be modelled. Beyond the J curve not only reveals a theoretical approach to Fair Value for private equity funds but also proposes a complete approach for investors to build up a comprehensive and effective programme for private equity investments. I am personally convinced that our industry should become more involved with this type of approach in order to best explain the interest of investing in private equity.

Pierre Hervé, General Secretary of Natexis private Equity, Chairman of AFIC’s Basel II and IFRS working groups, and Member of EFRAG’s Venture Capital working group

Beyond the J Curve is a timely guide for investors in private equity, with an elegant balance of analysis and practical suggestions. Its emphasis on monitoring and active portfolio management should promote more effective stewardship of private equity assets in the future.

Brenlen Jinkens, Director, Cogent Partners Europe

Much has been written about how to become an entrepreneur or how to invest in companies if you are a venture or private equity investor. What has been sorely missing is any advice on how to examine private equity from the institutional investor point of view. Beyond the J Curve is right on target, giving the private equity investment manager much needed guidance on how to put private equity into a modern diversified investment portfolio. As both a primer and an advanced guide, offering both theory and practice - this book provides practical and comprehensive education and advice on traversing the often murky and risky waters of venture and private equity investing. From primary due diligence to portfolio monitoring, it provides a thorough and advanced introduction to private equity investing for the portfolio investor. It should become a ’must-have’ reference for any current or prospective private equity investor.

Jesse E. Reyes, Managing Director, Reyes Analytics

Over the past 20 years private equity has become an important feature of the investment landscape and it is now an asset class that few institutional investors can ignore. Although private equity has attracted much interest over recent years, there have been very few authoritative studies that analyse the key components in creating and managing a portfolio of private equity investments. Thomas Meyer and Pierre-Yves Mathonet have applied intellectual rigour in their examination of the issues that fund managers confront when taking on this esoteric asset class. In principle it appears straightforward to hire managers to invest in private equity opportunities. However, nothing is further from the truth and Beyond the J Curve is an ideal companion to fund managers trying to navigate the swells and eddies of private equity investment.

Ray Maxwell, General Partner, INVESCO Private Capital

Beyond the J Curve is the first book that gives a comprehensive explanation of the management of a diversified private equity portfolio. In this groundbreaking book, Meyer and Mathonet provide both the theoretical underpinnings for, and practical realities of, building a successful portfolio of private equity investments. In today’s increasingly complex environment, this book is an invaluable resource for any institutional investor who is constructing or managing a portfolio of investments in private equity and/or venture capital.

Mark D. Wiseman, Chairman, Institutional Limited Partners Association (ILPA)

Copyright © 2005

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T.M.

To my family, to finally explain what I have been doing all day, and most of all to Mika Kaneyuki, my wife and best friend, who is my strength and purpose in life.

P.-Y.M.

To my wife Barbara, my very first supporter and raison d’être, who accepted being single many evenings and weekends because of this book, to my son John, who made me the happiest dad, and to my family and friends. I have in me something of you all and therefore, this book is also yours.

For other titles in the Wiley Finance series please see www.wiley.com/finance

List of Boxes

1.1Private equity as winemaking62.1Is private equity an asset class?92.2The J curve122.3Access to top funds193.1Well-intentioned structures can have unpredictable consequences386.1Risk-adjusted pricing656.2Risk and uncertainty687.1Independent risk management function738.1Niche strategies898.2Market timing919.1Random pick10510.1Emerging markets currency issues12611.1Transactions before maturity15511.2Venture capital as appraised asset class16016.1Superior selection skills23418.1Style drift27418.2Transparency27718.3Standard reporting28020.1Secondaries as benchmark for “verifiable fair value”?30120.2Securitisation: an alternative exit route30921.1Cornerstoning314

Acknowledgements

This book was written with the help of many individuals who have given invaluable assistance. We would like to express our gratitude to all of them and notably to:

• Gauthier Monjanel & Gabriel Robet for their hard work on the case studies in this book.

• Francis Carpenter, Chief Executive, European Investment Fund, who made this project possible and provided us great support. Also all our colleagues and especially Maria Leander for her “legal” advice, Sven Lahann for testing and implementing most of our concepts, and Jacques Lilli and Bruno Robino for their comments on the due diligence questionnaire.

• Juan Delgado-Moreira PhD, CFA, Baring Private Equity Partners, and Dr Michael Jean Gschrei of Dr Gschrei & Associates GmbH for their valuable comment and suggestions on the management of liquidity.

• Brenlen Jinkens, Director and Todd Konkel, Vice President, Cogent Partners, for having shared with us their expertise on secondary transactions.

• Chris Davison, Associate Director, Almeida Capital, for his initial help and encouragement and for taking the time to read chapters of the book and provide very useful comments.

• Dr. Didier Guennoc, Research Director, EVCA, for his longstanding support and collaboration.

• London Business School (LBS), for providing us with our financial background and for bringing us together. Also to Associate Professor Alexander Ljungqvist, NYU Stern School of Business (previously Visiting Assistant Professor LBS) for his unforgettable class on entrepreneurial finance and to Professor Eli Talmor, LBS, for his insights on discount rates.

• Daniel and Florence Cathiard for producing an amazing wine and for having helped us in drawing the analogy between winemaking and private equity.

Finally, to the team at John Wiley & Sons who helped us produce the book, including our Publishing Editor, Rachael Wilkie; Project Editor, Vivienne Wickham; Marketing Executive, Peter Baker, and Assistant Editor, Chris Swain.

Disclaimer

This book is targeting commercially-oriented institutions that are either already managing or considering setting up a private equity funds investment programme. Rather than proposing an “ideal” programme, it is our intention to discuss various methods and trade-offs. In this context, we have researched private equity market practices and discussed different approaches with industry practitioners.

Various concepts presented herein have been researched and developed in the course of our work with the European Investment Fund. Statements herein are, however, not made on behalf of the European Investment Fund or any of its representatives and nothing herein may be deemed to represent a policy or business practice of the European Investment Fund.

Part I

Private Equity Environment

1

Introduction

David Rubenstein, co-founder of the Carlyle Group, has been said to compare private equity with sex. According to him, if one tries out either one with reasonable expectations, one should be pleased with the results. To quote the Yale endowment 2002 annual report, private equity “offers extremely attractive long-term risk-adjusted return characteristics, stemming from the University’s strong stable of value-added managers that exploit market inefficiencies”. Certainly many potential investors will find annualised private equity returns of 29% to the Yale University’s endowment, since the inception of their programme in 1973 until 2003 as a “sexy” opportunity.

Unfortunately, such return expectations may often be juvenile and slightly exaggerated. One will be definitely disappointed if quick results are expected. As Raschle & Ender (2004) observed, the “overall private equity market has historically not delivered the often mentioned ‘guaranteed’ top return. Since the early 1980s the market size has developed approximately in line with the required return for private equity, which is basically the public market return plus an illiquidity premium”. Private equity is largely illiquid. Either you decide to make a long-term commitment and follow a systematic approach or you had better stay out entirely. Industry practitioners believe that investing consistently and continuously probably works best, while trying to time the market and getting in and out will lead to frustration. Indeed, it is only through a methodical approach and with a disciplined implementation over a significant time period, that the results can become highly rewarding.

1.1 ROUTES INTO PRIVATE EQUITY

There are different routes for investing in private equity. We believe that few institutions have the experience and especially the incentive structures that would allow them to invest directly in unquoted companies, and therefore most of them seek intermediation through the limited partnership structure that, according to Bosut (2003), “is the most ideal financial fund management structure avoiding possible conflicts of interest between the fund managers and limited partners, and aligning the incentives of the parties with each other”. For institutions the most relevant approaches to investing in private equity are, for example, through fund-of-funds specialists as intermediaries or through similarly structured dedicated in-house private equity investment programmes. Other routes are via the publicly quoted private equity vehicles, or to open a dedicated account managed by a private equity specialist, which is similar to the fund-of-funds route but without the pooling of interests.

1.2 THE LIMITED PARTNER’S VIEWPOINT

While start-ups and entrepreneurs and occasionally their financers catch the limelight, the “financers of the financers”, i.e. the limited partners, are generally overlooked. Most institutions themselves believe that this kind of investing is “just like any other asset” and do not pay too much attention to this—typically immaterial—part of their activities. Our book is about the portfolio management of investments in private equity funds and focuses on the limited partner’s investment process, as so far few publications address their needs. We use the expression “private equity funds investment programme” and for simplification will not differentiate between institutions’ in-house investment programmes and accounts managed by specialists on behalf of such institutions. Generally, intermediation in this asset class is continuously evolving and even an in-depth discussion of the current industry landscape goes far beyond the scope of this book.1

It is unclear at the moment whether some disillusioned LPs might conclude that this is a game that is just too hard to play.

Josh Lerner (quoted in Borel, 2004.)

1.3 THE CHALLENGE OF VENTURE CAPITAL FUND VALUATION

Venture capital is a subclass of private equity that poses specific challenges, mainly because of the difficulty of valuing such investments. This book was partly motivated by our involvement in internal and external discussions on how to address the requirements of “fair value” accounting under the new International Financial Reporting Standards (IFRS) and the treatments of risks under the new Basel Accord (Basel II) or the new Capital Adequacy Directive (CAD II). Not only banks but also other institutional investors under regulatory supervision, such as insurance companies, become more and more concerned about the quantification of risks.

Before talking about risks, however, one needs to tackle the question of valuations, and already at this point the problems become apparent. Established techniques can only be applied with restrictions, under heroic assumptions or not at all for venture capital funds. Because of the difficulties inherent in valuing investments in innovative technologies, early stage investments have so far caused significant problems for many institutions and have led to a strong reluctance to become exposed to such assets. It is not only impractical but also conceptually questionable—at least during its early years—to value a fund “bottom-up” by assessing individual portfolio companies. We will argue that looking at the so-called net asset value (NAV) alone is an oversimplified way of assessing the value of an investor’s stake in a private equity fund, ignoring material factors such as the undrawn commitments that are still to be paid into the fund and, notably, one of the most important factors stressed by all industry players, the quality of the fund manager.

1.4 HARD FIGURES OR GUT INSTINCT?

In the investment industry the majority of managers have a strong quantitative orientation and feel comfortable with the disciplined application of a decision science-based tool set. Precise projections of returns, risks and correlations have become an indispensable part of the modern investment management process. Specifically in the hedge fund industry, where occasionally even part of the investment decision is “delegated” to computer-based “black boxes”, this may be driven to the extreme. There is a heavy dependence on “proven” models and high quality data that give reliable forecasts.

At the other extreme, according to Swensen (2000), “judgemental investors rely on ‘gut instinct’, managing portfolios by the seat of their pants. Sensible investment operations avoid both extremes, melding reasonably rigorous quantitative disciplines with a substantial dose of informed judgement. Combining hard quantitative inputs with soft qualitative inputs satisfies the notion that successful investment operations incorporate both hard and soft factors”.

1.5 MANAGING WITH FUZZY FIGURES

In private equity the poor quality, limited availability and even the non-existence of data restrict the application of a quantitative tool set significantly. Some think that ever-increasing transparency and standardisation one day will have created a basis that makes a quantitatively driven management of these assets feasible. We do not believe that this is possible, as the industry is private and transparency therefore has its limits. Moreover, for venture capital, which is by definition mostly innovation, the environment is continuously evolving. Consequently, precise quantification is, in our eyes, out of reach in principle.

The focus on “risk” in venture capital may even be off the mark. In fact, because of the long time horizons and due to the nature of investing in innovative technologies, the traditional risk measures fail at capturing the “unknowns” of an uncertain environment that characterises this alternative asset class. Therefore, an investment process has to take this into account. In this context, Courtney, Kirkland & Viguerie (1997) remarked that danger lies “at the other extreme: if managers can’t find a strategy that works under traditional analysis, they may abandon the analytical rigour of their planning process altogether and base their decisions on gut instinct”. Unfortunately, this phenomenon appears to be all too common in venture capital investing.

1.6 MAKING THE GRADES

Building on the established credits rating principles, we developed a system for grading private equity funds. This so-called “grading” is a structured approach that takes quantitative and qualitative criteria into consideration.2 With this technique we have developed a new way of tackling the questions associated with valuations, portfolio and risk management of private equity funds investment programme. As Raschle & Jaeggi (2004) pointed out, “otherrating models, or models based on a systematic approach, have to date rarely been published in the literature or practised in the private equity industry ... only those fund-of-funds providers can be successful who have a clear basis for making their investment decisions and who are able to state the reasons for their decisions”.

Box 1.1: Private equity as winemaking

Private equity funds are blind pool investments, they are very long-term oriented and are exposed to economic cycles. As cycles are difficult to predict and as funds run over many years, most investors just try to identify the best funds available in the market, the so-called “first quartile fund managers”. To illustrate this approach, think about winemaking—it is not without reason that expressions like “vintage years” are used in the private equity industry. By convention, the vintage year typically is the calendar year in which a fund is established and the first drawdown of capital is made. The analogy to wine is not far-fetched and in fact is referred to occasionally.

It is easier to pick a good wine if one starts with a list of the vintage years. As in wine-making, venture capital has its good years and of course its bad years. Sometimes the quality of the year is not apparent until some maturation has taken place, but in many cases the indicators are apparent from the environment and maturation merely serves to confirm what everybody feared in the first place ... it will take a fair amount of tasting and time to see what the quality is and which hardy stocks modestly reward the palate. Quality brands will always stand out.

Smart (2002)

The difference between “traditional” asset classes and private equity funds can be compared to the difference between “ordinary” agriculture and wine-making. While it is quite common to grow at one time, say, wheat and at another time corn on the same piece of land—or even leave it idle from time to time—one cannot switch in and out from and to wine-making. A vineyard has to be cultivated consistently and over many years. For example, the average age of the vines at Smith Haut Lafitte is 30 years. Like a wine-grower, limited partners need to take a long-term perspective and need to be patient. Either this market attracts you and you decide to enter and stay in, or you forget about this market entirely. The entry barriers and switching costs are prohibitively high.

We know—or at least assume—that the market is profitable but we have to manage it in the best way. We need to build a portfolio of good fund managers and prune the bad ones. As in private equity, there are good vintage years for wine and bad ones. The wine-grower will not know in advance which ones will be spectacular and which ones will only be good for vinegar. Nevertheless, to make good use of his resources, he needs to participate in all vintage years regardless, because the good years will—according to historical observation—compensate for the bad years. Every wine-grower follows this basic approach to cultivate the vineyard. This approach leads to a certain average yield that can only be measured and improved over the long term, as the influence of weather etc. varies over time and as any improvement will only become visible after several years.

If the wine-grower aims for improvements and deviates from this approach, the yield may change; as the techniques in wine-making have been developed and tested over centuries, the assessment of the change’s impact is only possible through long-term observation.

1.7 OUTLINE

In this book we take the practitioner’s view and aim to give an integrated picture of a well-structured private equity investment programme. While we cannot present a magic formula that can give you immediately the sustainable high double-digit returns everybody is dreaming of, 3 we discuss the components of such a programme and how they are intertwined. In this discussion we focus on the principles rather than describing a specific environment. The set-up of a private equity investment programme is a complex task and is associated with a series of technical and organisational challenges. The process to starting a programme can take several years. To have any effect on the overall portfolio return, a significant percentage of the total assets under management has to be allocated to private equity. One could argue that this is best outsourced to a fund-of-funds, but for many medium-sized institutions there may be a case to set up their own in-house programme. Our book is organised in five parts as follows:

• We give a broad outline of the private equity environment with its structures and its dynamics.

• We define an investment process for a private equity fund investment programme.

• We describe the main tools for designing a portfolio of funds: portfolio construction, liquidity management and fund grading.

• To manage such a portfolio, a series of tools exist: we discuss monitoring, secondary transactions and restructuring in more detail.

• We demonstrate the application of our techniques in the context of managing in an uncertain environment.

The techniques we propose here for venture capital can also be used for private equity in general, although for later stage investments other tools could be more meaningful. For the purposes of this book we use the term “private equity” whenever data, observations or concepts are applicable in general, while we use the term “venture capital” when we discuss the specific challenges.

Many of the concepts presented here have been researched and developed in the course of our work with the European Investment Fund. However, for this book we have researched private equity market practices and discussed different approaches with industry practitioners. We target commercially-oriented institutions that are either already managing or considering setting up a private equity funds investment programme. Rather than proposing an “ideal” programme, we discuss various methods and trade-offs. Therefore, the statement made in this book represents the personal opinion of the authors and does not necessarily reflect the views of the European Investment Fund.

2

Private Equity Market

In the broad sense, “private equity” means a security that is not registered and not publicly traded on an exchange. In the USA, private equity securities are exempt from registration with the Securities and Exchange Commission because they are issued in transactions “not involved in any public offering”. Private equity investments are usually considered part of the family of alternative investments. Bance (2004) defines private equity as “investing in securities through a negotiated process” and emphasises the non-standardisation of the approaches followed. Private equity managers provide financing to private firms unable, or unwilling, to seek funding through public equity markets. Private equity is one of the most expensive forms of finance. Issuers are generally firms that cannot get financing from the debt or public equity markets.

Institutional investors typically focus on the “organised private equity market”, where professional management is provided by intermediaries.4 There is also the “angel capital” or the “informal private equity market” that, not without justification, is often called “family, friends and fools”. The number of investments made in the informal private equity market is probably several times larger than the organised private equity market, but it is difficult for institutional investors to gain the information necessary to invest in these markets efficiently.5 Institutions typically need to invest in larger chunks than is appropriate for angel investing and they have certain standards that need to be met if the opportunity is considered to be of institutional quality.

Box 2.1: Is private equity an asset class?

Modern portfolio theory suggests that asset allocation is generally more important than the selection of individual investments and requires estimations of correlations of returns among asset classes. A group of investments may be called “asset class”, when these investments are considered similar in potential risk and return but different from other existing asset classes. The three core asset classes are stocks, bonds and short-term securities or cash equivalents. It is most likely the scarcity and the low quality of the data available on the private equity market that explain the discussion about private equity being an asset class or not. While many large and well-established portfolio managers have for long operated under the working assumption that private equity is an asset class with its own right, quantitative analysis have failed so far to provide final evidence that these investments have a different risk-return profile.

In efficient markets the difference between top and median performance is relatively small, making the asset allocation decision very important. In private equity, the spread between top and bottom performance is in the double-digit percentage range. Therefore, for asset allocation decisions, the question of its characteristics as an asset class are of less relevance.

How significant is available statistical data? Private equity does not have reliable measures of return and correlation, while some degree of comparability exists for private equity funds. The mainstream limited partnerships are conceptually very similar and therefore allow some degree of modelling; on the other hand, the long investment horizons and the technical innovation cast questions on the relevance of historical figures. Available statistics may be representative for a specific environment but this environment is likely to change.

Can we base our projections on such data? At least they define the envelope of the possibilities and the “laws of gravity” of this asset class, as they also form the basis of the expectation for an investor about to enter the private equity fund market. While evolution is any process of growth, change or development, we cannot expect that this evolution will alter the overall characteristics of private equity as an “ecological niche” within the ecosystem of all asset classes. The metaphor “Red Queen” represents the situation in nature where creatures must adapt quickly to changing environmental threats just to survive from generation to generation.

In Through the Looking Glass, Alice complains to the Red Queen that she has to run just to stay in the same place. “Well, in our country,” said Alice, still panting a little, “you’d generally get to somewhere else—if you ran very fast for a long time, as we’ve been doing.” “A slow sort of country!” said the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

Lewis Carroll

According to this principle, evolutionary systems need “all the running they can do” because the landscape around them is constantly changing. We therefore believe that for private equity funds historical data can provide a yardstick, possibly with modifications to recognize structural changes and to compensate for anomalous periods, and assume that the available benchmark statistics for the entire private equity fund market—albeit stale—nevertheless can be seen as indicative.

2.1 FUNDS AS INTERMEDIARIES

The organized private equity market is dominated by funds—generally structured as limited partnership—as principal financial intermediary. Fund management companies—also referred to as “private equity firms”—set up these funds. Private equity funds are unregistered investment vehicles in which investors (the “limited partners”) pool money to invest in privately held companies. Investment professionals, such as venture capitalists or buyout investors (known as “general partners” or “fund managers”), manage these funds.

Figure 2.1 Private equity fund as pooled investment vehicle

Tax, legal and regulatory requirements drive the structuring of these investment vehicles with the objectives of transparency (i.e. investors are treated as investing directly in the underlying portfolio companies), low taxation and limited liability (i.e. investors liabilities are limited to the capital committed to the fund). While terms and conditions, and investor rights and obligations, were defined in specific non-standard partnership agreements, the limited partnership structure—or comparable structures used in the various jurisdictions—has evolved over the last decades into a “quasi-standard”:

• The fund usually has a contractually limited life of 7-10 years. The fund manager’s objective is to realise all investments before or at the liquidation of the partnership. Often there is a provision for an extension of 2-3 years.

• Investors—mainly institutions such as pension funds, endowments, funds-of-funds, banks or insurance companies, or high net worth individuals or family offices—are the limited partners and commit a certain amount to the fund. There is little, if any, opportunity to redeem the investment before the end of the fund’s lifetime.

• The main part of the capital is drawn down during the “investment period”, typically 4 or 5 years, where new opportunities are identified. After that, during the “divestment period”, only the existing and successful portfolio companies will be further supported, with some follow-on funding provided to extract the maximum value through exits. The manager’s efforts during this time are concentrated on realising or selling the investments.

• Commitments are drawn down as needed, i.e. “just-in-time” to make investments or to pay costs, expenses or management fees. Because private equity funds typically do not retain a pool of uninvested capital, their general partners make capital calls when they have identified a company to invest in. Therefore, the main part of the drawdowns is invested immediately.

• When realisations are made, or when interest payments or dividends are received, they are distributed to investors as soon as practical. Thus, the fund is “self-liquidating”, as the underlying investments are realised. However, these returns came mostly in the second half of the fund’s lifetime. Distributions can also be “in kind” as securities of a portfolio company, normally provided that these securities are publicly tradable.

• The management fees depend on the size of the fund. They generally range from 2.5% of committed capital for funds of less than €250 million to 1.5% for the larger buy-out funds. The fees are often scaled down once the investment period has been completed and adjusted according to the proportion of the portfolio that has been divested. There are, however, considerable differences from one fund to the next, particularly relating to what the managers do with income and expenses from their investment activity, such as directorship fees or transaction costs. These can have an impact on the returns and often account for material differences between gross and net returns.

• The main incentive for the general partners is supposed to be “carried interest” of, typically, 20% of the profits realised by the fund. Usually carried interest is subject to a “hurdle rate”, so that it only applies once investors have received their capital back and a minimum pre-agreed rate of return.

• Limited partners are simply investors with little or no influence on the day-to-day management of the fund. The interests of the limited partners are aligned with those of the general partners mostly by the managers’ own commitment into the fund and by the profit share or carried interest of the manager.

Box 2.2: The J curve

Between the inception and the termination of a fund, its interim returns, expressed as internal rate of return (IRR), follow the so-called “J-curve” pattern. Private equity funds tend to demonstrate a decline in value during the early years of existence—the so-called “valley of tears”—before beginning to show the positive returns in later years of the fund’s life (see Figure 2.2). The phenomenon is often more pronounced for venture capital, because it takes several years for value to be created.

This pattern—also referred to as the “hockey stick”—is explained by the funds’ structure with set-up costs and management fees, as well as by the valuation policies followed by the fund managers.

SET-UP COSTS AND MANAGEMENT FEES

As it is common practice to pay the management fees and start-up costs out of the first drawdowns, initially the value of the fund’s assets is less than the initial capital invested. Furthermore, during the early years, these fees and the set-up costs, compared to the capital actually invested, appear disproportionately high, as the basis for their calculation is normally the total fund size and not the capital invested.

Figure 2.2 Fund standard J-curve

VALUATION POLICY

When the fund is still in progress, the interim IRR computation takes the NAV as the last cash flow and assumes the liquidation of the portfolio at the current fund valuation. Therefore, the interim IRRs are subject to the valuation policy and its uncertainties inherent in private equity investments. In general, write-downs and write-offs are more likely to occur early on in the life of a fund than write-ups. This comes from the use of conservative valuation methods. They require recording of any impairment as soon as it is known, and preclude from revaluating upwards, promising investments before the occurrence of an event that would warrant an upward revision in value, such as a subsequent round of financing (or, under the new valuation guidelines, a change in fair value). Furthermore, realisations of successful investments require time and will only come in later years. For all of these reasons, even future top performers will normally show a negative return in their early years.

Lemons mature faster than pearlsProverb in Venture Capital

Meanwhile, the interim IRR becomes more meaningful as a fund matures and as the calculation relies less on subjective valuations and more on actual distributions of cash and stocks. The margin for error narrows significantly with growing age of the fund and reduced uncertainty. The first 4-6 years can give no real indication of final returns. After this period, the interim IRR will provide a reasonable indication of the final IRR. According to Burgel (2000), this period is shorter for buyout funds than for early stage and development funds. In any case, the true performance of the fund will only be known after the last distribution has been returned to the investors.

Figure 2.3 Portfolio standard J-curve

PORTFOLIO J CURVE

As portfolios are linear combinations of funds, they do have a similar J-curve pattern (see Figure 2.3), but more pronounced in the sense that the time to report a positive IRR and to get to the final IRR will be longer. However, the portfolio’s “valley of tears” should not be deeper than the average of those of the funds in its portfolio. This last statement only holds when the portfolio is managed in-house, as, when outsourced, the additional layer of fees will increase the “valley” but not significantly.

FAIR VALUE AND THE FUTURE OF THE J CURVE

Will the new fair valuation guidelines (see AFIC, BVCA & EVCA, 2004) drive the J-curve to extinction? Under the revised IAS 39, which triggered these new guidelines, there should be no conservative bias and the portfolio companies’ valuations should reflect their economic values, i.e. the net present value of their future cash flows. Therefore, that would only leave set-up costs and management fees. But if we want to determine the fair value of a fund we would need to take that into consideration too. And therefore this impact should also vanish. Later in this book, we develop a methodology to estimate the fair value of a fund.

From a strictly legal viewpoint, limited partnership shares are illiquid, while in practice secondary transactions occasionally take place.6 There is a private equity fund-raising cycle, and in regular intervals general partners need to return to the capital markets to fund-raise for another fund. As they rely on an exemption from the registration of the offer and sale of their securities, the general managers solicit qualified investors directly or through registered agents. One private equity management company can act as a “group”, managing several of such partnerships in parallel. Typically, limited partnership agreements do not allow follow-on funds by same manager before the end of the investment period or a larger part of the fund is invested. Private equity funds primarily have the following functions :7

• Pooling of investors’ capital for investing in private companies.

• Screening, evaluating and selecting potential companies with expected high growth opportunities.

• Financing companies to develop new product and technologies, to foster their growth and development, to make acquisition or to allow for a buyout or a buyin by experienced managers.

• Controlling, coaching and monitoring portfolio companies.

• Sourcing exit opportunities and realising capital gains on disposing portfolio companies.

If general partners understand that their current fund is underperforming, they will not be confident that another fund can be raised once their results become apparent to their investors. One way out for them may be to try raising a follow-on fund as quickly as possible. If raising a new fund is not possible any more, only r(s) in the context of the fund currently managed can be maximised. In this situation fund managers begin to resist the limited partners’ attempts to reduce fund size. Also, in cases where management fees depend on the valuation of portfolio companies, poor performers may try to maximise their income by avoiding writing down investments.

2.2 THE PROBLEM OF PREDICTING SUCCESS

While a wide divergence between top and bottom performers may provide an opportunity to do extremely well by selecting the top-performing managers, it also exposes the portfolio to a high degree of underperformance risk. If an institution is unlucky enough to pick a bottom-quartile manager, the returns will be likely to prove extremely disappointing.

The greatest “risk” of investing in private equity is not so much that the underlying investments are in small companies that will fail more readily than a quoted company (though some undoubtedly do, particularly in early stage/start up funds). It is the risk of investments being committed to the funds of managers who do not have the skills to build, develop and successfully realize a portfolio of companies

Aitchinson et al. (2001)

2.2.1 Can success be repeated?

Much of private equity’s appeal for investors has been a consequence of the strong returns achieved by “top-quartile teams”. There is a general belief that success in private equity is not luck, but based on skills. Various analyses undertaken suggest that past success is a good predictor for future performance.9 Certainly one would expect that professional fund managers who have worked together to build companies could apply their experience to new funds and stand a better chance for success.10 Their names are known in the industry; they have an established reputation of adding value to their portfolio companies and good opportunities will be referred to them. Therefore, there is a virtuous circle and “top teams” attract proposals of higher quality. As private equity investment is constrained by the volume and quality of proprietary deal flows, this gives top teams a higher probability of identifying opportunities and gives simply an informational advantage over other funds. Moreover, not only their reputation but also the increased sizes of their follow-on funds gives them stronger negotiation power vs. entrepreneurs and also vs. competing funds.

If your first fund was top quartile, there is a 45% chance your next fund will also be top 25% and a 73% chance it will be top half. A new fund management team has a 16% chance of being in the top quartile ... Success in private equity is persistent.

Conor Kehoe, Partner McKinsey & Co.

Others disagree. The research firm Asset Alternatives studied 182 venture capital firms that had raised at least two funds.11 The authors found that only 5% of the firms performed in the top quartile 50-75% of the time and only 3% of firms did more than 75% of the time. That means that only 8% of all firms12 performed in the top quartile more than half of the time. “If, in fact, there was a tendency for the same firms to perform in the top quartile, we would expect larger percentages at both the 50% and 75% levels”. They conclude that past performance has been a fairly bad indicator of a successor fund’s future performance.13

Even if previous top-quartile performance may indeed be predictive for future success, this criterion is usually unobservable pre-investment, as the interim performance does not allow knowledge of whether or not the fund is first quartile when the investment decision has to be made.

As one example to explain the point (see Figure 2.4): according to analysis conducted by von Braun (2000), investors could benefit by letting the first-time fund pass and by investing in the follow-on fund if this first-time fund has performed in the first quartile of its peer group. Based on von Braun’s research, the probability of the second fund performing in the top quartile of the peer group would be 41%, consistent with comparable studies undertaken by McKinsey.14

Figure 2.4 Superior returns through picking first time “winners”?

This observation is certainly plausible. Such teams have proved their skills but are still “hungry” enough to give their best in the second fund. However, there are two problems to turn this finding into an investment strategy

• The follow-on fund is normally raised when the first fund is yet in its second or third year. At this point in time, it simply cannot be known for sure whether the first fund will really give a top-quartile return, and the limited partner has still to make his investment decision based on a largely unrealised track record.

• Furthermore, even in cases where the track record is reasonably certain, such fund managers raising their second fund will give preference to their existing limited partners. As a result, they will in all likelihood not do a “road show” and actually few institutions will know about this opportunity at all.

2.2.2 What is success?

One problem is that it is difficult to substantiate “success” in private equity. As the approach to equity valuations is based on comparisons, the typical definition, as used above, is “first-quartile”15 performance. If we base our definition of success on the quartile position in the benchmark, comparison should be made against funds that are subject to same market conditions to assure that we are comparing apples with apples—that would be the vintage year cohort of the peer group. However, from vintage year to vintage year the composition of the peer group will be changing—rarely can two funds managed by the same management team be measured against the same peers. In other words, you may be comparing the first ten runners in the New York Marathon against the first ten of the “Volks” running event in the German Rhineland-Palatinate’s Trier - centainly in both cases a strong competition but definitely not the same league. Selecting the “best” funds with top-quartile performance is a challenging proposition and, in fact, is quite difficult to achieve on a consistent basis. Even “top funds” will not have achieved this at all times and, as such, “first quartile” relates to the majority of their funds at best.

Lots of money has been lost on the assumption that a model that correctly predicts the past can predict the future.

Dr Henry Kaufman

At the end of the day, the quartile position within the benchmark may not even be of relevance to investors who operate with absolute return target measure, such as “in excess of 15% per annum over the long-term”. If the overall return of the asset class is high, e.g. when only top quality funds comprise the peer group, this relative assessment is of less importance. Your limited partners will certainly “forgive” you being a “bottom-performing” fund manager if you have generated, for example, 10% return for them. Sometimes performance targets are defined as an out-performance against the respective quoted index (e.g. FTSE All Share in the UK), such as “between +3% and +5% per annum over the long-term”. So even if return figures are low and the fund performed at the lower end, investors may console themselves as long as the performance is in line with the target.

Probably the relevant measure for success, at least for the private equity firm, is whether it manages to raise a follow-on fund. It takes a while for a firm to “die out” because performance needs a long time to prove itself. According to normal terms and conditions, it is permitted to form a new fund after at least 70-80% of commitments have been drawn down and invested. Jesse Reyes of Thomson Venture Economics (see Meek, 2002) argues that, while it is relatively easy to raise first or second funds, it is “the third one that is hardest. If you raise a first fund, you can usually raise a second within a few years because it is still too early to tell exactly how the first one has done—there are few realisations. The third one is always much harder because by then, you’d better have some results to show investors”.

2.2.3 Tolerance for failure

There are circumstances where funds have a very loyal investor base and, even when under-performing in most conventional respects, will continue to get funding.16 Some investors, after all, are not driven solely by return objectives, but see “strategic” benefits. These might stem from the benefits of getting access to the knowledge of portfolio companies, e.g. in the case of corporate venturing.17 Or they might be the relational benefits for a lending bank of investing with a manager who will need access to debt to finance leveraged transactions. Equally, the costs of switching from one manager to another are often so significant that many investors appear to have an unlikely tolerance for underperformance. In other words, history suggests that many managers have been funded beyond a point at which it might have been obvious that they were unlikely to be consistent top-quartile performers.

To some degree, success can also be a self-fulfilling prophecy. Strong group cohesion is relevant not only for the fund management team but also for their relationship with the limited partners. If crises have been weathered together, there is simply more tolerance for the inevitable occasional hiccups during a 10 year investment period.

2.3 BROAD SEGMENTATION OF INVESTMENT UNIVERSE

2.3.1 Institutional quality funds

Continuity is an important factor, and investors want to see that the general partners have set up organisations and cultures that make the fund sustainable. Occasionally advisors, gatekeepers or consultants use the term “institutional quality” regarding the funds they refer to their clients. Typically they get a little bit vague when asked to elaborate on a more specific definition. Generally, it is just a grand way of referring to funds managed by established groups without having a specific meaning.

The term “institutional quality” is the recognition that a fund management company is financially strong and a good organisation to deal with, having an established “brand” name, often with “star” investment managers, and which accepts investments only from selected high-quality limited partners. Additionally, it typically has a clear strategy and competitive strengths, shared responsibilities in the team, and manages succession through attracting, mentoring, training and retaining talent. Its track record is clear, as it has managed multiple funds with consistent top-tier performance. Such well-known top-tier funds have established networks for high quality deals, personnel, information and funding and can build on intangibles like reputation and bargaining power in negotiations that give them an edge. For example, a brand that enjoys a nearly mythical reputation is Sequoia Capital in the USA. Sequoia was involved in the startup of companies like Apple, Yahoo!, Google, 3Com and Cisco Systems. Raschle & Jaeggi (2004) identified Sequoia’s key strengths as the choice of the right financing models, the fast recruitment of the best management staff for portfolio companies, thanks to its network, and its financial clout and staying power during market downturns.

As the industry is quite young and associated with certain personalities, it is difficult to build up a brand identity detached from certain individuals.18 A fund management company only becomes a brand if it outlives those people associated with it by setting up structures and processes. So far this has been rather a US phenomenon,19 but slowly fund brands are becoming established in Europe, too. Of course, “institutional quality” is an important decision criterion, particularly for investors with little familiarity in private equity. As in IT procurement, where “no manager got fired for buying IBM”, a well-known fund is more easy to defend as an investment decision. As investment managers usually put it, “I don’t have to justify an investment in a top-tier firm to my boss and our board”. A claim often heard is that institutional quality funds have a higher resiliency during market downturns, or, slightly cynically, that they are more likely to be backed by their investors, since it is more difficult to explain why to “pull the plug” if the fund enjoys such a strong reputation.

Moreover, consistently successful fund management companies have loyal investors who are likely to commit to future fund-raisings, and who to some degree also benefit from the firm’s reputation, as they are perceived as “quality investors”. Rather than going through the hustle of a full-blown fund-raising exercise, the general partners quickly tap into their established limited partner base. Consequently, brands are exclusive and difficult to access, which opens opportunities for advisors who claim to be able to get an entry into over-subscribed funds. Sometimes these funds fail to fulfil their promise and their limited partners turn away, opening an entry route for limited partners that are newcomers in private equity. The due diligence concerns related to institutional quality funds is a large existing portfolio, total funds under management and an increase in management fees, which can jeopardise the carry-based incentive structure. General partners can often “dictate” their terms. As a result, the fund’s structure—particularly high management fees or increased carried interest—can deviate from what limited partners would perceive as an “ideal” fund.

Box 2.3: Access to top funds

A historical review of private equity performance reveals two important trends: first, median private equity returns tend to under-perform public equity indexes, and second, there is a wider dispersion between top-quartile and bottom-quartile returns than for funds of quoted assets. It is generally believed that there is a higher degree of repeatability of top-quartile performance in private equity. Under the assumption that the past and future performance of a fund are correlated, funds that have performed well in the past tend to be oversubscribed. If returns have been high, limited partners from prior funds are highly interested to commit to follow-on funds. Even if follow-on funds are occasionally larger, the limited partners are then less shy to commit higher amounts.

Despite the growth of successful funds, there is a limit to what can effectively be deployed in the market. In venture capital the market can only absorb a limited amount of financing. To quote David Aronoff, general partner at Greylock Capital, the motto in venture capital is “undersupply of capital for oversupply of good ideas”. If too many institutions want to benefit from venture capital’s lucrative returns, there is a danger that this sector will become artificially inflated. In situations where the industry contracts, even better funds will need to downsize and force their limited partners to put their capital into either other funds or asset classes.

According to Flag Venture Management (2003b), access to the best funds is the number one entry barrier for newer funds-of-funds. Manager access is an issue for newcomers also because of the tacit convention within the private equity market that general partners will reward the loyalty of limited partners with virtual guaranteed access to future funds. The loyalty works both ways: if a limited partner stands with a general partner through a difficult investment cycle, that limited partner will almost invariably have access to the firm’s next fund. If a general partner has performed well with an initial fund, then that fund’s limited partners are very likely to sign on consistently as investors in future funds. It can take decades to build the reputation and relationships necessary to gain admittance to top-tier funds.