Inside Private Equity: Erratum on Page 97

By James Bachman | Published: October 26, 2009

David Terris of Vincent Performance was kind enough to send me a note about an error he found in Inside Private Equity.

Table 7.2 (p. 97) should actually have an XIRR of -17.05%. This result should then be fed into the calculations that are beneath the table.

Thanks David.

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Limited Partners Deserve More Information

By James Bachman | Published: October 6, 2009

Many limited partners are demanding to be more informed about the underlying companies in their private equity portfolios. More specifically, LPs want to get a better handle on how earnings, debt levels, and valuations are changing over time. These types of details are critical for portfolio managers because it allows them to better monitor the underlying companies, make comparisons across sectors and deal types, and measure the effectiveness of the General Partner.

The most resourceful LPs cobble together these types of details from a variety of sources. The most common sources for collecting data are from quarterly reports, at annual meetings, and at advisory board meetings. This is a painstaking process that often leads to a less than ideal result. It is well known that quarterly reports vary dramatically in terms how much detail is disclosed. Many GPs provide no information about the balance sheets and income statements of the underlying companies. Some GPs provide brief synopses about the operational performance of the companies. Moreover, there are only a handful of GPs that are model citizens when it comes to providing comprehensive information about their companies to LPs.

Annual meetings and advisory boards serve as a good opportunity to learn more about the companies, but they are not the best medium for collecting these types of details on a regular basis for the entire portfolio. As a result, the LPs interested in these details are forced to either make request additional information from the GP or simply settle for the data they have collected thus far.

Historically, requests from LPs for additional information were often met with resistance. Even if the initial request was fulfilled by the GP, there was very little the LP could do to receive this data on a reoccurring basis (e.g. quarterly). As a result, the LP, again, is left with an incomplete picture of their portfolio.

The good news for LPs is that there have been some coordinated efforts to make these types of details available on a regular basis in the quarterly reports. Evidence of this coordination can be seen in the Institutional Limited Partners Association’s Private Equity Principles. In the section discussing transparency, the principles state that selected financial information needs to be made available to LPs as a part of the quarterly report. Selected financial information includes: valuation, revenue, debt, EBITDA, profit and loss, cash position, and burn rate.

The inclusion of these details as a part of the Private Equity Principles is a great first step to enforcing some level of consistency. It is important to keep in mind that both the GPs and LPs benefit from sharing this type of information because this asset class cannot continue to thrive in the dark. When a GP puts their LPs in the position to not even be able to answer the most basic of questions (e.g. how much leverage is there in the portfolio?), they not only make life difficult for the LP but they make it impossible for them to defend their allocation to this asset class.

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Obituaries are premature, a Deutsche Bank Research study

By James Bachman | Published: July 20, 2009

Thomas Meyer of Deutsche Bank Research just published a study titled Obituaries are premature. The study provides an overview of what has happened over the past few years and why the current environment is a good entry opportunity. The focus of the study is on buyouts with particular emphasis on activity in Europe.

Excerpt:

The financial crisis is not sparing the private equity industry. High uncertainty and a dearth of debt financing are making acquisitions difficult. The volume of new buyouts has slumped dramatically. The recession is hurting private equity (PE) funds’ highly leveraged portfolio companies particularly hard. Asset write-downs and lower returns are likely. Last year, European buyout funds lost over 25% in value on average.

But obituaries are premature. Two qualities help the private equity industry in the present crisis. Firstly, many (but not all) PE funds have considerable capital reserves. They can use these reserves to support portfolio companies or to seize new investment opportunities. Secondly, more and more companies are in need of restructuring. Here, private equity can leverage its traditional strengths.

Interesting tidbits:

  • The performance of top quartile funds has been higher when GDP growth rates are lower. More specifically, funds that started to invest when GDP growth rates were low had higher IRRs than funds that started to invest when GDP growth rates that were high.
  • In 2007, the market value of portfolio companies held by PE firms was equivalent to somewhere between 2 and 3 percent of the total market capitalization of public companies.
  • According to the World Economic Forum’s Global Economic Impact of Private Equity Report, portfolio companies held by PE firms have the best management practices.
  • In 2007, portfolio company sales from one PE firm to another PE firm accounted for over 30 percent of all exits in Europe.
  • The correlation coefficient between the spreads of U.S. LBO loans and high-yield spreads is 0.9.
  • In 2008, deals in China and India accounted for 8 percent of the total number of buyout targets.
  • The study estimates that capital reserves (aka overhang, unfunded commitments) of private equity firms is currently somewhere between $500 and $1,000 billion. This is larger than estimates I have seen elsewhere, but is probably more reflective of the amount of dry powder out there.

Missteps:

  • Some of the analyses focus exclusively on top quartile funds. I very much dislike any analysis that omits 75 percent of the data. There are times where it is useful to study top performers, but it happens all too frequently in PE research. Portfolio managers need to know about the good, the bad, and the ugly.

Bottom line:

This study is an interesting read. The tone is dispassionate which is appropriate for this type of content. I particularly liked that the commentary focuses on the long-term and that it highlights the importance of private equity’s role as a governance instrument.

Hat tip to James Burron for sending me the study.

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The Bachman Index (20090702)

By James Bachman | Published: July 2, 2009
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Private Equity Mathematics, a PEI Media Publication

By James Bachman | Published: June 29, 2009

In March, PEI Media published a book titled Private Equity Mathematics. Oliver Gottschalg, Assistant Professor of Strategy and Business at the HEC Paris, edited the book. At $665 (not a typo), Private Equity Mathematics is certainly the most expensive book I (read Burgiss) have ever purchased. PEI has a knack for putting out beautiful publications and at this price point I had hoped that the content would be phenomenal.

Note: I will probably summarize/review some of the chapters in later posts, but here are my thoughts on the book as a whole.

Bottom line

This book is nothing more than a loosely organized collection of articles. It lacks a consistent narrative and the nomenclature varies between chapters. Some of the chapters stand on their own, but many of them fall flat. This is definitely a case where the whole is worth less than the sum of its parts. Additionally, I was disappointed to see that some of the content was simply repurposed from prior articles (i.e. it is not original content).

Free content

I have discovered that the majority of the content in this book is available on the Internet (i.e. its free). So for those of you unwilling or unable to spend $665 on Private Equity Mathematics, enjoy:

  • Chapter 1: Measuring private equity performance: a closer look (Based on this article which we reviewed here)
  • Chapter 2: The private equity J-Curve: cash flow considerations from primary and secondary points of view  (Available here)
  • Chapter 3: Assessing the risk of private equity fund investments (Available here)
  • Chapter 4: Benchmarking leveraged buyout transactions (Based on this article)
  • Chapter 5: Private equity performance benchmarking (A significant portion of this chapter was based on this article)
  • Chapter 7: Performance drivers in private equity investments (Based on this article)
  • Chapter 10: Fund of funds portfolio perspective (Available here)
  • Chapter 11: Investment valuations in private equity buyouts (Available here)
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The hazards of using IRR to measure performance: The case of private equity

By James Bachman | Published: June 23, 2009

Ludovic Phalippou, Associate Professor of Finance at the University of Amsterdam, is well known for his work in private equity. In this post, I summarize and review his recent paper titled The hazards of using IRR to measure performance: The case of private equity.

Abstract:

Most of the investments in asset classes such as real estate and private equity (include buyout, mezzanine and venture capital) are made via private partnerships. Measuring performance in these partnerships is important for investment allocation decision as well as for compensation. The main performance measure that is used in practice is the Internal Rate of Return (IRR). However, it is known that the effective Rate of Return (RoR) experienced by investors differs from IRR. This difference means that the incentives of the asset managers partly differ from the objective of the investors.

This article makes two main contributions to the literature on performance evaluation. First, it shows the problems that arise when IRR is used as a performance measure in the context of private partnership investments. It shows that in addition to the well-known pitfalls, IRR leads to a number of issues. First, it provides severely distorted incentives for the timing of cash flows and grouping of funds. Second, it biases upward volatility estimates. Third, at least for venture capital and buyout investments, simple average performance measures are significantly upward biased. Fourth, in a situation where “kick-backs” can happen, the use of IRR provides incentives to alter significantly cash flow amounts. The second contribution is that it describes in details a solution. While it is known that using Modified IRR (labeled MIRR), or, equivalently, Net Present Value, (labeled NPV) largely tackles the well-known pitfalls of IRR, its practical implementation in a private partnership context is not obvious. I show how MIRR can be implemented at the investment level and at the fund level in order to not only tackle the well-known pitfalls of IRR but also provide the right incentives to the fund managers.

Interesting tidbits:

  • The effective rate of return experienced by investors can differ dramatically from the IRR. This fact, for whatever reason, seems to be ignored in the investment community.
  • The dispersion of performance is exaggerated because of the IRR’s reinvestment rate assumption. The range of outcomes is much more narrow when a measure like the Modified IRR (MIRR) is used because it better reflects the actual effective rate of return.
  • Practitioners and academics often reference the difference between the returns of top and bottom quartile funds in private equity as compared to other asset classes. This comparison is just silly. First, IRRs and TWRRs are not comparable. Second, the IRR exaggerates the (perceived) dispersion because of the reinvestment rate assumption.
  • Averaged IRRs (weighted or otherwise) are different than the IRR of the actual cash flows. Nuff said.
  • The IRR is heavily influenced by early winners. There is a huge incentive for fund managers to return money quickly. The paper discusses the recent behavior of buyout funds that returned money quickly by borrowing money using portfolio company assets as collateral and then using that money to to pay dividends to LPs.
  • Despite the advantages of using the MIRR, many practitioners resist using it because it requires that a cost of capital and reinvestment rate be identified. Phalippou proposes a simple solution. Cost of capital can be tied to a general hurdle rate (e.g. 8 percent) and the reinvestment rate can be determined by the returns of the S&P 500. This proposal makes a lot of sense and it can be easily implemented.

Missteps:

  • None.

Bottom line:

Read it, re-read it,  and then send it to your friends. Phalippou does a phenomenal job describing the hazards of using the IRR to measure performance. He also makes a solid argument for the use of the MIRR.

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The Bachman Index (20090622)

By James Bachman | Published: June 22, 2009
  • 70 to 80 percent of transactions completed in emerging markets are minority stakes (EMPEA)
  • Leveraged buyouts represent less than 5 percent of the transactions in emerging markets (Emerging Private Equity Magazine)
  • In 2008, capital raised by emerging markets focused funds was $66.5 billion (EMPEA)
  • Saudi Aramco has 300 billion barrels of oil reserves (as compared to Exxon Mobil’s 20 billion) (Emerging Private Equity Magazine)
  • Private equity investment as a percentage of GDP is 1.5 percent in Dubai and 0.1 percent in Saudi Arabia (Emerging Private Equity Magazine)
  • All of the U.S. auto companies combined account for only 3 percent of the total market capitalization of the global auto industry (Business Week)
  • There are six banks worldwide with a market capitalization greater than $100 billion. Three of those six are from China. They include ICBC, China Construction Bank, and the Bank of China (Bloomberg Markets)
  • Florida State Board of Administration is looking to invest $250 million in funds that are targeting high-technology businesses in Florida (Florida Growth Fund)
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Right-Sizing the U.S. Venture Capital Industry

By James Bachman | Published: June 15, 2009

Paul Kedrosky, Senior Fellow at the Ewing Marion Kauffman Foundation, published an eight page study last Wednesday that argues that venture capital must shrink considerably for it to be a competitive asset class.

Excerpt:

The U.S. venture capital industry is at an inflection point. It has had many successes over the last three decades, and is prominent worldwide for its role in financially catalyzing notable, high-growth companies. More recently, however, venture capital returns have stagnated and declined, with the industry having seen little recovery since its go-go days of the late 1990s.

There is a growing and important debate about where the venture industry goes from here. No one is seriously arguing that the venture capital industry will cease being crucial in driving the growth of important companies in information technology, clean technology, and biotech, all of which are risky and, to a greater or lesser degree, capital-intensive. But there is ample reason to believe that the venture industry, at least in the United States, will be differently sized and structured in the future.

Interesting tidbits:

  • It is unfair to give the venture industry full credit for the success of venture backed companies.
  • Approximately 0.2 percent of the new businesses created each year in the U.S. obtain venture capital financing. Source: Kauffman Index of Entrepreneurial Activity
  • Over the past decade, roughly 16 percent of the fastest-growing private companies in the U.S. (as determined by Inc. Magazine) were/are backed by venture capital.
    • On a related note, I am not sure if the Inc. 500 is the best proxy for the success of private companies.
  • The article blames the current state of (weak) venture capital returns on at least three possible causes:
  1. Too much capital chasing too few deals
  2. Shrinking exit markets
  3. Lack of new venture-ready markets
  • Some stats about venture capital investing as a percentage of GDP:
    • In the 1980s, it was under 0.1 percent
    • In 1991, it was 0.04 percent
    • In 1995, it was 0.1 percent (again)
    • In 2000, it was 1.1 percent
    • Post-boom, it was 0.16 percent
    • At present, it is 0.19 percent
  • Kedrosky estimates that pace of investing will shrink by half in the coming years.

Missteps:

  • On pages 3 and 4, the article incorrectly compares the returns of venture capital to the returns of the public market. This type of comparison is made all of the time and it is just plain wrong. IRRs for venture capital are not directly comparable to the TWRRs (time-weighted rates of return) of the public markets.
  • At some level, the article assumes that the information provided by Cambridge Associates and Thomson Reuters is at least representative of the industry. It is important to point out that both of these firms provide “benchmarks” for U.S. Venture Capital. Cambridge Associate’s 10-year number is 35.00 percent and Thomson Reuters’s number is 15.50 percent (as of 12/31/2008). The difference between these two “benchmarks” is 19.50 percent. Both providers certainly cannot be right. I would go as far as saying both are likely to be wrong.

Bottom line:

This study was certainly interesting and timely. I think the industry will love this content because it is plainspoken and accessible. Although I disagree with some of the conclusions (e.g. I think the industry can actually grow and be still be competitive), I would recommend that anyone interested in a high level summary of the recent developments in venture capital read this study.

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Real Estate and Private Equity: A Review of the Diversification Benefits and Some Recent Developments

By James Bachman | Published: June 11, 2009

Urbi Garay and Enrique ter Horst of IESA have published an article in the Journal of Alternative Investments (Spring 2009 issue) that summarizes recent research in the area of portfolio diversification.

Excerpt:

This article examines the literature on the benefits of adding real estate and private equity investments to an investor’s portfolio, and also examines some recent and important developments in these two sectors from the investor point of view. The first part of the article is dedicated to real estate investments and the second to private equity.

Interesting tidbits:

  • I always enjoy being reminded of the size of various markets:
    • U.S. Residential Real Estate Properties: $22.4 trillion (as of 12/31/2006)
    • U.S. Commercial Real Estate Properties: $5.3 trillion (as of 12/31/2005)
    • Worldwide Commercial Real Estate Properties: $15.0 trillion (as of 12/31/2005)
    • U.S. Equities: $19.3 trillion (12/31/2006)
    • U.S. Fixed Income: $25.9 trillion (12/31/2006)
  • I like that they omitted an estimate for the size of the private equity market. Why? Because little is known about its true size.
  • Fisher and Goertzmann [2005] find that the realized internal rate of return (IRR) for commercial property is less than the time-weighted rate of return (TWRR). It is always nice when researchers distinguish between the IRR and the TWRR.
  • Case and Shiller [2003] argue that real estate prices are “stick downward” because owners are unwilling to sell their property under a minimum reservation price. This idea is particular interesting as it relates to private equity transactions. For instance, one could argue that the downward stickiness of private equity valuations can be partially attributable to minimum reservation prices.

Missteps:

  • Towards the end of the article the authors discuss the use of top quartile, weighted-average, and average IRRs. I am not a big fan of any of these measures. On the averaging front (weighted or otherwise), the numbers do not reconcile with true IRRs. There are no shortcuts when it comes to computing IRRs.
  • On the quartile front, there is simply not enough information to decide whether or not the investment’s “returns” are good or bad. The IRR is, at best, a proxy for the performance of the investment. More specifically, the IRR should always be paired with additional measures like the investment multiple (TVPI) because they help to paint a more meaningful picture about how much wealth was gained (lost).

Bottom line:

The article does a great job summarizing recent studies on the benefits and characteristics of real estate and private equity returns. I look forward to digging into many of the articles that are referenced in the paper.

References:

Case, K., and R. Shiller. “Is there a Bubble in the Housing Market?” Brookings Panel on Economic Activity, September 4-5, 2003.

Fisher, J., and W. Goertzmann. “Performance of Real Estate Portfolios.” Journal of Portfolio Management, Special Issue: Real Estate, 2005.

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Cogent Research Bulletin No. 2: Good News for LPs on FAS 157

By James Bachman | Published: June 11, 2009

Katita Palamar and Brelen Jinkens of Cogent Partners recently published a corporate white paper describing how recent changes in FAS 157 requirements are going to affect LPs.

Excerpt:

Limited Partners have been struggling with how to apply FASB Standard 157 requirements for quite some time now. As a leading secondary market advisor to private equity LPs and a provider of private equity monitoring and diligence services, Cogent Partners has had numerous conversations on this subject with LPs and other market participants. It now seems that relief may be on the way, as the FASB acknowledges the difficulties in applying the complex FAS 157 requirements to private equity assets.

Interesting tidbits:

  • Fair value was a requirement before FAS 157. FAS 157 simply clarified that LPs could no longer just accept the NAVs provided by GPs.
  • The AICPA Practice Aid and Draft Issues Paper caused endless headaches for LPs. I would even go as far as saying that they made life impossible for LPs over the past couple years.  I wonder how many hours were consumed trying to figure out a way to comply with what was put fourth in those documents.
  • FASB recently met to discuss possible revisions to the requirements. From the article, the Board decided that “…an investor entity would estimate that fair value of its interests in alternative investments using the net asset value as of the investor entity’s financial statement date, as long as the net asset value has been calculated in accordance with the investment companies Guide.” In short, the NAV can be used as fair value in most circumstances. This is fabulous news for LPs who were being told by their auditors and valuation advisors that they needed to revalue everything from the bottom up.
  • For roll-forwards, LPs can use an adjusted valuation (link this to some sort of glossary). Basically you need to adjust the valuation for cash flow and re-price public companies, if there are any, in the fund.

    • Bottom line:

    This type of article is my favorite type of content: short and to the point with a meaningful (and practical) message. Plus it was good news for LPs, so it gets bonus points.

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