- Private equity investing can be compared to wine making. Ex-ante, the wine grower will not know which years will produce the best wines, but he will participate in each year as the good years will balance out the bad years.
- J Curve: the beginning years of a private equity partnership will have negative returns (“valley of tears” due to setup costs and fees) before investments mature and show positive returns in the latter years.
- Due to conservative valuation methods, write-downs and write-offs are more likely to occur in the early life of a PE fund, before write-ups can be ascertained by refinancings later on. Valuations are initially based on book value and thus will tend to understate PE volatility.
- McKinsey study: if the first fund is top quartile, the probability of the second fund being top quartile is 45%, and top half is 73%. A new team’s probability of being top quartile is only 16%. Experience matters! However, new teams are likely “hungrier”, more focused because their attention will not be diverted by existing funds, and they will be building their reputation.
- Median PE returns are under public equity returns. There is a wide dispersion between top and bottom quartile performers, and top performers tend to repeat. In recent decades, U.S. top quartile VC funds returned more than double the median fund. Therefore, manager selection and qualitative evaluation are key.
- “Hurt money”: the GP’s co-investment in the fund. Typically 1%, but the larger the co-investment in terms of the partners wealth, the greater the hurt, the more aligned the incentives with the LPs.
- LBO and VC funds are counter-cyclical, and LBO usually has higher beta to public markets. Other major differences:
- LBO is debt-financed, so tends to do well in bear markets when debt is cheap; VC is correlated to small cap, so tend to do well in bull markets where there are exit opportunities.
- LBO is in stable, mature industries with measurable risk; VC is in start-up emerging technology/markets with unmeasurable risk.
- LBO: high % of successes with limited write-offs; VC: many write-offs with a few huge winners.
- LBO success lies in backing experienced managers; VC success lies in backing successful entrepreneurs.
- LBO uses financial engineering, corporate restructuring approaches; VC uses product development, commercialization approaches.
- According to Venture Economics, the commitment ratio between LBO and VC is approximately 3:1. Therefore should consider a 75% LBO / 25% VC allocation.
- PE fund-of-funds double-layer fees costs an additional total 1%-3% of returns.
- Lack of data/ valuation, lack of comparables, long investment horizon, high uncertainty asset class, makes quantification of PE difficult, if not impossible. PE beta is not well-understood. A risk approach would be to compare the fund to peers, restrict investments to institutional quality, and be highly selective. Quality co-investor LPs can lend financial strength to the partnership, help address operational issues, and impose market discipline. Risk control is based on good judgment!
- Risk vs. uncertainty. Risk can be modeled probabilistically; uncertainty does not have probability measurements. Reducing risk in high uncertainty situations: experience, research and due diligence; use expertise to weed out inferior proposals; avoid areas where you do not possess expertise.
- ‘Naïve’ allocation of 5-10% and time diversification dollar cost averaging approach to PE may be a sound strategy. Because risk and return data for PE are imprecise (non-continuous) and unstable (non-normal), there should be no rigid PE allocation in an optimized portfolio context. Allocations should be based on opportunities and expertise. Vintage year timing is as difficult as public market timing.
- While studies show PE having low correlations to traditional stocks, bonds, and even small-cap stocks, some of that may be caused by artificial dampening of volatility from conservative valuations.
- PE should be viewed less as a diversifier (particularly for a portfolio including small-caps), but more as a return enhancer.
- PE is an “alpha-seeking” asset class. Under-diversification can be optimal by preserving large positive skewness. For FOF, studies show about 20-25 funds, spread over about 3 vintage years is sufficient diversification to participate in an investing cycle.
- Liquidity management, the managing of cash available for commitment calls while minimizing cash drag, is an important and unique aspect of the private equity asset class. Buyout and mezzanine funds typically draw down more quickly (established companies) and distribute more quickly (annual preferred dividends and interest payments) compared to venture funds. Typically, less than 90% of commitments are called—LP’s overcommit 110% or greater as a cash management strategy.
- Currency management in international PE investments matter. Since large cash inflows and outflows periods are distinct, currency views can play an impact.
- Zimmerman study identified 287 publicly traded private equity vehicles from 1986-2003; only 114 after adequate liquidity screen. They found that PTPE (publicly-traded PE) was not much different than public equities though it generally had higher beta and should not include a liquidity premium.
- A reasonable discount rate for PE is public equities plus 1% – 3% (return expectations can be higher, i.e. 5% – 8%). PE (not PTPE) should earn a liquidity and information premium compared to public markets.
- Secondary partnership interests are often traded at a discount: 15-20% for LBO funds, 30-35% for good venture funds, and sometimes 40-50% for others.
- In early years, NAV is not a fair representation of a fund’s value. It is too large as a portfolio break-up value, since the underlying investments are illiquid; it is too small as a terminal wealth economic value, since it does not account for undrawn commitments and the GP’s management skill. It does not distinguish fund structure and temporary impairments. In the late years, it is irrelevant, as majority of cash flows are realized.
- PE investing—need to be comfortable investing in a blind pool. This requires expertise and judgment (“a dependable gut”). Grading-based models (similar to credit risk models) are superior to strictly quantitative models as quantitative data is sparse and unreliable, and qualitative assessments are more tenable and comprehensive. Seeking precision is unwise for high uncertainty asset classes. “Better to be vaguely right than to be precisely wrong.”
- Benchmarks: to peer group cohort of funds of comparable vintage year, geography, and/ or investment stage; or by absolute return (3% – 5%) over public equities (i.e. opportunity cost).
- Early write-offs of failed portfolio companies is not necessarily a bad signal. Early exits can help preserve liquidity and management focus on the ‘stars’.
- Management team skill should account for the majority of fund selection. Key characteristics are: region/ industry expertise (in building companies or generating exits), access to deal flow, complementary and deep team, cohesion, and stability.
- Quartile rankings early in vintage years is meaningless. Less than half of VC funds with above median rankings prior to year 3, finish above median. Funds that write-down aggressively will suffer early but win at the end.
- As PE evolves, newly launched funds will overwhelmingly exhibit characteristics associated with past winners. Solely relying on historical top quartile records cannot guarantee success as the new peer group is more competitive. Need to qualitatively rank the new fund proposals.
- Benefits of secondary PE interests: discount, diversification, accelerated life and J curve, access to invitation-only funds, partial portfolio track record.
- “Although the excitement of transforming an entrepreneur’s vision into profitable reality encourages almost an air of philanthropy, and public and private sector alike will often champion the wider social benefits of venture-backed businesses, it should never be forgotten that venture capitalists invest to maximize returns. Venture capitalists are efficient killers.”
- Savvy investors avoid funds with policy-driven initiatives or backed by policy makers. Policy drivers impede the pure investment drivers.
- PE fund investors need to consider the imbedded real options: the implicit and valuable right to invest in follow-on funds and co-investments. The higher the uncertainty, the higher the value of the real options.
- Success is PE hinges on manager selection and a long time horizon, both of which may be due to the real options of reinvesting in top-tier funds. Endowments were first movers into PE, and “have a seat the table”, which may explain why they consistently choose superior funds. A fund with many endowment investors is a positive signal.
Finished: 30-Jul-2008