I have clients who are new to investing in private equity, and one of the first conversations we have is about "what is private equity"?

Private equity, generally speaking, is an equity (stock) investment in a privately-held company.  Private = privately held company.  Equity = stock.  It's a little more complicated than that, but that's a useful starting point.

The term "private equity" can be used in different contexts and can mean different things.  I group these in 4 categories:

Asset Class.  First, the term "private equity" can refer to the private equity asset class.  An asset class is basically a group of assets that have similar characteristics and behave similarly.  Common asset classes include: public stocks; public bonds (also called fixed income), cash, real estate and private equity.  There are also others, and different investors may define asset classes differently.  This usage of the term "private equity" typically occurs when investors are discussing allocations to asset classes - for example "we are allocated 40% to public equities, 40% to public fixed income; 18% to private equity and 2% to cash."  Within the private equity asset class, there are different strategies, including venture capital, growth equity and buyouts.  For more on venture capital, growth equity and buyouts, please see my posts "LP Corner: What is Venture Capital? Here's My Definition", "LP Corner: Venture Capital vs Growth Equity - A Comparison" and "LP Corner: What are Buyouts? Here's my Definition."
 
Transaction.  Second, the term "private equity" can refer to a type of transaction – which is primarily buyouts.  However, it can also describe a growth equity investment.  However, the term "private equity" isn't used to describe a venture capital investment.  Venture capital is a unique strategy within the private equity asset class, and the term "venture capital" is used very specifically.
 
Firm.  Third, the term “private equity” can be used to describe an investment firm.  A “private equity” firm is one that primarily invests in buyout transactions, but the term can also apply to firms that invest in growth equity.  One doesn’t use the term “Private Equity firm” to describe a venture capital firm - those are simply called "venture capital" firms.

Industry.  Finally, the term "private equity" may refer to the private equity industry.  The private equity industry starts with the private equity strategies of venture capital, growth equity and buyouts and also includes investors in the private equity asset class, such as public and private pensions, sovereign wealth funds, corporations, foundations, endowments, family offices and high net worth individuals.  Also included are firms and funds - venture capital firms, growth equity firms and buyout firms, as well as corporate venture capital efforts.  Add in service providers such as attorneys, accountants, valuation firms, database firms, back office support, etc. as well as industry groups (such as the NVCA and ILPA), conference providers and the press, and you end up with a very large industry.
 
So you need to understand the context in which the term is being used.

I hope this explanation is helpful.

© 2018 Allen J. Latta. All rights reserved. ​

​The denominator effect refers to an investor's private equity portfolio value exceeding its target allocation due to the decline in value of other elements in the investor's overall investment portfolio.  Conversely, the “reverse denominator effect” refers to private equity value falling below its target allocation due to the increase in value of other elements in the portfolio.

In order to understand Denominator Effect and the Reverse Denominator Effect, this post will first review basic portfolio allocation and rebalancing, and then will briefly review fractions.
 
Portfolio Allocations and Rebalancing
Most investors will develop a portfolio investment strategy by allocating a portion of the portfolio to different investment classes (called “asset classes”) such as public equities (stocks), fixed income securities (bonds), real estate, cash and private equity.  Investors may define asset classes differently and may allocate their portfolio across asset classes differently.
 
Let’s say an investor has $1 billion to invest.  After working with their investment advisor, they have decided to create target allocations for their portfolio as follows: 40% to public equities, 40% to fixed income and 20% to private equity. (We’re keeping it simple here; most investors will allocate to more than 3 asset classes).  These are target allocations – the actual values may vary from the target value.
 
The target allocation will look like this:

​To read more, please click on "Read More" link below.

I am pleased to be a speaker at the upcoming ACG Intergrowth conference being held on Wednesday, May 2 through Friday, May 4, 2018 at the Marriott Marquis San Diego Marina in beautiful San Diego.  I will be speaking on the panel "Roadshow Dos and Dont's" as part of the seminar "Inside the LP Mind: A Fundraising Seminar" being held on Wednesday May 2.  The panel will discuss best practices for buyout funds hitting the fundraising trail.  It should be an interesting panel!

Here's a link to the seminar: http://intergrowth.org/education/inside-the-lp-mind-a-fundraising-seminar-with-buyouts-insider/.
Here's a link to the conference: ​http://intergrowth.org/. 

If you're at the conference, please say hello.

,This one of a series of posts on fund performance metrics.  Other posts in this series include:

• LP Corner: Private Equity Fund Performance – An Overview
• LP Corner: Fund Performance Metrics – Multiples TVPI, DPI and RVPI
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part One
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part Two
• LP Corner: Fund Performance Metrics – Public Market Equivalent (PME)
• LP Corner: Fund Performance Metrics - Private Equity Fund Performance - this blog post
• LP Corner: Gross vs Net Returns

​We have discussed how to evaluate fund performance, but a common area of confusion is gross returns versus net returns.  I briefly introduced this topic in ​LP Corner: Private Equity Fund Performance - An Overview, and this post expands on that introduction.

When talking returns in private equity, it is very important to know what kind of returns you are discussing: gross or net returns.  The difference between these two metrics can be meaningful, and so it is important to know what is being discussed.  Gross returns, simply stated, are the returns a fund obtains from its investments, without deducting any management fees, fund expenses or carried interest.  Net returns are the returns a limited partner (LP) receives from the fund, after deduction of all management fees, fund expenses and carried interest.  LPs are about net returns, as net returns are the real returns an LP receives from its investment in a fund.
 
When we talk about gross vs net returns, it can apply to gross vs net IRRs or gross vs net TVPI multiple.

The graphic below shows the difference between gross and net returns for a fund.  LPs invest in a fund.  The fund invests in portfolio companies.  Gross Returns are the returns the fund obtains from its investments in portfolio companies.  Gross Returns are before deducting management fee, fund expenses and carried interest.  Once the fund does deduct the management fee, fund expenses and carried interest, the return the LPs obtain from the fund are the Net Returns. 

​To read more, please click on "Read More" link below.

This one of a series of posts on fund performance metrics.  Other posts in this series include:

• LP Corner: Private Equity Fund Performance – An Overview
• LP Corner: Fund Performance Metrics – Multiples TVPI, DPI and RVPI
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part One
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part Two
• LP Corner: Fund Performance Metrics – Public Market Equivalent (PME)
• LP Corner: Fund Performance Metrics - Private Equity Fund Performance - This blog post.
• LP Corner: Gross vs Net Returns
  

We have now discussed the three metrics that are primarily used to evaluate the performance of private equity funds: (1) the multiples TVPI, DPI and RVPI; (2) IRR; and (3) PME.  We will now discuss how to use these metrics to evaluate the performance of private equity funds.
 
Overview
There are several ways to evaluate the performance of a fund, or a portfolio of funds, with the main methods being:

• Absolute return.
• Comparative return to other similar funds (Quartile Analysis).
• Comparative return to the public markets (PME Analysis).

 
Absolute Return
Absolute return refers to a specific threshold requirement for a fund’s performance.  For example, some LPs may say that they expect a 3.0x TVPI and 30% IRR net return from early stage venture capital funds, or a 2.0x and 20% return for buyout funds.  If a fund’s return exceeds these metrics, then it “outperforms” the metrics.  If a fund’s returns are less than these metrics, then the fund “underperforms.” 
 
A note about absolute return.  Most funds experience a J-Curve, where performance declines in the first couple of years of a fund when fund expenses and investment losses exceed investment gains, but the fund’s performance improves over the next several years.  The J-Curve is more pronounced for early-stage venture capital funds.  The J-Curve looks something like this:

For more on the J-Curve, see my post: “LP Corner: The J-Curve.”
 
The point here is that using absolute returns are really only useful late in a fund’s life or after the fund is liquidated.  If one were to apply a 20% absolute return metric to the fund in the J-Curve example above, the fund would underperform all years until the last year in the graph.

To read more, please click "Read More" to the right below.

​This one of a series of posts on fund performance metrics.  Other posts in this series include:

• LP Corner: Private Equity Fund Performance – An Overview
• LP Corner: Fund Performance Metrics – Multiples TVPI, DPI and RVPI
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part One
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part Two
• LP Corner: Fund Performance Metrics – Public Market Equivalent (PME) - This blog post.
• LP Corner: Fund Performance Metrics - Private Equity Fund Performance
• LP Corner: Gross vs Net Returns
  

 
We have now discussed two of the three primary metrics uses to evaluate the performance of private equity funds: (1) the multiples TVPI, DPI and RVPI; and (2) IRR.  We will now explore the third primary metric: Public Market Equivalent, or PME.
 
Overview
Broadly speaking, PME is a return metric that compares the return of a private equity fund (or a portfolio of funds) to the hypothetical return of a chosen public stock market index, such as the S&P 500 or Nasdaq, using the cash flows as the fund as a basis for investment in the stock market index.  For example, a fund may have an IRR of 15%, while the PME obtained using the S&P 500 as the index is 10%, suggesting that the fund has outperformed the S&P 500 by 500 basis points (bps).
 
There are several variations of PME, but these are commonly used:

• LN PME, developed by Austin Long and Craig Nickels in 1996
• PME+, developed by Capital Dynamics in 2003
• KS PME, developed by Steve Kaplan and Antoinette Schoar in 2005
• mPME, developed by Cambridge Associates and introduced in 2013
• Direct Alpha, developed by Oleg Gredil, Barry Griffiths and Rüdiger Stucke in 2014

 
LN PME
The LN PME (also known as the Index Comparison Method or ICM) is widely considered the “first” PME approach (and it is often referred to simply as “PME”).  The LN PME matches each contribution and distribution of a fund with a hypothetical purchase and sale of a reference public market index, such as the S&P 500.  The residual value of the fund is not matched to the LN PME; rather, the LN PME residual value is based on the performance of the hypothetical invested capital in the index.  With these cash flows, an LN PME return for the public market index is compared directly against the IRR for the fund.  If the fund’s IRR exceeds the LN PME, then the fund has outperformed the public market index.  If the LN PME IRR exceeds the fund’s IRR, then the fund has underperformed the public market index.  Note that the IRR generated using LN PME isn’t a “real” IRR – it’s an estimation because of the manipulation of the residual value.
 
One nice thing about the LN PME is that it is conceptually straightforward.  However, the mechanics of LN PME have some issues.  One issue for the LN PME approach is that the residual value for the PME index can be negative.  This can occur if the fund has distributions early in the life of the fund, or has a series of large distributions late in the life of the fund.  The problem is that a fund can’t have a negative residual value (technically a fund could have a negative residual value, but it would be a very rare case).  As a result, LN PME isn’t used very often in private equity.  The other forms of PME attempt to address the drawbacks of the LN PME.
 
Let’s look at an example:
 
First consider the fund that we want to evaluate.  The fund is presented below:

This one of a series of posts on fund performance metrics.  Other posts in this series include:

• LP Corner: Private Equity Fund Performance – An Overview
• LP Corner: Fund Performance Metrics – Multiples TVPI, DPI and RVPI
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part One
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part Two - This blog post
• LP Corner: Fund Performance Metrics – Public Market Equivalent (PME)
• LP Corner: Fund Performance Metrics - Private Equity Fund Performance
• LP Corner: Gross vs Net Returns
  

In this post, we will explore internal rate of return (IRR) as a tool for evaluating fund performance metrics.
 
Recap
In my prior post, we discussed the basics of IRR in a fund context.  In this post, we build on that to explore what happens year by year for that fund.
 
In Example 1 in the last post, we introduced a fund, where the LP paid $30 million to the fund in a capital call at time = 0 and received $80 million back from the fund (as distributions) at the end of year 5.  These simple cash flows yielded an IRR of 22% and a TVPI of 2.67x.

​

This one of a series of posts on fund performance metrics.  Other posts in this series include:

• LP Corner: Private Equity Fund Performance – An Overview
• LP Corner: Fund Performance Metrics – Multiples TVPI, DPI and RVPI
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part One - This blog post.
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part Two
• LP Corner: Fund Performance Metrics – Public Market Equivalent (PME)
• LP Corner: Fund Performance Metrics - Private Equity Fund Performance
• LP Corner: Gross vs Net Returns

In this post and the next post, we will explore measuring fund performance using internal rate of return or IRR. This post will provide an overview of IRR.  If you already have a good grasp of IRR, you can move to part two of this series: LP Corner: Fund Performance Metrics - Internal Rate of Return (IRR) - Part Two.
 
IRR Overview
In a basic sense, IRR is the return from a series of cash flows over time.  In the Private Equity space, IRR is commonly used to evaluate the performance of private equity (including venture capital, growth equity and buyout) funds.  IRR is best calculated using Excel, Google Sheets or another financial spreadsheet program.
 
Simple IRR Examples
Let’s assume that an LP commits $30 million to a fund, and that the fund returns $80 million in distributions to the LP.  (For a discussion on committed capital, see "LP Corner: On Committed Capital, Called Capital and Uncalled Capital.") On a multiple basis, this equates to a Total Value to Paid-in-Capital (TVPI) of 2.67x ($80M / $30M) – which sounds pretty good.  But let’s explore a bit deeper.

Note that in these examples, we are looking at cash flows from the perspective of an LP - payments made by the LP and money received by the LP.  This is known as a "Net IRR" because it focuses on the cash flows to and from the LP.  For a discussion of gross vs net returns, see "LP corner: Private Equity Fund Performance - An Overview."

Example 1:  Assume that when the fund has its closing (which is time 0 for purposes of calculating the IRR in Excel), it calls all capital from the LP (in reality, this doesn’t happen, but humor me as this is an example).  In five years, the fund distributes $80 to the LP.  This looks like this:

This one of a series of posts on fund performance metrics.  Other posts in this series include:

• LP Corner: Private Equity Fund Performance – An Overview
• LP Corner: Fund Performance Metrics – Multiples TVPI, DPI and RVPI - this blog post.
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part One
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part Two
• LP Corner: Fund Performance Metrics – Public Market Equivalent (PME)
• LP Corner: Fund Performance Metrics - Private Equity Fund Performance
• LP Corner: Gross vs Net Returns
  

In this post, we will explore using multiples as a tool to evaluate fund performance.
 
The multiples are:

• Distributions to Paid-in-Capital, or DPI
• Residual Value to Paid-in-Capital, or RVPI
• Total Value to Paid-in-Capital, or TVPI

 
Here’s some important terminology that will help explain the multiples:

• Paid-in-Capital = the capital contributed by LPs to the fund.  Paid-in-capital is also known as “contributed capital” or “called capital” or sometimes “drawn capital.”  Note that Paid-in-Capital is different than Committed Capital.  Recall that an investment in a private equity fund occurs over time.  An investor in the fund, known as a limited partner or LP, agrees (commits) to invest a certain amount in a fund, say $10 million, as and when the manager of the fund, known as a general partner or GP, needs the capital.  In this case, the $10 million is the LP’s commitment.  As the GP asks for a portion of this commitment (known as a “call”), the amount paid by the LP to the fund is known as Paid-in-Capital, or PIC (this is also known as “called capital”).
• Distributions = the value of the cash and stock that the fund has given back (distributed) to the LPs.  Distributions are typically low early in a fund’s life, ramping up over time as investments are exited.
• Residual Value = the remaining value of the fund at a given point in time.  Residual value is the value of the fund’s investments plus other fund assets (cash, etc.) less fund liabilities.  So, for example, if the fund has 12 remaining investments with an aggregate estimated fair value of $100 million and another $3 million in cash, the Residual Value of the Fund is $103 million.  Early in a fund’s life when investments are being made residual value is typically high (reflecting the value of the investments) and declines over time as the fund exits its investments and makes distributions to the LPs.
• Total Value = the total value of the fund, which is the sum of the distributions and the residual (remaining) value of the fund at a given point in time.  The mathematical relationship among these metrics is:

​​​To better understand the above terminology, let’s look at the terms graphically:
​

I am pleased to have been invited to speak at the SuperReturn US West conference being held on February 12-14 at the Four Seasons Hotel in San Francisco.  Here's a link to the conference website: https://finance.knect365.com/superreturn-us-west/ 

I will be speaking on two panels.  The first is an Emerging Managers Workshop, where we will discuss best practices for raising a fund.  This workshop will be held on Monday, February 12 at 4:00 pm.  The second panel will be on Emerging LPs in Venture and Tech, where we will discuss the LP environment for venture capital, tech and crowdfunding. This panel will be held on Tuesday, February 13 at 4:45 pm.

I hope to see you there!

This one of a series of posts on fund performance metrics.  Other posts in this series include:

• LP Corner: Private Equity Fund Performance – An Overview - This blog post.
• LP Corner: Fund Performance Metrics – Multiples TVPI, DPI and RVPI
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part One
• LP Corner: Fund Performance Metrics – Internal Rate of Return (IRR) – Part Two
• LP Corner: Fund Performance Metrics – Public Market Equivalent (PME)
• LP Corner: Fund Performance Metrics - Private Equity Fund Performance
• LP Corner: Gross vs Net Returns
  

Introduction
How do LPs measure performance of a private equity fund?  It’s not a simple as one would think.  This post introduces a number of concepts, each of which will be discussed in more detail in future posts.
 
The following are the basic metrics used to evaluate fund performance:

• Rate of return.  This is also called internal rate of return, or IRR.
• Multiples.  These multiples include Total Value to Paid-in-Capital, Distributions to Paid-in-Capital, and Residual Value to Paid-in-Capital.
• Relative performance.  This is performance relative to comparable funds (also called quartile performance).
• Public market equivalent performance.  This is known as PME, and has a number of variants.

 
Each of the above performance metrics have positives and negatives.

To read more, please click on "Read More" to the right below.

I have been intrigued by Softbank's $97 billion Vision Fund, the largest corporate venture fund in history.  The Vision Fund is making waves across the venture capital spectrum, with investments made or planned in companies such as Uber, WeWork, Roivant, Fanatics, Slack and Plenty.  The article by Hazel Sheffiled for Institutional Investor titled "The $100 Billioon Venture Capital Bomb" is a very interesting exploration of the motivations for the fund by its founder, Softbank's Masayoshi Son.  It's an interesting article, and worth a read.

Link:​ https://www.institutionalinvestor.com/article/b15ywfxthq1f16/the-$100-billion-venture-capital-bomb 

Softbank has completed its purchase of Fortress Investment Group, it was announced yesterday.  The deal was originally announced in February 2017 at a price of $3.3 billion.  Fortress went public in 2007 at $18.50 per Class A Share, and its shares declined dramatically during the financial crisis and never really recovered, selling to Softbank at $8.08 per share.

I'm looking forward to seeing what Softbank has in store for Fortress, and how it fits into Softbank's overall strategy.

Link to Softbank press release:
https://www.softbank.jp/en/corp/news/press/sb/2017/20171228_01/ 

Consulting firm NEPC, LLC has announced the results of its Q3 2017 NEPC Endowment and Foundation Poll, and the results contain the following findings:

• Allocation to PE:
  • 31% have an allocation to private equity of over 10%.
  • 14% have no allocation to private equity.
  • 29% had an allocation of 1-5%
  • 27% had an allocation of 6-10%
• 51% plan to increase their allocation to private equity in the next 12 months.
  • 39% plan to maintain expoure
  • 10% plan to decrease exposure
• Outlook on PE returns
  • 44% anticipate lower returns for PE going forward
  • 39% anticipate returns in line with past returns
  • 17% anticipate higher returns
• Current valuations:
  • 34% believe PE is overvalued
  • 2% undervalued
  • 10% in line iwth historical valuations
  • 17% not sure
  • 37% indicated that it depends on the strategy.

My take-aways from this are that as overall portfolio returns fall, endowments and foundations are considering increasing their exposure to private equity, as this asset class has outperformed other traditional asset classes.  They are doing this even with the expectation that PE returns will fall over time.

Link to NEPC press release:
http://www.nepc.com/insights/nepc-survey-endowments-and-foundations-increase-private-equity-exposure-despite-expecting-lower-returns 

There's an interesting opinion piece on TechCrunch by Jon Evans called "After the end of the startup era."  In this piece, Mr. Evans argues that the golden age of the startup may be over, and in its place is a new world where big companies rule.  He asserts that many of the developing technologies (AI, hardware, self-driving cars, AR/VR and cryptocurrencies) favor large companies with talent, data and money available to develop these expensive and complex technologies.  It's an interesting piece.

Link:  https://techcrunch.com/2017/10/22/ask-not-for-whom-the-deadpool-tolls/ 

In the Reuters article "SoftBank's big checks are stalling tech IPOs," author Heather Somerville explores the impact of deep-pocketed investors on the IPO market.  As deep pools of capital are available to companies, it delays a traditional reason for companies to go public.  SoftBank, which closed a $93 billion investment fund in May, has made some significant investments in companies such as WeWork, which provide these companies with capital so they don't have to go public. In addition, along with the big checks comes big valuations, and there is some concern that these companies would not achieve the same valuation in the public markets.

Link:
http://www.reuters.com/article/us-wsjd-conference-softbank-group/softbanks-big-checks-are-stalling-tech-ipos-idUSKBN1CO3BXwww.reuters.com/article/us-wsjd-conference-softbank-group/softbanks-big-checks-are-stalling-tech-ipos-idUSKBN1CO3BX 

I'm pleased to be speaking on two panels at the upcoming PartnerConnect West 2017 conference in Half Moon Bay, CA on October 10 and 11, 2017.  The first panel is "The LP View On The VC Cycle -- Where Are We In It, And Should LPs Be Allocating More to VC Today?" and the second panel is "Growth Equity Shark Tank: LPs Review a Live Growth Equity Pitch."  The conference link is here: https://partnerconnectevents.com/pcwest2017/agenda

Bloomberg yesterday (8/2/2017) posted a fascinating piece on the Bell Canada Enterprises (BCE) leveraged buyout that fell apart during the financial crisis.  The article is "How the World's Biggest Buyout Deal Crashed and Burned" and it's worth a read.

Link:  
https://www.bloomberg.com/features/2017-bce-oral-history/

The Wall Street Journal reported today in the article "From $2 Billion to Zero: A Private-Equity Fund Goes Bust in the Oil Patch" that EnerVest Ltd.'s 2013 energy-focused private equity fund is "now worth essentially nothing."  According to the article, the $2 billion fund "borrowed heavily to buy oil and gas wells before energy prices plunged" and "is now worth essentially nothing."  Investors in the fund included leading pension plans, foundations and other institutional investors.

It's rare for a private equity fund to become almost worthless.  The article states that only seven private equity funds larger than $1 billion have ever lost money for investors, according to Cambridge Associates LLC, a leading investment adviser.  It's more common for early-stage venture capital funds to suffer losses, and I know of a few funds of the 1999 to 2000 vintage years that lost a significant portion of their value.

This is a good reminder that investing in private equity, growth equity and venture capital funds is risky, and includes the risk that the fund may become worthless and the investor may lose their entire investments.

Link to article:
https://www.wsj.com/articles/from-2-billion-to-zero-a-private-equity-fund-goes-bust-in-the-oil-patch-1500210002

​First time investors in private equity funds are sometimes alarmed / confused / surprised to learn that their fund investment has a negative return in the early years of the fund’s life.  Then, to their relief, as the fund ages, the fund’s return increases.  This is known as the ”J-Curve” and it is a common phenomenon in private equity, particularly early-stage venture capital.  

​A simplified hypothetical representation is of the J-Curve is below:

In a nutshell, Michigan has shifted public school teachers to a defined contribution plan, but allows teachers to opt for a more traditional defined benefit pension, but one that splits the costs 50/50 between workers and the state.  It's an interesting article and worth a read.

Link:
http://www.investors.com/politics/editorials/michigan-just-prevented-a-fiscal-crisis-are-other-states-paying-attention/