A simplified hypothetical representation is of the J-Curve is below:
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:
For investors that are new to investing in private equity funds (venture capital funds, growth equity funds and buyout funds), one area of confusion is often around how the fund cash flows work from the investor perspective. This blog post attempts to explain this.
As an initial matter, it is important to understand that private equity funds are very different from mutual funds. When an investor invests in a mutual fund, the investor will write a check on day 1 and at some point later in time will withdraw money from the fund. Private equity funds operate on a very different basis - known as a "called capital" basis. Let me explain.
Investing in private equity funds is a long-term process. Private equity funds have finite lives, unlike mutual funds. Most private equity funds come to market with a 10 year term with up to two one-year extensions at the discretion of the manager. This suggests a fund term of 10-12 years. However, most funds exist for much longer than 12 years from the initial call of capital to final liquidation.
I view the life of a private equity fund as having four phases:
The four phases of a fund’s life can be viewed graphically:
The private equity world has a lot of terminology. In a prior post, I discussed the structure of a private equity fund, and introduced the terms "limited partners" (or "LPs"), the "general partner" ( or "GP") and the "management company." In this post, we'll explore fund "sizes" and a little bit of how investments in private equity funds work.
The "size" of a private equity fund is based on the total amount of money all investors commit to invest in the fund - known as "committed capital." Because a private equity fund invests capital over time, the fund does not need all of the investors' money at the inception of the fund, and so the fund "calls" capital over time. Private equity funds typically have initial terms of 10 years, but most of the new investing occurs during the first several years (usually 3-5 years) of the fund, known as the "investment period." As a result, the fund calls the bulk of capital from the investors during this investment period.
Let's use an example.
For investors new to investing in private equity funds, the mechanics of how funds work can be a bit confusing. This post introduces the typical private equity fund structure that's used in the United States - the limited partnership.
Basic Limited Partnership Structure
In a basic limited partnership, there are several passive investors (known as "Limited Partners" or "LPs") and the manager of the fund, (known as the "General Partner" or "GP"). The diagram below illustrates this basic structure.
Private equity funds (buyout, venture capital and growth equity funds) are typically structured as limited partnerships, which have two types of partners: limited partners, or LPs, which are passive investors in the fund; and a general partner, or GP, which is the manager of the fund. As I evaluate funds, one of the fund terms that receives special attention is the amount of money the GP will commit to the fund - which is called "GP Commitment" or "GP Commit."
In a prior post "Mike Moritz on Private Equity (aka Leveraged Buyouts)" an opinion piece penned by the famed venture capital investor was discussed. Now there's a rebuttal to Mr. Moritz's article.
Mike Moritz, the famed venture capital investor at Sequoia Capital, has published an opinion piece on the New York Times called "Stephen Scharzman's Bad Business Advice." In this opinion piece, he takes a swipe at the leveraged buyout business, which is now known as private equity. He focuses on the amount of debt used in these transactions and the attendant cost-cutting that often includes layoffs. I have met Mike Moritz on a couple of occasions, and found him to be a very smart and opinionated person. His piece is worth a read, even if you don't agree with his positions.
Calpers, the largest US pension fund, is anticipating weaker returns from private equity, according to the Bloomberg article "Calpers Sees Next Headache in Slowing Private-Equity Cash Gusher." After several years of receiving strong distributions, Calpers believes that the outlook for returns may be diminishing, leading to an ever larger gap between beneficiary costs and revenue from contributions and investing, according to the article
The Harvard Crimson has an article "A Tale of Two Endowments" comparing the endowment performance between Harvard and Yale. David Swensen, Yale's Chief Investment Officer, has posted some impressive returns over the past decade.
The NY Times has an interesting article "Ruling on Pension Fund Debt Could Shake Up Private Equity Industry" that is worth a read. A federal District Court in Massachusetts has held that two separate private equity funds were jointly liable for the pension fund debt of one of their portfolio companies Scott Brass. The case revolves around some unique facts and some interpretations of ERISA, the law governing these retirement plans, but it could deter private equity firms from acquiring companies with unfunded pension liabilities. Time will tell.
NY TImes (general overview):
White & Case article (legal analysis):
There's a fascinating story from the NY Times DealBook that highlights some of the risks that private equity investors face when doing business in South America. Add jail to the list. In "An Airline Investment in Uruguay Becomes a Catch-22" the unhappy story of a Latin American private equity firm Leadgate and its founders is recounted. The firm acquired a majority interest in the troubled airline, Pluna, that was Uruguay's national airline. After restructuring the airline and making operational improvements, a perfect storm of politics, litigation, surging fuel prices and a volcanic eruption sent the airline into a downward spiral. After unsuccessfully trying to raise capital, the private equity firm transferred its ownership to the Uruguay government.
Unfortunately for the principals of the PE firm, they were all later detained and one of them has remained in prison for several years, without any charges filed.
It's a remarkable cautionary tale about private equity investing in South America.
The California Public Employees' Retirement System, known as CalPERS, is considering changing the benchmark it uses to measure its Private Equity performance, according to the Private Equity Annual Program Review dated December 15, 2004 and media reports. According to the report (page 10), the current benchmark for the private equity program is based on a combination of certain public stock indices plus 300 basis points, lagged by one quarter. The report recommends that the benchmark should be reviewed as the current benchmark "creates unintended active risk" for the private equity program as well as for the total pension fund. This report is really interesting, and I recommend that you download it and peruse it.
The report (on page 16) finds that their private equity performance has under-performed against the current PE policy benchmark over the 1, 3, 5 and 10 year periods. It also finds that their PE performance has under-performed CalPERS' global equity performance in the last 1 year by 4.8%, but out-performed the global equity performance over the last 3, 5, 10 and 20 year periods: 1.5% over 3 years, 3.0% over 5 years; 5.7% over 10 years and 3.0% over 20 years. The report also indicates that CalPERS has also an internal asset liability management assumption that the PE program will perform at 9% per year.
I'm always interested in the performance benchmarks used by private equity investors. As every program is unique, I have found that the benchmarks used are as varied as the programs themselves. If you're an LP investing in private equity, I'd be very interested to know what benchmark(s) you use to evaluate your private equity program's performance - please comment to this post or contact me through the About/Contact page.
Link to the CalPERS' Private Equity Annual Program Review:
Pantheon Ventures has released a study of nearly 700 private equity and venture capital funds to determine whether there is an inflection point in a fund's life where expected value creation and distributions become negligible relative to the fund's total value that it has already achieved. The study "Residual Value in Mature Private Equity Funds" is very thoughtful and has some interesting findings:
This is a very good research effort, and I recommend it.
Link to Pantheon's website: http://www.pantheon.com/
Link to the study page: http://www.pantheon.com/news-publications/534-replicating-investment-strategy
Link to the study .pdf: http://www.pantheon.com/images/stories/pdfs/residual_value_in_mature_private_equity_funds.pdf
There's an interesting, although a bit technical, article in the NY Times DealBook by Victor Fleischer that discusses how the Obama administration could, by executive action, change the tax treatment of carried interest from capital gains to ordinary income. This is a hot topic for any private equity or venture capital fund manager that has carried interest, as it could almost double the tax burden on carried interest, or carry as it is known in the industry. The article is "How Obama Can Increase Taxes on Carried Interest" and the link is here: http://dealbook.nytimes.com/2014/06/12/how-the-president-can-increase-taxes-on-carried-interest/
There's a recent post in India's The Economic Times titled "Private Equity Funds Face Tough Challenges Today" that I found very interesting. The post highlights a number of challenges facing private equity in India:
Here are links to my prior posts on difficulties investing in India:
Link to The Economic Times article:
There's an interesting post today on Seeking Alpha discussing listed private equity called "Listed Private Equity: From Skeptic To Believer" by Jessica Rabe and Robert J. Martorana, CFA. Note that the article is behind a firewall, so you may have to register to read the entire article. As an advisor to a listed private equity vehicle, I read this article with interest.
The authors describe listed private equity (LPE) as including "publicly traded companies that focus on private equity investments" and note that LPEs have many different strategies, and may be diversified by geography, styles and financing types. It's an interesting article and worth a read, but I have some differing views than the authors.
In my view, LPEs offer certain benefits to a typical retail investor:
Transparency. The authors of the article also list transparency as a benefit. In my experience, this is not always the case. An investment in a private equity fund or private company typically carries with it very strong confidentiality provisions. Some funds even prohibit the disclosure of the name of the fund or the fact that an investment has been made. LPEs that invest in these funds may in fact provide less information than if an investor were to invest directly in the fund or company.
Trading discounts. The authors note that LPEs trade at discounts (or sometimes premiums) to the NAV. This is something retail investors must consider carefully when evaluating an investment in LPEs. For LPEs that invest in private equity funds, the range of discount can be very wide. This discount could be due to the quality of the underlying investments, the leverage used by the LPE, over-commitment by the LPE, cash on hand, interest rates, and other market and macro-economic factors. Currently LPEs on the London Stock Exchange focusing on investing in private equity funds (these are known as funds-of-funds) are trading at discounts ranging from 10% to 36%, with an average discount of 21%.
Types of LPEs. There are many different types and styles of LPEs. The main structures are funds-of-funds, direct investment vehicles, and managers. Funds-of-funds typically invest in private limited partnerships of buyout and/or venture capital funds, and can focus on different geographies, etc. Direct investment vehicles typically invest in private companies via buyouts, growth equity investments or venture capital investments. There are also hybrids of funds-of-funds and direct investment vehicles. Manager LPEs are typically the management companies of large private equity firms such as Blackstone or KKR. Each of these different types of vehicles have differing characteristics that must be properly evaluated when making an investment.
LPE investing in LPEs? To me, one of the reasons to invest in an LPE is to obtain access to buyout funds and hard-to-access venture capital funds that a retail investor could not do on their own. But the LPE described by the authors appears to invest in other LPEs and has an expense ratio of 2.58%. Maybe I'm confused here, but in my view, why would one pay a 2.58% fee to a vehicle that invests in other listed vehicles? Based on the table provided in the article, one could easily replicate the holdings of the LPE at much lower cost.
In my view, LPEs can offer retail investors with access to a hard-to-access, hard-to-evaluate, illiquid asset class. However, any investor in these vehicles must do their due diligence on the LPE itself, and the strategy employed, and must be aware of the risks involved in these investments. Both JP Morgan Cazenove and Numis Securities in London have research groups that cover LPEs and I would recommend anyone interested in these vehicles to contact them for more information on the LPE universe.
Link to Seeking Alpha article:
In yesterday's article "The death of private equity's fee hogs," Dan Primack of Fortune explores the decline of monitoring fees charged by private equity funds to their portfolio companies. In the article, he discusses the recent sharp decline in these fees and the correlation with the recent increase in these fees being paid directly to the limited partners of the fund. As a limited partner, I welcome this trend. This is also in line with the ILPA's best practices guidelines, found in their Private Equity Principles publication. Note that the practice of charging portfolio companies monitoring fees applies in buyout funds, as venture funds have historically not charged monitoring fees to their portfolio companies.
Link to the Fortune article: http://finance.fortune.cnn.com/2013/09/05/the-death-of-private-equity-fee-hogs/
Link to the Institutional Limited Partners Association (ILPA): www.ilpa.org
Link to ILPA's Private Equity Best Practices publication:
Insight Venture Partners, the New York-based venture capital-private equity hybrid firm, has raised $2.57 billion for its eighth fund, according to reports. To date, the firm has raised $7.6 billion across eight funds, with 190 investments and 24 IPOs. The firm focuses on technology investments focusing on the software and Internet sectors. The firm has investments in Twitter, Tumblr and Flipboard to name a few.
To me, this demonstrates the success Insight has had with its model, and also shows the bifurcation of fundraising in the venture market: the haves and the have-nots. Those established firms that have consistently achieved superior returns for their funds are able to raise money quickly, while those firms that are new or don't have superior track records are left to fight with the sharks.
Here's a link to the Insight Venture Partners website:
Here are some links to articles discussing the Insight fundraising:
Business Insider: http://www.businessinsider.com/insight-venture-partners-has-closed-a-massive-new-257-billion-fund-2013-5
There's an interesting article posted today on Time.com titled "Why Pension Funds Are Hooked on Private Equity" which discusses the relationship between pension funds, as investors in the private equity asset class, and the funds themselves which can provide outsized returns to the pension funds. The article also touches on the carried interest tax issue as well as how pension funds are underfunded which is driving the search for returns. Here's the link: http://business.time.com/2013/04/15/why-pension-funds-are-hooked-on-private-equity/
Dell Inc. is going private in a $24.4 billion deal led by Michael Dell and private equity firm Silver Lake. This is the largest buyout since the financial crisis and the biggest since Hilton Hotels were acquired by Blackstone Group in the summer of 2007 for $26 billion. Michael Dell is rolling over his existing 14% equity stake in Dell and will contribute additional cash from his private investment vehicle, MSD Capital. Microsoft Corp. is loaning $2 billion to the deal. Additional debt financing will be provided by Bank of America Merrill Lynch, Barclays, Credit Suisse and RBC Capital Markets. The sponsors are offering $13.65 per share, which represents a 25% premium over the stock price when the news of the discussions leaked out, but a small premium over recent trades.
Dell is the third largest personal computer maker, behind Hewlitt Packard and Lenovo. By going private, Dell will have more flexibility to transform the business that he started while he was in college in 1984.
Links to articles:
NY Times DealBook: http://dealbook.nytimes.com/2013/02/05/dell-sets-23-8-billion-deal-to-go-private/
The Wall Street Journal's recent front page article "Pensions Bet Big With Private Equity" explores the approach used by Teacher Retirement System of Texas with respect to its allocation to private equity. According to the article, the $114 billion fund has committed about 30 billion to private equity, or roughly a 26% allocation to private equity, giving it the highest allocation among the ten largest pension funds in the United States, where the average allocation is 21%. The returns from private equity for the pension fund have been 7.4% , 4.8% and 15.6% over the past ten year, five year and three year periods, respectively. The pension fund is 82% funded, compared to the average funding level of 76% among large pension fund nationally.
It's an interesting article, but I feel it could have been more interesting if it had included specific comparisons to California's CalPERS and CalSTRS plans. Here's the link:
Dividend Recapitalizations (also known as leveraged dividends) by private equity firms rose in 2012, according to an article today by Pensions&Investments. In "Cheap Debt Means Private Equity Finally Pays Off" the use of dividend recaps in the US by private equity firms in 2012 rose to 77 in number and $33.4 billion in amount, up from 55 in number and $17.7 billion in amount in 2011. Reasons for the increase included the availability of cheap debt, higher valuations of portfolio companies, uncertainty regarding the fiscal cliff and tax rate increases, and lenders having cleaner balance sheets.
Here's the link to the article:
Leverage is increasing in buyout deals according to a recent WSJ.com article. In "Debt Loads Climb in Buyout Deals," the article explores how leverage is increasing in these deals. According to the article, since the beginning of 2008 buyout deals were funded with 42% of equity, but this has dropped to 33% in the past 6 months, getting closer to the levels seen in 2006 and 2007. In addition, the average debt in buyout deals in the second half of 2012 has been 5.5x EBITDA, which is also close to pre-crisis levels.
Here's a link to the WSJ.com article: http://online.wsj.com/article/SB10001424127887324296604578179343631127394.html
As an investor in private equity funds (primarily venture capital funds and mid-market buyout funds), I have been to many, many investor meetings. I've seen great meetings, good meetings and some meetings that could have been better. Over time, I've developed some thoughts on how private equity fund managers can improve GP-LP relations with their annual meetings. Here are my thoughts for GPs as they plan their investor meetings:
I hope these thoughts are useful for GPs. I welcome any additional thoughts from GPs or LPs on how investor meetings can be more productive.
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