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I am pleased to be a speaker at the upcoming Emerging Manager Connect West conference being held on Tuesday, May 1, 2018 at the Marines Memorial Club in San Francisco . I will be speaking on the panel "Roadshow 101: Leading Emerging Manager Investors Discuss the Dos and Dont's for Successful LP Meetings." Here's a link to the conference website:
https://partnerconnectevents.com/emcwest2018/index.php
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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:
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:
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 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:
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 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:  To read more, please click on "Read More" to the right below.
This one of a series of posts on fund performance metrics. Other posts in this series include:
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.  To read more, please click on "Read More" to the right below.
This one of a series of posts on fund performance metrics. Other posts in this series include:
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:  To read more, please click on "Read More" to the right below. This one of a series of posts on fund performance metrics. Other posts in this series include:
In this post, we will explore using multiples as a tool to evaluate fund performance. The multiples are:
Here’s some important terminology that will help explain the multiples:
 To better understand the above terminology, let’s look at the terms graphically:  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:
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:
Each of the above performance metrics have positives and negatives. To read more, please click on "Read More" to the right below. Consulting firm NEPC, LLC has announced the results of its Q3 2017 NEPC Endowment and Foundation Poll, and the results contain the following findings:
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 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:  To read more, please click on "Read More" to the right 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. To read more, please click on "Read More" to the lower right. 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:  To read more, please click on "Read More" to the lower right.
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. To read more, please click "Read More" to the lower right. 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.  To read more, please click "Read More" to the right below.
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", "GP Capital Commitment" or "GP Commit."
To read more, please click "Read More" to the lower right. In a couple prior posts I've discussed my definition of venture capital and compared early-stage venture capital to growth equity. Those posts can be found here:
In this post, I'll describe buyouts. To read more, please click on "Read More" to the right below. 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. Stephen Davidoff Solomon's opinion piece "A Venture Capitalists's Misguided Critique of a Trump Adviser" rebuts Mr Moritz's article in a number of ways. Whether you agree or disagree with the opinions of Mr. Solomon and Mr. Moritz, this very public debate is pretty fascinating.
Link to prior post: http://www.allenlatta.com/allens-blog/mike-moritz-on-private-equity-aka-leveraged-buyouts Link to Mr. Solomon's article: https://www.nytimes.com/2017/02/14/business/dealbook/a-venture-capitalists-misguided-critique-of-a-trump-adviser.html Link to Mr. Moritz's article: https://www.nytimes.com/2017/02/07/opinion/stephen-schwarzmans-bad-business-advice.html 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.
Link: https://www.nytimes.com/2017/02/07/opinion/stephen-schwarzmans-bad-business-advice.html?_r=0 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 Reasons for the reduced outlook for private equity returns include an "unprecedented" $1.47 trillion in capital overhang in the private equity market - known as dry powder - which PE firms will use to invest in companies. As PE firms are expected to invest the capital they raise, this could present a problem as PE firms compete for deals, increasing entry prices.
Another interesting point in the article is that Calpers has had negative cash flow for the five of the past seven years, which is leading to a shortfall forecast at $9.2 billion by fiscal 2032. What's troubling is that this forecast is based on a 7.5% annualized return from Calpers' investments, when a prominent consultant has projected a more conservative 6.0% annual return rate. If the 6% annual return rate is accurate, the shortfall could be much higher. Link: http://www.bloomberg.com/news/articles/2016-10-07/calpers-sees-next-headache-in-slowing-private-equity-cash-gusher 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.
Link: http://www.thecrimson.com/article/2016/9/29/a-tale-of-two-endowments/ 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.
Links: NY TImes (general overview): http://www.nytimes.com/2016/04/22/business/dealbook/ruling-on-pension-fund-debt-could-shake-up-private-equity-industry.html White & Case article (legal analysis): http://www.whitecase.com/publications/alert/private-equity-funds-held-liable-pension-obligations-portfolio-company 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. Link: http://www.nytimes.com/2015/05/15/business/dealbook/risky-web-of-privatization-in-uruguay-where-charges-are-optional.html?ref=dealbook 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: http://www.calpers.ca.gov/eip-docs/about/committee-meetings/agendas/invest/201412/item09c-01.pdf |
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