​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:

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.

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.  

Link:  https://www.nytimes.com/2017/02/07/opinion/stephen-schwarzmans-bad-business-advice.html?_r=0

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

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:

• By year nine, the median fund had generated 96% of its total gain when measured by Total Value to Paid-in-Capital (TVPI) and had generated 80% of its distributions.
• There was no statistically significant evidence that venture funds behaved differently than buyout funds, although the degree of dispersion in the TVPI profiles was greater for venture funds.
• The results were generally not skewed by any specific vintage or associated market conditions.
• Lower-quartile funds funds in the study (compared to top and second quartile funds) were late bloomers, and more of the total value creation and distributions occurred later than the top and second quartile funds.

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:

• Poor returns
• Overpricing by GPs
• Businesses failing to meet growth forecasts
• Over-intermediation (a highly competitive investment banking environment where bankers over-promise)
• Poor performing IPOs
• Reluctance of Indian business owners to give up majority control, leading to fewer sale transactions
• Fall of the rupee negatively impacting US dollar denominated funds, as currency hedging is not a market practice.

Here are links to my prior posts on difficulties investing in India:
http://www.allenlatta.com/1/post/2012/08/sequoias-india-strategy.html
http://www.allenlatta.com/1/post/2012/07/global-investors-put-indian-private-equity-on-hold-the-times-of-india.html
http://www.allenlatta.com/1/post/2012/06/rupee-slump-deepens-india-private-equity-quagmire-reuters.html

Link to The Economic Times article:  
http://articles.economictimes.indiatimes.com/2013-11-29/news/44575456_1_gps-indian-private-equity-rupee-fall

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:

• Access to a "restricted" asset class.  Typically, investors in private equity limited partnerships or in private companies must meet certain eligibility requirements (income and net worth) that many retail investors may not meet.  In this sense LPE vehicles may provide retail investors access to this restricted asset class.  Also, in the case of venture capital, many of the funds are invitation-only, and so an LPE may provide access to these highly sought-after funds.
• Liquidity.  LPEs trade on public exchanges and so the shares are liquid, and retail investors can generally buy and sell shares with relative ease.  One big exception to this is that some LPEs have limited float and trading volumes, which may make trading more difficult and widen the bid-ask spreads.  
• Access to an illiquid asset class.  Investments in private equity limited partnerships or directly in private companies have many restrictions on transfer, which make selling the investment very difficult and when it does occur, it will typically occur at a discount to the net asset value (NAV) of the investment.  LPEs provide retail investors with indirect access to venture capital and buyout funds or direct investments in private companies.

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:  
http://seekingalpha.com/article/1867791-listed-private-equity-from-skeptic-to-believer

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:   
http://ilpa.org/wp-content/uploads/2011/01/ILPA-Private-Equity-Principles-version-2.pdf

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:  
http://www.insightpartners.com/

Here are some links to articles discussing the Insight fundraising:
TechCrunch:  http://techcrunch.com/2013/05/28/insight-venture-partners/

Business Insider:  http://www.businessinsider.com/insight-venture-partners-has-closed-a-massive-new-257-billion-fund-2013-5

ZDNet:  
http://www.zdnet.com/insight-venture-partners-new-fund-2-57-billion-7000016055/

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:

WSJ.com: http://online.wsj.com/article/SB10001424127887324900204578285582125381660.html

NY Times DealBook: http://dealbook.nytimes.com/2013/02/05/dell-sets-23-8-billion-deal-to-go-private/

Bloomberg: http://www.bloomberg.com/news/2013-02-05/dell-taken-private-as-pc-market-slump-hastens-24-billion-buyout.html

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:  
http://online.wsj.com/article/SB10001424127887323485704578258242293295894.html

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:  
http://www.pionline.com/article/20130107/PRINTSUB/301079975/cheap-debt-means-private-equity-finally-pays-off#

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:

1. Investor meetings are important for both GPs and LPs.  For LPs, this is our best time (and often only time during the year) to speak with several members of the investing team and to develop these important relationships.  For GPs, this is your best time to cement the relationships you have with your LPs in a very favorable environment.
2. Have an ANNUAL meeting.  There are some funds that have meetings on less than an annual schedule.  Many LPs conduct an annual review of funds and the underlying portfolio portfolio companies.  The best way to understand the firm, the funds and the underlying portfolio companies is by meeting with the GP on an annual basis.  
3. Have the meeting soon after the release of the audited financial statements.  As an LP, I want the best information I can get about the fund performance and the best information is soon after the release of the annual report.  April and early May are good months for investor meetings.
4. Invite ALL investors to the investor meeting.  As I mentioned, the investor meeting is the best opportunity an LP has to speak with several members of the investing team.  This is really critical for LPs to develop the relationships with the investing team and to understand the strategy better.  A GP that excludes an LP from an investor meeting because the LP is "too small" is sending a terrible message to the LP that they just aren't important.  That's bad for everyone.
5. The best days for annual meetings are Tuesday, Wednesday and Thursday.  Many LPs (especially foreign LPs) will travel long distances to attend the annual meeting.  Having to travel on weekends is painful for most people, and so scheduling investor meetings for Tuesday, Wednesday and Thursday helps with travel schedules.  Also, if you have foreign LPs, check the holidays for their countries before scheduling the annual meeting.  For example, if a US fund has several key LPs that are from France, these LPs may not be able to attend if the meeting is held on July 14, which is Bastille Day.  Once the meeting date is scheduled and invitations sent, don't change the date of the meeting unless it is an emergency.  Many LPs book non-refundable flights and hotels, and so will suffer economic losses if the date is changed.
6. Provide handouts and electronic copies of the meeting materials.  Provide LPs with printouts of the presentations for the investor meeting.  It is really helpful to have the presentations so notes can be written in the margins to add the color commentary to the slides.  It is this commentary that sometimes is really insightful.  Also, provide LPs with electronic copies of the slides, either on your website or on a USB key.  Some funds have in the past have not provided LPs with printouts or electronic copies of the presentations on the grounds of confidentiality.  However, LPs have signed confidentiality agreements either in the limited partnership agreement or separately, and GPs can have LPs sign a confidentiality statement at the investor meeting in order to receive the handouts.  Not providing handouts sends LPs a message that you don't trust us.  That's a bad message to send.
7. Provide substance over style.  I'm less concerned about activities and celebrity speakers than I am about learning about the firm's dynamics, industry developments, fund performance and portfolio company progress.  Dazzle me with substance and don't worry about activities and celebrity speakers.
8. Encourage questions.  Questions from the floor are often the best way to learn what is going on at the firm, fund(s) and portfolio companies.  Encourage questions during the presentations or open the floor to questions after each session.
9. Provide performance metrics.  What LPs want to know is how the fund is doing.  Providing net IRR information, multiple information and quartile performance helps LPs to understand how the fund is doing.  Also, have a discussion of the firm's valuation guidelines - when are discounts taken, use of comps v. DCF v. prior round valuation v. recent transactions.  All of these are helpful for LPs to understand how conservative the valuations are.
10. Give the bad news.  If the fund or portfolio company isn't doing well, address that in the meeting. Its better to address bad news head-on than hide it.
11. Firm overview.  It's really helpful for the GP to re-state the investment strategy and how the firm is situated in the industry.  It's also important to discuss changes at the firm.  Questions such as:  What are the firm's core strengths?  How does the investment strategy provide outsized returns?  How is the firm differentiated from its peers?  What has happened at the firm over the past year?  You'd be surprised that some firms neglect this important aspect of the meetings.
12. Industry overview.  I like to hear the partners' take on the industry - past, present and future.  It is very helpful to hear what has changed in the past year, how the environment is today and where the partners think the industry is heading in the future.
13. Fund review.  Provide a detailed analysis of the fund's performance and changes since the last year.  Fund performance metrics (see above) are key.  Also provide an assessment of the performance of the portfolio companies.  For private portfolio companies, metrics such as revenue and revenue growth, EBITDA and EBITDA growth, exit timing and type, comparable companies, etc. are all helpful for LPs to understand the performance and valuation of the portfolio companies.
14. Capital markets presentation.  It's also helpful to hear a capital markets expert (investment banker) discuss the M&A and IPO environment.
15. Portfolio company presentations.  I am a big fan of portfolio company presentations, especially when they are preceded by the responsible investing partner discussing the investment thesis and the deal.
    
16. Reception and dinner.  I'm also a fan of receptions after the meeting and sit-down dinners.  It's a great way for LPs to interact with the investment team in a more informal setting.
17. Ideal agenda.  Here's my ideal agenda:  

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.