Allen Latta's Blog on Private Equity - Allen Latta's Thoughts on Private Equity, Etc.

LP Corner: Understanding the Capital Call Model and the Impact of Cash Drag

12/4/2018

Why is it that mutual funds take an investor’s capital on day 1, while PE funds take an investor’s capital over time? That’s the topic of this post.

When an investor makes an investment in a mutual fund, the investor invests the entire amount of the investment on day 1. The mutual fund manager will quickly use this money to increase existing positions in the fund or make new investments. It’s easy for the mutual fund manager to put the money to work by buying publicly-traded securities.

Investments in private equity funds are different. Private equity funds operate on a “called capital” model. By way of background, when an investor (known as a “limited partner” or “LP”) makes a legal commitment to a private equity fund, the LP commits to providing the fund with a certain maximum investment amount, which is known as the “LP commitment.” For example, if an LP agrees to invest a total of $10 million in a private equity fund, that $10 million is the LP commitment. For more background, please see the following posts:

To read more, please click “Read More” below.

LP Corner: Fund Terms - No Fault Divorce

8/4/2018

Divorce, Private Equity style...

Private equity funds have long lives. Private equity limited partnership agreements (LPAs) typically provide for an initial 10-year term, plus two one-year extensions at the discretion of the general partner of the fund (GP). However, fund terms often stretch out for much longer, sometimes 15 to 18 to 20 or more years. This is truly a long-term commitment, for both the limited partners (LPs) and for the GP. For an overview of LPs, GPs and limited partnerships, please see my prior post "LP Corner: US Private Equity Fund Structure - The Limited Partnership."

Because funds stay around for a long time, things will change. Partners may leave the fund’s management company; the investment strategy might drift away from the initial strategy; the investment performance may be terrible to the point that the LPs want to stop the GP from investing; the fund or management firm may be embroiled in a scandal; or in rare cases, the GP may behave badly (not illegally or in violation of the LPA, but in ways that may place their personal interests above the best interests of the LPs). There are many other changes that can occur during the life of a fund.

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

Compelling PE Roadshows: The Investor Perspective

8/1/2018

I am pleased that my article "Compelling PE Roadshows: The Investor Perspective" has been published today on PEHub. In this article, I offer suggestions to Private Equity managers on how to deliver a great roadshow presentation, with advice for before, during and after the meeting.

Here's the link: https://www.pehub.com/2018/08/compelling-pe-roadshows-the-investor-perspective/

Let me know what you think!

LP Corner: Fund Terms - Key Person Clause

7/28/2018

This is a continuation of a series of posts on fund terms. Prior posts include:

When an LP invests in a fund, it is because the LP believes that the investment team will successfully invest the fund. But what happens if members of that investment team leave the firm in the midst of investing? What happens if a key member of the team dies, or is convicted of securities fraud? A “key person” clause (historically known as a “key man” clause) provides LPs with protections in case these events, and others, occur.

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

LP Corner: Should Venture Capital Funds Have a Preferred Return Hurdle?

7/21/2018

Why is it that most buyout funds, many growth equity funds and few venture capital funds have an 8% preferred return hurdle? Why should there be a difference among the different strategies?

What is a preferred return hurdle?
A preferred return hurdle is a component of the fund manager’s carried interest.

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

LP Corner: Fund Terms - Management Fee

6/23/2018

This is one of a series of posts on fund terms. Other posts include:

In private equity, the term “2 and 20” refers to the traditional compensation structure for private equity funds: 2% management fee and 20% performance fee (also known as “carried interest” or “carry”).

In this post, we will explore management fee.

Historically, management fee was intended to provide fund managers with enough money to pay modest salaries, rent modest offices and incur modest expenses. It was said that management fee was intended to let the fund manager “keep the lights on” and that the performance fee (known as “carried interest” or “carry”) was where the fund manager made its money. While investors in private equity funds (known as “limited partners” or “LPs”) continue to take this view, terms in fund documents (known as the "limited partnership agreement" or "LPA") relating to management fee have become more complex.

Let’s dig in.

In previous posts, we have explored committed capital and the investment period:

We will look at management fee in three phases of a fund’s life: the investment period, the harvesting (or realization) period and during extensions.

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

LP Corner: What is Private Equity?

5/2/2018

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, buyouts, and distressed debt. 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, but 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.

LP Corner: Gross vs Net Returns

3/21/2018

,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.

LP Corner: Evaluating Private Equity Fund Performance

3/9/2018

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.
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.

LP Corner: Fund Performance Metrics – Public Market Equivalent (PME)

2/26/2018

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, 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:

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

LP Corner: Fund Performance Metrics - Internal Rate of Return (IRR) - Part Two

2/19/2018

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.

LP Corner: Fund Performance Metrics - Internal Rate of Return (IRR) - Part One

2/15/2018

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.

LP Corner: Fund Performance Metrics – Multiples TVPI, DPI and RVPI

2/3/2018

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:

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:

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

LP Corner: Private Equity Fund Performance - An Overview

1/20/2018

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:

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.

LP Corner: The J-Curve

7/8/2017

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.

LP Corner: Private Equity Fund Cash Flows from the LP Perspective

7/3/2017

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.

LP Corner: The Four Phases in the Life of a Private Equity Fund

6/24/2017

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:

Formation;
Investment;
Harvesting; and
Extension.

The four phases of a fund’s life can be viewed graphically:

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

LP Corner: On Committed Capital, Called Capital and Uncalled Capital

6/10/2017

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.

LP Corner: US Private Equity Fund Structure - The Limited Partnership

6/3/2017

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.

LP Corner: Thoughts on GP Commitment

5/13/2017

This is one of a series of posts on fund terms. Other posts include:

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.

LP Corner: Venture Capital vs Growth Equity - A Comparison

4/15/2017

Private Equity is a term that has two common meanings: (1) as an asset class, which covers strategies such as venture capital, growth equity, buyouts, mezzanine financings and distressed debt; and (2) as a transaction type, where it really means buyouts.

There is often some confusion between venture capital, growth equity and buyouts, and this post explores the similarities and differences between venture capital and emerging equity. More specifically, this post will explore the difference between early stage venture capital and growth equity. Venture capital itself has a number of stages, from seed, to early-stage, to late-stage financings. By comparing early-stage venture capital to growth equity, the differences are more clear and understandable.

An IPO Hotter than Snap?

3/30/2017

The Fortune article "Snapchat Actually Isn't the Hottest IPO This Year" argues that MuleSoft is actually a hotter initial public offering than Snap. This argument is based on post-IPO trading metrics, such as first day "pop" (first day closing trade price vs IPO price) and price-to sales metrics. It's an interesting article. Link: http://fortune.com/2017/03/30/snapchat-ipo-snap-stock-mulesoft/

A Response to Mike Moritz's Article on Stephen Scharzman

2/14/2017

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 on Private Equity (aka Leveraged Buyouts)

2/9/2017

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

Silicon Valley Needs Startup Drano - Article

1/19/2017

There's a recent Bloomberg Gadfly article by Shira Ovide called "Silicon Valley Needs Startup Drano" that explores the imbalance in venture capital between funds flowing into venture capital funds and companies and the money being returned from these companies and funds. I enjoyed this article, both for its Drano metaphor as well as for its content. I have been very concerned about this imbalance for some time now, and this article explains it well.

The bottom line is that too much money is going into venture funds and companies, and too little is being returned to investors. In my view, this will lead to overall lower returns for the venture capital industry and will highlight the need to be very selective when investing in venture capital funds in order to select only the best managers who can deliver exceptional returns.

Link:
https://www.bloomberg.com/gadfly/articles/2017-01-11/silicon-valley-startup-pipeline-needs-shot-of-drano