Performance Measurement for Private Equity by Lauge Sletting. 23 May 2013 DDF Forum for Performance measurement

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1 Performance Measurement for Private Equity by Lauge Sletting 23 May 2013 DDF Forum for Performance measurement

2 Measuring performance in Private Equity Benchmarking Cases: Pension Fund and private equity Fund How we do it? 2

3 The fundamental dynamics of Private Equity investments The commitment is called just-in-time during the investment period Distributions occur throughout the life of the fund At any given time NAV provides an estimate of future distributions The cash flow characteristics of private equity funds The initial years are affected by calls and immature investments thus often yielding negative returns As the portfolio matures and the fund implements value creating initiatives performance will improve The return characteristics of private equity funds Management and harvesting period Investment period Fund return negative Portfolio matures and performance will continuously improve Year Year Calls Distributions IRR 3

4 Measuring performance in Private Equity IRR + Incorporates the cash flow dynamics and measures the time-efficiency of the invested capital - Neglects how much money the fund has generated - Not comparable to normal time-weighted returns - Other technical issues includes: multiple solutions, assumes a positive distribution exists, assumes reinvestment at the same rate, highly nonlinear and i.e. pooled <> average IRR. Multiples: Distributed-to-invested Residual value-to-invested Total value-to-invested + Takes the invested amount into account thus measuring the effectiveness of the investment - Neglects the time-value-of-money I.e. it ascribes the same performance for funds generating (2x) in four years, as funds generating 2x in 10 years Quarterly returns based on NAVs* + Easily comparable to other asset classes - Return based on interim NAVs and subject to various valuation methodologies etc. Calculated as the period s return over a the simple average of the capital account in the beginning and end of the period 4

5 Illustrating the issues with NAV as an approximation of future value However, all measurements in private equity is challenging No market prices are available Differences in valuation norms Different accounting principles Long term investment horizons the real value is not know until the fund closes Time lack in information and stale pricing Valuation progress early estimates of value is not a good indicator for final return! USDmn Cost Value 14.0x x 1.0x 1.5x 4.5x Entry Exit 5

6 LPs and GPs performance calculation can differ The capital account is reported directly from the GP to the LP -> no difference across the 2 different views The net profit for the GP comes from their P&L-accounts whereas the net profit for the LP is the sum of distributed gains and income plus the calculated revaluation Balance sheet GP-fund LP All information is available Limited information is available Investments Distributions FX Revaluation/ net profit Profit and loss Capital account Investments and distributions are the cash flow between the fund and the companies Net profit are based on a full P&Laccount within the GP-fund and includes administrative costs, etc. Investments (calls) and distributions are at investor level and not necessarily in the same period as the companies cash flow to/from the GP-fund Calls might include expenses No net profit is available Revaluation is calculated as the residual value of the cash flow and the capital account Profit for the period is based on cash flows and the calculated revaluations Distributed gain Distributed income Revaluations Profit for the period 6

7 Performance in private equity Benchmarking Case: Pension Fund and private equity Fund How we do it? 7

8 Benchmarking in Private Equity Benchmarking to other private equity funds Several data providers exists, including Private Equity Intelligence (Preqin), Cambridge Associates, ThomsonOne and Burgis Important to split across between vintage, stage and geography Methodology Preqin Cambridge ThomsonOne Burgis Data collected from public records typically reports from public pension funds and other institutions that must provide their financial performance reports as mandated by e.g. The U.S. Freedom of Information Act or similar legislation in other countries Consultancy firm that provides advisory services and in doing so has access to financial information for a large number of funds. May also obtain information directly from fund managers Uses surveys sent to private equity funds relying on selfreporting The firm provides monitoring and book-keeping systems for investors and in doing so has direct access to financial information from funds Disclosure Data is public Reporting is confidential Reporting is confidential Reporting is confidential Level of detail and flexibility Issues Some flexibility, able to build benchmark of closest peers as managers are known Should limit selection bias, however could exclude some top-performing funds due to the public disclosure Predetermined benchmarks only, not possible to adjust settings Selection bias Very flexible, possible to make detailed benchmarks across multiple categories Selection bias and survivorship bias Medium flexibility, able to generate the most commonly used statistics Selection bias 8

9 Benchmarking in Private Equity Benchmarking to other asset classes Quarterly fund return against public return + premium, e.g. MSCI World +300 or Russell bp etc. What time horizon? Which index? Which premium? Stale pricing and valuation methodologies? The Public Market Equivalent A hypothetical strategy of investing the private equity cash flows in a public equity index. If the value is above 1 private equity outperforms the public index, and vice versa 9

10 Performance in private equity Benchmarking Case: Washington State Investment Board How we do it? 10

11 The IRR is only an estimate and may differ from GP s IRR 11

12 No equivalent book value until realisations 12

13 IRR is pooled across vintage and type of fund (venture, buyout, etc.) Different vintages Pooled IRR 13

14 Private equity returns 2012, 5.3%; cost on private equity 1% 14

15 Benchmark is Russell 3000 plus 300 bp but how is performance vs Benchmark Private equity returns FY 2012, 5.3%; vs Benchmark 6.8 % or 10.2%? Russell 3000 Index Broad-Market Indexes 3Q Q Q Q Q Q Q % 2Q % 3Q Q Q % +3% 3.8% +3% 15

16 Quarterly return in ThomsonOne Benchmarking to public stocks - characteristic Quarterly returns to MSCI Unrealised returns are correlated to public markets due to mark-to-market Realised returns are nearly uncorrelated to public markets Typical estimates of correlations to public markets Unrealised returns 60-80% 0-20% Quarterly return ThomsonOne versus MSCI World 20% 15% 10% 5% 0% -5% -10% -15% Realised returns* -20% -30% -20% -10% 0% 10% 20% Quarterly return in MSCI * Analysis made by north Sea Capital on buyout, expansion/growth and special situation investments ThomsonOne estimation α= 8.2% p.a. β = 0.54 R 2 = 0.55 Correlation = 74.0% 16

17 Conclusion Measuring performance in private equity is a difficult task Needs to be quantitative AND qualitative Needs to take into account the different characteristics of the asset class and the different managers Many different parameters to evaluate and current performance does not necessarily indicate anything about final performance Requires an continues active dialogue with managers ensuring the managers focus on creating value. This also provide us with valuable information on the status of the underlying companies 17