Behind the Private Equity Wheel. How Investors Can Use Data to Improve Their PE Manager Selection Process

Transcription

1 Behind the Private Equity Wheel How Investors Can Use Data to Improve Their PE Manager Selection Process 1

2 Deciding which private equity managers to invest with is remarkably similar to the process of buying a new car. Before you make a commitment to buy a car, your first step will be to carry out research on cars in the market, what type of car you need and more. Once you ve selected a category of car you are potentially interested in, you will seek further information. There are various sources available to gather this data: magazines, online reviews of cars, manufacturer literature, to name a few. You can even book some test drives and speak to sales representatives to research. You take all this information and start to narrow down your options. In the automotive industry, easy-to-use websites exist that allow you to use some high-level criteria to filter out cars to find the best fit for you. These criteria might include price, speed, horsepower, fuel tank size and miles-per-gallon (MPG). But how do you determine what the best car is? 2

3 Define Best In the automotive industry, a car s top speed is often the headline number used to gauge performance. It is a nice easy way to compare two cars. If Car A s top speed is 196 MPH and Car B s is 113 MPH, Car A is the clear winner. But is this really a relevant measure of performance for your purposes? How often are you actually going to be driving at top speed? If you start to look at more details of a car s specifications, then what is the best becomes debatable. For example, you could be more concerned about how much you will be regularly spending on gas for this new car. In that circumstance, MPG is a much more appropriate measure of performance over top speed. Car A Car B Top Speed: 196 MPH MPG: 16/23 Top Speed: 113 MPH MPG: 35/57 3

4 Look Beyond Headline Numbers The consequences of making a bad investment decision in private equity are much greater than when buying a car, or even when investing in other asset classes. Whichever metric you think most accurately represents performance, you still shouldn t just take it at face value. It s not uncommon for manufacturers to try and present their performance in the best possible light. To get the best top speed and fuel efficiency, manufacturers may over-inflate their tires, tape up the doors or remove some seats. But after all your diligent research, what happens if you make a bad decision about the car you buy? The consequences could be that your car s performance is poor, it isn t as fast as you thought, it might not be as efficient and cost you more money, or maybe it isn t reliable and breaks down frequently. Luckily, you can sell your car relatively easily and reverse your decision. A lot of these processes are similar to the process of evaluating private equity managers before investing the high-level overview of the market, filtering down by certain criteria and even the opaqueness of performance metrics. One of the key differences however is that the consequences of making a bad investment decision in private equity are much greater than when buying a car, or even when investing in other asset classes. In this ebook, you will learn how to reduce the risks of making bad private equity fund investments by understanding how to interpret performance metrics and what areas of managers track records to investigate to improve due diligence and your manager selection process. 4

5 The Private Equity Investing Process What the car buying process shares specifically with private equity compared to other asset classes is that performance numbers are mostly opaque, with little insight on the investors side of how they were generated. It s also much easier to research other asset classes than it is to research private equity because: Private equity uses different terminology than other asset classes. Performance calculations are very different and not easily comparable to other asset classes. Analyzing managers past performance can be complex and time consuming without the right tools. Private equity is also an illiquid asset class you are making a long-term, binding commitment that will last around ten years. This means you can t just trade out of a bad decision. Secondary markets do exist, but it is difficult, time-consuming and costly to reverse your decision. There s also no instant feedback in private equity valuations are not constantly updated. This means there is a longer time-frame to understand how your investments are performing. Given the consequences of a bad decision, are you spending enough time researching private equity investment opportunities? If not, what can you do to enhance your private equity fund manager selection process? 5

6 The Importance of Understanding Private Equity Performance One of the first steps you can take is to better understand private equity performance measures. Like the automotive industry, private equity uses a headline number too Internal Rate of Return (IRR) is one of the most commonly used metrics in the industry to display performance. But even though IRR is a widely used measure, it can still be confusing and often misleading and it s imperative to understand how that number is derived. When evaluating private equity fund managers or specific deals, if we only measured performance by IRR, then it is very easy to pick a winner. But is this an accurate measure for private equity? 6

7 Define Best If we begin to factor in TVPI (the multiple), Profit, Holding (the holding period of the deal or portfolio) and Cost, then a winner is not so easy to identify. As with your car purchase, it all depends on your preferences and requirements. Are you concerned with the speed at which a manager can return capital? Or maybe you care more about the actual amount returned. Using these additional metrics will help you understand the true performance of a manager. In the example below, Deal A is the clear winner when looking only at IRR. Even when you factor in the multiple of the total investment made in the deal, again, Deal A looks like the winner. But now adding more parameters you can also see that it took Deal A five years to generate 50% IRR with a 1.5 multiple. Would you have been better off with Deal C, which only made 40% IRR with a 1.4 multiple, but did it in two years? Could you have used that extra three years to put your money elsewhere and make even more money overall? These are the types of questions you need to consider, and having all the information will help inform your decision-making process. 7

8 Look at Performance Numbers in Context IRR can be manipulated by the timing and weight of the cash flows going out and coming in. This means returning capital quickly can make a deal with a lower multiple produce the same IRR as a deal with a higher multiple. Without being able to gain insight into additional metrics such as TVPI, then it is very difficult to accurately compare the performance of different managers. In the table, you see Deal D and Deal E have both each produced an IRR of 26%. But, looking deeper, you see that Deal D has returned significantly more profit than Deal E. The reason is that Deal E returned three quarters of its cost in a very short time-frame. Getting an early win in private equity can really help to boost that headline performance number. IRR is a key metric within private equity, and it can tell you a lot about performance. But it has to be looked at in conjunction with: The timing of the cash flows has it been inflated by quick returns? The multiple generated how does it compare to actual cash returned? The amount of capital being put to work how much do you have to invest? Looking at IRR in context will help you get a truer representation of a manager s performance for better due diligence and investment decisions. 8

9 A Need For Deeper Due Diligence IRR and TVPI are useful numbers at the initial screening stage in the due diligence process but it s important to not just solely rely on them and instead to dig past them and understand how performance was generated. The probability of a manager repeating top quartile performance in their next fund has decreased dramatically since 2000* and so it s not enough to base decisions purely on headline numbers. Your due diligence process should include asking three key questions about performance: 1. How has a fund manager created value? 2. Who on the team was a value driver? 3. What was the manager s performance relative to public markets? You need to investigate and understand how repeatable performance is given current and potential market conditions. * Has Persistence Persisted in Private Equity? Evidence From Buyout and Venture Capital Funds, 2013, Robert S. Harris, Tim Jenkinson, Steven N. Kaplan and Ruediger Stucke 9

10 1. How has a manager created value? Valuation Bridges will give you clear insight and understanding into the real drivers of a manager s performance have they added value in the portfolio through operational expertise? Growing revenue? Improving profits? Or was it a case of taking advantage of a frothy market and selling at a much higher multiple? Understanding this will give you a better idea of how repeatable their strategy and performance is given current and forecast market conditions. 2. Who on the team was a value driver? You also have to remember that a fund manager is made up of individuals and is only as good as their deal team. This is why carrying out deal attribution analysis is so important for an effective due diligence process. If there is a star performer leading all the top deals, what risks do the fund and your capital incur if that person leaves? Getting to the bottom of these questions helps you better negotiate when drafting investment terms for the Limited Partnership Agreement. 3. What was the fund performance compared to a public market benchmark? Finally, it is important to benchmark the returns of a private equity fund manager against those of the public markets over the same time frame. This can be done by using Public Market Equivalent (PME) Analysis which invests a manager s cash flow transaction into a variety of listed stock market entities. By doing so, you can assess the opportunity cost of investing in private equity versus other asset classes and also find out the true alpha that was generated by a fund manager. 10

11 Getting Behind the Numbers Just as you do when buying a car and reviewing fuel economy and top speed, it s important to get behind the headline performance numbers provided by private equity fund managers. Doing so allows you to make more informed investment decisions on who to invest with, rather than trying to predict future performance based solely on high-level returns data. Key areas of a track record to investigate: 1. IRR Calculation Methodology 2. Unrealized Investments Valuations 3. Deal Omission 11

12 IRR Calculation Methodology Again, IRR is one of the most important performance metrics and you will want to understand exactly how it was calculated. Not just how it was derived by cash flow weights and times, but how a manager has aggregated the performance of funds to produce an IRR figure. IRRs can be calculated in two ways: 1. Horizon IRR 2. Zero-Based IRR Fund I 32% Horizon IRR Fund II 13% This method views performance for set time Fund III 21% horizons and means IRR can vary greatly depending Fund IV 26% Fund V 27% on the time period the manager uses. Below you can see performance would look very different if Total Track Record aggregated from 15 years ago, compared to 5 or even 10 years ago. Using shorter time horizons Current Track Record can be justified, but as an investor you need to understand exactly how and why an IRR has been calculated a certain way. Zero-based IRR This method assumes all investments or funds started on the same date. As the example below shows, this shortens the time frame of investing and so boosts the IRR. This approach can be appropriate for evergreen vehicles, but zero-based performance figures never reflect reality. 0 5 Fund I 32% Fund II 13% Fund III 21% Fund IV 26% Fund V 27% 13 years years

13 Unrealized Investments Valuations When an investor is reviewing a manager s track record as part of their new fund s due diligence, it s more than likely that the portfolio will contain unrealized investments. In private equity, valuations are calculated subjectively and one study showed a strange pattern. This graph shows that five months prior to reaching a first close, manager s Net Asset Values (NAVs) were peaking during fundraising and moderately increasing until after the final close when they normalized and came back down. These unrealized investments may play a large or small part in a portfolio and so good due diligence will involve understanding the impact of a change in the NAVs will have in overall, final performance of a fund. 13

14 Deal Omission Fund managers may remove past deals altogether from their track record. Reasons may include: That deal was led by ex-team members. That was a deal size we don t do anymore. That deal was in a region we no longer invest in. These can be perfectly valid reasons, but when investigating a manager s past performance always be sure to gain their full history of portfolio companies and dig into reasons for any exclusions. 14

15 Three Ways to Improve Your PE Fund Manager Selection 1. Understand how performance numbers were calculated to be able to compare managers on a like-for-like basis. 2. Don t rely on headline numbers alone to select managers - investigate how they generated performance. 3. Ask questions - track record analysis won t give you all the answers, but it will give you the questions you need to ask managers. 15

16 Ready to Get Started? Find out how evestment s private equity analytics solutions can help you gain deeper insight into managers performance and obtain the data you need for better and more informed due diligence and selection. Learn More Request a Demo About evestment evestment provides a flexible suite of easy-to-use, cloud-based solutions to help the institutional investing community identify and capitalize on global investment trends, better select and monitor investment managers and more successfully enable asset managers to market their funds worldwide. evestment s mission is to help make smart money smarter. 16