Buyout Returns Soar While Hedge Funds Underperform

by Michael Roth

Private equity is an alternative asset class but we view it as a subset of the broader equity asset class. It shares this commonality with hedge funds which have been in the news a lot over the last few years because of their dismal returns. No story was bigger than CalPERS’ decision to exit hedge funds 18 months ago. However, the decision was not too surprising when you take a step back and look at hedge fund returns in relation to other asset classes.

The chart below uses quarterly time-weighted returns to plot the growth of one dollar invested in three different buckets of the equity asset class since 2006.

From 2006 through Q3 2015, hedge funds have dramatically underperformed the North American buyout industry as well as the public markets. The chart above shows that $1 invested in the HFRI Fund Composite Index would have resulted in just $1.40 as of Q3 2015. That’s 49% lower than what $1 invested in the buyout industry would have generated as of Q3 2015.

Lower Risk Has Not Compensated for Lower Returns

The hedge fund industry could try to make an argument that lower returns have been in exchange for lower volatility and risk. However, the difference between the standard deviation of the HFRI’s returns and North American buyouts’ returns is less than 100 basis points. This reduction in risk is not nearly enough to compensate for a 49% lower return over the last 9.5 years.

Wrapping Up

Buyout returns have dramatically outperformed their hedge fund brethren.  It’s a more complicated calculation that simply taking from one allocation and putting it into another but, given how stark the difference in returns has been, it’s surprising that we have not heard about a larger move out of hedge funds and into buyouts.

Venture Capital Continues its Hot Streak

by Michael Roth

Bison’s June 30, 2015 final benchmarks were published last week. Using our cash flow dataset (“Bison funds”), we are able to analyze close to 1,300 North American private equity funds and identify industry trends.

Horizon IRR

The chart below illustrates the 1, 3, 5, and 10-year horizon IRRs for North American All PE, Buyouts, and Venture Capital / Growth Equity.

For the second consecutive quarter, the venture capital industry has a higher IRR over the 1, 3, and 5-year periods than the buyout industry. VC is still lagging buyouts on the 10-year horizon but it has narrowed the gap by 100 basis points over the last two quarters.

Time-Weighted Returns

The chart below looks at the returns for private equity and the public markets using an apples-to-apples time-weighted methodology.

Over the short-term and long-term, private equity is outperforming the public markets, represented here by the Russell 2000 and Russell 3000 total return indices. Similar to the horizon IRRs, venture capital is outperforming buyouts over the 1, 3, and 5-year periods. Over the 10-year period, buyouts are still outperforming venture capital by more than 200 basis points. Looking at the medium-term (3 and 5-year horizons), the public markets are outperforming through June 30, 2015. It will be interesting to see how these numbers hold up as of Q3 and Q4 2015.

Investment Activity

Investors are surely happy with the strong returns but they must also be pleased that GPs were busy selling assets and locking in gains. The chart below illustrates the ratio of distributions to contributions during each of the last four quarters. A ratio greater than 1.0 means there were more distributions than contributions in the quarter.

Both the venture capital and buyout industries saw their Distributions/ Contributions ratios jump in Q2 2015. Given how tumultuous the public markets were during the second half of 2015, it will be interesting to see how this ratio changes in Q3 and Q4. The surge in distributions is also notable for the VC industry because the inability to return money to investors has been an issue that I have highlighted before.

 

How Do GPs Calculate Net Asset Value?

by Michael Roth

For funds that are not fully exited, the net asset value (“NAV “) is the primary component of its total value. This means the NAV plays a critical role in determining a fund’s performance metrics (TVPI multiple and IRR). It is the sum of each portfolio company’s NAV and these values are determined by the GP. As a result, it is important to understand how a GP values their portfolio companies and the accounting standards that guide this process.

At the gross cash flow level, this includes the value of the GP’s equity ownership stake in each portfolio company that has not been sold. At the net cash flow level, this includes: (1) the value of the GP’s equity ownership stake in each portfolio company that has not been sold and (2) the amount of carried interest that has been accrued by the manager given the fund’s current value.

Technically speaking there is a hierarchy, broken up into three levels, that GPs must follow when they value companies. The hierarchy below has been paraphrased from the FASB’s “Fair Value Measurements and Disclosures (Topic 820)”:

Level 1 –  Investments must be valued using objective, observable, unadjusted quoted market prices for identical investments in active markets on the measurement date, if available.

Level 2 –

1. Objective, observable quoted market prices for similar investments in active markets.
2. Quoted prices for identical or similar investments in markets that are not active.
3. Inputs other than quoted prices that are observable for the asset.
4. Inputs that are derived principally from or corroborated by observable market data by correlation or other means.

Level 3 – Subjective unobservable inputs for the investment where markets are not active at the measurement date. Unobservable inputs reflect the firm’s own assumptions about the assumptions that market participants would use in pricing the investment and should be developed based on best information available under the circumstances. The entity’s own data shall be adjusted if information is reasonably available without undue cost and effort that indicates that market participants would use different assumptions.

In short, the majority of private equity portfolio companies are considered “Level 3” assets because they are illiquid assets that are only valued on a quarterly basis. As a result, companies can be valued by using a combination of factors that are ultimately subject to the GP’s discretion. The exception to this “rule” is when a GP exits a company via the public markets and holds publicly listed stock. Those assets will be “Level 1” assets.

A Deeper Dive into Level 3 Assets

Since there is considerable leeway with valuing Level 3 assets, I will discuss the most common methodologies used by GPs: industry comparables, precedent transactions, and the discounted cash flow (“DCF”) method.

Industry Comparables Method

The industry comparables method seeks to find publicly listed companies whose business operations either fully or partially match the business operations of the company being evaluated. Comparable companies are initially filtered by geography and sector. From there, GPs will look to narrow down the peer set further using either revenue, EBITDA or enterprise value (“EV”) metrics. For example, if I am valuing a company with an EV of $300 million, it is more appropriate to compare it to companies of a similar size rather than a company that has an EV of $4 billion.

Once GPs have a comp set, they will find the average EV/EBITDA multiple and use that multiple as the basis for valuing their company. Depending on company metrics, GPs may make adjustments to the multiple higher or lower. Factors that could impact this include higher (or lower) historical revenue or EBITDA growth, higher (or lower) forecasted revenue or EBITDA growth,  higher (or lower) EBITDA margins, higher (or lower) debt levels, and company size relative to the comps. These are the most common factors and offer a sense of possible areas where subjectivity could come into play.

Precedent Transactions Method

Precedent transactions are recent acquisitions that have occurred of similar companies. GPs will use the valuation metrics (EV/EBITDA or EV/revenue) to value their companies. This data can be difficult to find and is often limited to transactions of public companies. The other common issue with this method is that valuation information is often stale because precedent transactions occurred several years earlier when market conditions were different. Generally speaking, precedent transactions that have occurred within in the last year are considered to be valid data points.

DCF Method

The discounted cash flow methodology uses a GP’s cash flow model to estimate the company’s value. This is the most subjective method and has a tendency to be viewed with skepticism whenever it is used. That is because you are relying on the GP’s estimates for a large number of inputs, including revenue growth, EBITDA growth, and EV/EBITDA multiples and the discount rate. A slight adjustment to any one of these factors could have a meaningful impact on a company’s valuation.

When a GP uses a DCF model to value a company, it is important to understand why they are doing this and what assumptions they are using. At Bison and from my prior fund of funds days, I have not seen a DCF model used by itself very often. Sometimes, a GP will use this alongside the industry comparables methodology. In this situation, they will assign a weighting (ex. 50/50 or 75/25) to the valuation generated by the industry comps method and the DCF method.

Wrapping Up

Knowing how a GP calculates the NAV helps inform your opinion about the validity of the fund’s performance metrics but it can also offers insights into the GP’s character – are they fair and honest; do they have a tendency to be aggressive; or maybe they are slow to adjust to a changing situation. From an LP perspective, make sure to ask the right questions – how and why are you valuing your companies in this way? From a GP’s perspective, make sure that you are consistent and transparent about your valuation process. Nothing raises red flags more than dramatically changing your methodology or shrouding your process in secrecy.

The Horizon IRR Metric Keeps Being Misused

by Michael Roth

Accurately measuring performance and estimating asset class returns is the most important part of the asset allocation process. The reason it is important is two-fold: (1) return estimates have the biggest impact on your asset allocation model and (2) studies have shown that asset allocation is a critical component of returns.

Considering this, industry trade groups, like the BVCA, and service providers, like Cambridge Associates, continue to inappropriately tout a horizon IRR calculation in comparison to the public market’s 1,3, 5, or 10 year time weighted rate of return.

As I have discussed previously, it is a mistake to think an IRR and a time weighted return are one and the same. Both are annualized rates of return but they deal with cash inflows and outflows in different ways. IRR specifically accounts for the timing and size of cash flows when calculating the returns generated while the time weighted return specifically excludes the impact of cash flows and weights the returns in each time period equally. Each method has their shortcomings and ideal use cases. Take these metrics out of context and they can be misleading.

What difference does a return calculation make?

I used a portfolio of 481 North America and Global buyout funds from Bison’s cash flow dataset to analyze the difference between the horizon IRR and the time weighted return. Both return calculations were performed using quarterly cash flows.

Should Private Equity Fees and Carried Interest be Changed?

by Michael Roth

The media has made a big deal recently about private equity fees due to the revelations that CalPERS and CalSTRS have not kept track of the fees paid and carried interest earned by their private equity managers. More broadly, there is an increasing effort by LPs to receive greater disclosure about fees and reduce expenses.

My concern is that, in most cases, the focus on fees overlooks the real question: Do private equity returns justify the amount paid in fees and carry?

In this post, I will analyze the management fees paid to private equity managers but also look at them in the context of returns generated. Good returns should be rewarded but perhaps the conditions for receiving carried interest should be revisited.

Public Equity and Private Equity Fees Are Structured Differently

Private equity fees are frequently criticized as being outrageous in relation to their public market mutual fund peers. The glaring problem with this comparison is that mutual funds and private equity funds charge their fees on a different base. Private equity funds charge a 1.5 – 2% fee on commitments during the 5 year investment period. Thereafter, funds typically charge .75 – 1.25% of net asset value. Mutual funds charge an ad valorem fee, meaning the fee is charged on the fund’s NAV. As the fund’s value increases, your management fee, in absolute terms, goes up.

To get a sense for the cost of management fees, I chose to compare Carlyle Partners IV to an index fund, a large cap mutual fund, and a small cap mutual fund. These three mutual funds will highlight the impact of fees at the different fee levels.

Clearly, an index fund charges a fraction of the cost of a mutual fund or a private equity fund. However, if you have an investment mandate to earn returns in excess of the market, you are not going to choose an index fund. The more interesting comparisons are the large cap and small cap mutual funds against Carlyle IV. Just glancing at the numbers, it appears that Carlyle Partners IV is charging more than twice as much as Fidelity and 21% more than Putnam’s fund.

Fees Need to be Viewed on an “Apples to Apples” Basis

Critics inaccurately condemn private equity because they just look at the headline number. Let’s compare the cost of fees over a 10 year period to evaluate the true cost over the typical private equity fund’s life. For the three mutual funds, I used their 10 year returns in my assumptions to calculate the average fee over time.

For Carlyle IV, I assume the fees are the same as what they are for their more recent flagship funds. I use the fund’s actual NAVs, based on Bison’s cash flow data, to determine the post-investment period fees.

Over the 10-year span, Carlyle IV’s fees were just 6% more than Fidelity’s fund but were 40% LESS than Putnam’s fund. When an accurate comparison is done, private equity management fees do not look nearly as egregious as headlines may lead you to believe.

You Must Consider Returns

The question I asked at the beginning was whether or not private equity returns justify the amount paid in fees and carry?

To answer this question I looked at returns in two ways. First, I performed a simple analysis which calculated a TVPI multiple for the public market funds using their 10-year average annual return.

Using the 10-year CAGR for the three mutual funds, I arrived at each investment’s value after ten years. The TVPI multiple is equal to End Value / Commitment. Despite an average management fee that was 6% higher AND a 20% incentive fee, Carlyle IV managed to generate 13.6% more value than Fidelity’s fund. In the case of Putnam’s fund, Carlyle IV outperformed the fund while costing almost $700,000 less than in management fees.

This comparison is not completely relevant for analyzing a private equity manager because it ignores the PE manager’s ability to manage the cash flows. To account for this, I performed a PME analysis against the S&P 500 Total Return Index. The analysis tells a compelling story about the differential between Carlyle IV and the public markets.

Buying and selling the S&P 500 Total Return Index at the same times as Carlyle IV would have resulted in a 1.22x TVPI multiple and a 3.65% net IRR.

For those who think I may have selected a very convenient example to illustrate my point, I would refer you to my last piece, which analyzed the PME performance of North American and Global private equity funds. In nine of thirteen vintage years, buyout funds outperformed the Russell 2000. Digging into a fund level analysis, 52% of buyout funds analyzed outperformed the Russell 2000.

Carried Interest Hurdles Rates Should be Changed

When a fund’s returns are good, their fees look justified but what can you do when the returns are poor? Private equity gets it right by structuring the fees to have an incentive component. It is hard to justify Putnam earning 1.7% on average over the last 10 years given that they have returned just 6.2% annually.

Despite the conditional nature of carried interest, there is still an outcry over their payment. Part of this is partisan political beliefs that will never be satisfied but part of it is due to insufficient hurdle rates. There is a mismatch between the return expectations LPs place on themselves and the GPs. Internally, many LPs expect private equity to beat the public markets by 200 – 300 bps but they allow GPs to earn carried interest by generating an IRR greater than 8%. LPs should force GPs to meet the same return hurdles that they place on themselves.

Wrapping Up

Private equity fees are appropriately divided into management fees and carried interest. This ensures that managers are incentivized to maximize returns and not just accumulate assets. To ensure that incentives are completely aligned, the hurdle rate should be modified to acknowledge the link between public markets and private equity markets. Strong performance should be rewarded but that reward should include a condition that the manager generates excess returns over a market benchmark.

A PME Analysis of Private Equity

by Michael Roth

Before we move on to 2015, let’s take one final look at where private equity stands as of Q4 2014. Using our cash flow data, I compared the pooled net IRR for the 2000 through 2012 vintage years to the Bison PME for the Russell 2000®. I focused on North American and Global funds, where the Russell 2000 could be a relevant public market comp. Funds in this analysis account for close to $1 trillion of committed capital.

Buyout Funds vs. Russell 2000

North American and Global buyout funds have outperformed the public markets in nine out of the thirteen years analyzed.

Buyout funds enjoyed strong outperformance of the public markets from 2000 through 2005. Since then, buyout fund performance has been mixed with four of the last seven vintage years underperforming the markets. The reason for this is two-fold. Everyone knows how funds from these vintages, primarily 2006 – 2008, did some bad deals (think TXU) and have had to lengthen their holding periods to try and recoup their cost (think Freescale). A higher number of bad deals and longer holding periods have clearly hampered returns for these vintages.

What also can not be ignored is the incredible bull market in public equities over the last six years. The Russell 2000 has tripled since it bottomed out in 2009. This is not meant as an excuse for the private equity industry but an acknowledgement of the public market’s incredible, and probably unrepeatable, returns over the last six years.

More recent vintages seem to be showing favorable signs. However, it can be hard to draw definitive conclusions from PME analysis when funds are only nearing the end of their investment period and have not yet had time to mature.

Venture Capital & Growth Equity vs. Russell 2000

North American and Global VC/GE funds have outperformed the public markets in just six of the thirteen vintage years analyzed. However, four of the six years have occurred since 2007 – highlighting the VC/GE market’s recent strength.

The venture industry has also suffered due to the strong public markets while underperformance in the early 2000s can be attributed to the dot-com crash. Compared to the buyout industry, VC/GE performance against the public markets has been mixed, though there are encouraging signs in the more recent vintages.

Wrapping Up

Compared to each other, the buyout industry has bested the VC/GE industry in eight of the thirteen years. However, VC/GE have outperformed buyouts in four of the last six year through 2012. Whether or not VC/GE can sustain this recent strength will likely depend on their ability to exit these high momentum companies which have seen tremendous valuation increases over the last few years.

Here’s Why the Venture Capital Crash Will Hurt

by Michael Roth

The primary issue with the current valuation bubble is the industry’s inability to distribute returns to investors. LPs have continued to show faith in the venture capital industry, but their leniency may be what ends up hurting them whenever the bubble pops.

Half of the Industry’s Total Value Created Since 2003 Is Just “Paper Profits”

A good way to visualize the industry’s problem is too look at the ratio of DPI (distributed capital to paid in capital) to TVPI (total value to paid in capital). During a fund’s early years, you expect to see a large difference between between DPI and TVPI (ratio closer to 0%). As a fund gets closer to the end of its 10 year life, you expect the DPI and TVPI to converge. In the chart below, that is illustrated by the DPI:TVPI Ratio line approaching 100% as you move right to left.

 

Looking at the ratio can tell you one of two things:

1. A lower ratio could be indicative of a portfolio that has good upside potential remaining.
2. A lower ratio could be indicative of a portfolio that is having issues exiting portfolio companies and realizing returns.

The way to identify where a fund stands would be to compare it to its peers, but also to look at the age of the fund. As I mentioned, a fund approaching 10 years old should have a DPI:TVPI ratio that is approaching 100%.

Since 2003, the median DPI:TVPI ratio for the venture capital industry has been below 50%. This means that half of the total value created by the VC funds since 2003 is only on paper. Similarly, a large portion of the recent valuation increase for VC funds is only on paper and that is where it may stay unless VC firms begin to distribute returns.

Half of the Funds Raised Since 1998 Have Distributed Less Than Investors Paid In

Another concern for the VC industry is the proportionate size of distributions. Specifically, looking at VC returns on an absolute basis, the industry has not had a strong DPI ratio since 1996, when distributions significantly exceeded paid in capital.

Worse yet, the median DPI ratio has not been greater than 1.0x since the 1998 vintage year. This means at least half of the funds raised since 1998 have yet to distribute a return in excess of paid in capital to investors since 1998. To give you a sense of how big of an issue this is, venture capital firms have raised $480 billion since 1999, according to NVCA figures.

By comparison, you only need to go back to 2003 to find a median DPI figure above 1.0x for the North American buyout industry.

What Does This Mean for the Current Euphoria?

The ability of managers to realize returns should be a real concern for investors in light of the recent rise in valuations. But looking at recent fundraising data, investors are buying into the hype.  In 2014, venture capital firms raised more than $30 billion, which is well above the average amount raised since 2001. Investors seem to be putting a lot of faith in VC managers, their ability to value portfolio companies, and their ability to realize returns.

The amount of leeway given to venture firms is confounding since buyout firms are often advised by LPs to make some distributions from their existing portfolio before they consider going out fundraising again. LPs often say “show me some exits” before they feel comfortable recommitting to the next fund. With an average DPI:TVPI ratio of 16.5% for the 2007 – 2012 vintage years, venture capital firms may be avoiding this pressure for the most part. The average DPI: TVPI ratio for buyout funds of the same vintages is 22.5% (37% higher).

Wrapping Up

The VC industry’s inability to distribute returns to investors is a glaring deficiency that is leaving investors exposed to likelihood that valuations will come back down to earth. Unless there is a dramatic wave of distributions, the recent valuation bubble will be yet another painful lesson for LPs who seem to keep forgetting the industry’s inability to distribute returns.

Don’t worry about the VCs though. They will still be earning a 2% fee on the record amount of capital they have recently raised.

Introducing Bison PME

by goksor

CHANGING HOW YOU THINK ABOUT PME BENCHMARKING

Today Bison is announcing the Bison PME methodology for estimating an IRR for a public market index. The new methodology addresses shortcomings of other public market equivalent (PME) IRR methods and how they handle cash flows. It is built on the work of Steven N. Kaplan and Antoinette Schoar presented in a 2005 paper titled Private Equity Performance: Returns, Persistence, and Capital Flows and introduces a way for estimating public market index cash flows for PME analysis. Investors can use the Bison PME alongside Kaplan Schoar PME to evaluate the speed and size by which alpha is generated relative to public markets.

IRR AND ESTIMATING PME PERFORMANCE

Investors increasingly use PME calculations to determine whether a fund manager is able to outperform the public markets. Where investors calculate public market returns using a time-weighted return calculation, they calculate private equity returns using a money-weighted return calculation (IRR). This has led to apples and oranges comparisons that are hard to evaluate. PME calculations enable investors to calculate a money-weighted return for a public market index.

Most of the PME calculations generate an IRR for a certain market index. This allows for apples to apples comparison of a fund’s IRR versus a public market index. It means, however, that PME calculations are exposed to some of the problems inherent in evaluating returns with only an IRR metric. For instance, we have previously shown that an early distribution can inflate a fund’s IRR and similarly that a fund with a lower TVPI multiple can generate the same IRR as a fund with higher TVPI multiple. There are two major points to remember about why IRR is best understood in combination with a TVPI:

IRR is a money-weighted measure – The IRR calculation is impacted by the size and timing of cash flows. This exposes the calculation to manipulation since multiple variations of cash flows can generate the same IRR. For PME IRR calculations, we believe it is important to replicate the pace of value realization in the fund when calculating an IRR for a public market index. At the same time, the PME calculation has to be sensitive to the impact of the market on the cash flows.

IRR measures speed and not size of returns – The IRR calculation assumes that realized returns can be re-invested at the same rate of return. This means that a proportionally large distribution occurring early in a fund’s life will have a disproportionate impact on the IRR for the life of the fund. When evaluating a private equity fund, it is important to look at the fund’s IRR alongside its TVPI multiple. This standard should also be followed when conducting PME analysis.

INTRODUCING BISON PME

Bison PME is a calculation that enables investors to measure public market IRR and TVPI performance. We developed the methodology after closely evaluating other PME methodologies and their shortcomings that result from how they handle the private equity fund’s cash flows. Specifically, we believe that it is important to leave constant the speed and proportionate value generated in the fund when calculating a PME IRR. We want to lower the risk of PME IRR being impacted by how IRR is calculated market. Based on early testing of 125 funds, Bison PME showed less volatility than other PME methodologies while accurately reflecting changes in public market index value.

CLICK HERE TO LEARN MORE ABOUT CALCULATING BISON PME AND READ OUR INITIAL WHITE PAPER.

We believe PME methods are important for understanding private equity performance and encourage investors to incorporate it into their fund performance analysis. The Bison PME method is an open standard provided for free. We believe it is best used side-by-side to Kaplan Schoar, but also encourage comparison with other PME methods.

Bison PME is available today for free to all Bison Performance Calculator users.

Bison Open Benchmark

by goksor

Bison launches a new benchmark for private equity and venture capital. The benchmark is available for free at Bison.co as of today October 15, 2014. This new benchmark will help investors evaluate managers against peers and indicate institutional investors ability to pick winners.

Since launching in 2011, Bison has worked with institutional investors to collect performance data for private funds. Over 200 partners now contribute to the data set. Together, they provide ongoing updates on over 20,000 investments for 3,700 different funds in private equity and venture capital. Bison now has an open private equity data set where each source is visible.

The Bison benchmark will avoid many of the shortcomings for private equity benchmarks. Full transparency will help investors control for outliers among peers in the benchmark and also see number of known commitments to a fund. At the same time, where the Bison data comes directly from a variety of institutional investors, it includes both small and large funds, winners and losers, and a consistent core representation of funds. What is more, the Bison benchmark includes a unique view into how returns for different vintage years grow over time. This year-to-year measurement will help investors see if their managers are trending above or below the median for a vintage year.

“The industry has been looking for a new benchmark for a long time. An open benchmark will help investors like public pensions, endowments, and foundations understand their performance in the asset class, but also help the public see how well their money is being cared for,” says Michael Nugent, CEO, at Bison. He concludes, “We at Bison wants to make it easy for everyone to understand performance in private equity.”

Download our free private equity benchmark at www.bison.co.

Making sense of PMEs

by Michael Roth

The private equity industry has always had its own way of measuring performance. Unlike a mutual fund, investors are committing to a blind pool of capital where GPs have discretion over the timing of inflows and outflows. This is why there is a difference in how you measure performance between a private equity fund and an equity mutual fund. Analyzing multiples of invested capital and IRRs – as opposed to a time weighted rate of return on public markets – allows investors to analyze a fund’s performance relative to its peers. However, if you are looking to compare a private equity fund’s performance to the public markets, you need to calculate a public market equivalent (“PME”) return measure. There are five main PME methodologies: