Here’s How To Use the Valuation Bridge

by Michael Roth

The valuation bridge is a valuable tool that both GPs and LPs can use to determine how and where “value creation” is coming from. In order to maximize the value of this analysis, it is important to understand what the valuation bridge tells you but also what it doesn’t tell you.

The valuation bridge identifies whether the total value of the fund has grown as the result of revenue growth, margin improvement, multiple expansion, or paying down debt.

Revenue growth and margin improvement, together, are the drivers of EBITDA growth.

• Revenue Growth – Revenue growth is the proportion of equity growth that can be attributed solely to revenue from the time of investment to the most recent/exit date. A positive number means the company has been able to execute on its growth strategy.
• Margin Improvement – Margin Improvement is the proportion of equity growth that can be attributed to the change in EBITDA margins from the time of investment to the most recent/exit date. A positive number means the company has been able to improve its operational efficiency and earn more of its revenue as EBITDA.

Multiple expansion is the proportion of equity growth that can be attributed to the change in the Enterprise Value / EBITDA multiple from the time of investment to the most recent/exit date. A positive number means the Firm was able to “buy low and sell high”. What an investor needs to determine is whether this is due to:

• Growth and/or operational improvements that make the company more attractive than its peers or
• Stock picking that is primarily due to market timing.

Fundamentally improving the company is the preferred source of multiple expansion. This is because it is more repeatable than timing the markets.

Debt Paydown is the proportion of equity growth that can be attributed to the change in net debt (total debt minus cash). A positive number means a company has reduced their net debt, which may be due to paying down debt or an increase in cash.

Other is frequently referred to as the “combination effect”. It aggregates the combined effects of EBITDA Growth (Revenue growth and margin improvement) and Multiple Expansion.

The valuation bridge does not tell you whether the portfolio companies outperformed the markets.

The valuation bridge does a good job dissecting the sources of equity growth. What is does not tell you is whether a company’s operational changes were better or worse than the public markets. This is important because viewing the operational changes in isolation does not tell you whether a manager added value or whether the portfolio companies benefitted from overall market trends.

This is why we developed the Market Bridge. Over the course of a fund’s life, a private equity manager earns a management fee of 1.5% – 2.0% during the investment period (first three to five years) and 1.0% – 1.5% during the remainder of the fund’s life. This is well above the average fee paid on an index mutual fund. Our Market Bridge allows user to determine whether GPs are actually earning their premium fees by adding value in excess of public market peers or just benefitting from financial engineering and/or market timing.

Closing Thoughts

The valuation bridge provides a powerful summary of the sources of value creation. However, the valuation bridge, viewed in isolation, does not identify whether a manager is truly adding value. If a GP invested in J. Crew, the valuation bridge will tell me how they created value and the Market Bridge will tell me if they added value in excess of their retail sector peers over the course of the investment.

Bison Performance Workshop Recap

by Michael Roth

Bison hosted its first Performance Workshop in connection with Buyouts East here in Boston on March 25, 2015.  The goal of the workshop was to try to evaluate how private equity investment returns impact asset allocators and managers.  For those of you who did not have the opportunity to join, here is a summary of some of the topics and points covered.

Keynote Address – “Does Smart Money Really Exist?” 

Michael Nugent, cofounder and CEO of Bison, provided private equity performance and asset allocation insights using Bison’s dataset of cash flows covering over 1,200 funds. 

Analyzing the dataset, the majority of which had vintage years of 2000 or later, he noted that the mean and median PME alpha for the funds was slightly negative compared to the Russell 2000.

 Michael also presented on how three of the largest institutional investor groups, US public pensions, UK public pensions, and US foundations allocated money to these funds. The presentation also looked at the 25 foundations with the largest private equity portfolios as their own subset since they are considered among the most sophisticated LPs. The main takeaways from this sampling included:

• Based on the % of funds with a PME alpha greater than 0 (outperformed the public markets): Top 25 US foundations (55%) were the smartest investors followed by Foundations (54%), US Public Pensions (51%), and UK Public Pensions (46%).
• US public pensions are more likely to invest directly in buyout and venture funds while UK public pensions have invested a large portion of their PE allocation into fund of funds.

Performance Workshop – “What does adopting PME mean for the industry?”

Rasmus Goksor, cofounder and COO of Bison, moderated this workshop with industry experts: John Kim (Principal at Kelso), Jesse Reyes (Managing Director at J-Curve Advisors), and Hugh Wrigley (Managing Director at GEM).  It was an engaging discussion highlighting both shortcomings and strengths of peer benchmarks, PME analysis, and manager investment behavior.

Some highlights from the discussion:

• Private equity still lacks the analytical tools and access to public market comps that would make quantitative analysis pervasive in the same way as it is for Hedge Funds.
• To use PME for manager selection, the industry needs a PME benchmark for ranking one fund against another.
• Criteria for what index to measure against when doing PME analysis needs to be developed.
• Managers are unlikely to time market or become more selective about sectors as a result of PME growing in popularity.
• Connecting a fund’s growth to sector growth may help uncover operational value add.

 Academic Research – “Private Equity Performance Persistence”

Professor Kyle Welch, George Washington University, was given unique access to Bison’s fund cash flow data for his research into private equity performance persistence.  Presenting his findings for the first time, he highlighted four points:

1. Private equity needs a new metric for measuring operational value add beyond IRR and TVPI.
2. Bison PME has a stronger correlation to a high IRR than the Cambridge Benchmark.
3. A high IRR is not an indicator of future performance.
4. A high IRR is also not an indicator for manager ability.

 Panel Discussion – “LP investment expectations for 2015” 

Michael Nugent hosted a discussion with three prominent limited partners, Amy L. Schondra, Vice President at Hirtle Callaghan, Diane Mulcahy, Direct of Private Equity at Ewing Marion Kauffman Foundation, and Jed Johnson, Investment Director at Crow Holdings Capital Partners.

• All panelists noted that they are focused on lower middle market buyout funds, emphasizing that they like smaller funds where the GPs are highly motivated.
• They expressed with concern the latest venture capital bubble, which is most apparent in late stage venture capital.

Why CalPERS Private Equity is Underperforming Their Benchmarks

by Michael Roth

We recently conducted an analysis of CalPERS’ private equity portfolio since 2000 using peer benchmarking analysis and PME analysis. As the largest private equity investor in the US, CalPERS is often viewed as an influential LP in the private equity community. While they are good at picking managers from its peer universe, PME analysis showed CalPERS to be insufficient at selecting managers that deliver alpha.

To be sure, private equity has been their best performing asset class in their portfolio over the long term but it has been underperforming CalPERS’ benchmarks over the 1, 3, 5, and 10-year horizons. Looking at investments made since 2000, CalPERS has committed 63% of their capital to above average managers. However, PME analysis showed that 57% of their capital is committed to funds that underperformed the Russell 2000.

Takeaways

• Link between 1^st quartile funds and PME outperformance – 75% of first quartile funds outperformed the market.
• PME analysis shows peer analysis not comprehensive enough – 42% of funds that outperformed market were not in first quartile of peer universe.
• Buyout funds performed best against the markets – 53% of their capital committed to buyout funds outperforming the market.
• Fund of Fund performed the worst against the markets – 17% of the capital committed to fund of funds outperformed the market.

Conclusions

PME analysis has existed for close to 20 years but it’s use in fund analysis has really been perfunctory until recently. Most analysis is focused on peer universe analysis but PME analysis is increasingly being seen as a necessary and additive analysis that should be a part of the due diligence process. Bison believes this analysis could have aided CalPERS in their manager selection and investment style allocation.

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.

The Problem With Long Nickels PME

by Michael Roth

Long Nickels was the industry’s first foray into comparing private equity to the public markets. At first glance, Long Nickels is intuitive, simple to execute, and its output is an IRR measure which is easily understood. This is likely why early results of our LP survey indicate Long Nickels is the most widely used PME methodology. Despite its widespread adoption, the Long Nickels calculation makes certain assumptions that need to be highlighted so investors understand why the calculation can be unreliable with typical private equity fund cash flows.