The institutional investor community, including pension plans, university endowments and insurance companies, has reaped the benefits of investing in private equity for decades.
Over the past 20 years, private equity’s share of institutional portfolios has grown significantly, with allocations generally ranging from 10% to 20% because of its superior long-term results compared to other asset classes (Figure 1).
For instance, the 2014 Yale endowment update reported that 31% of the university’s $23.9 billion endowment was invested in private equity as of June 30, 2014, and that the private equity investments had generated an annualized return of 15.4% over the prior 10-year period.
While institutional investors have been enjoying strong returns from private equity for many years, most high-net-worth investors have had little or no exposure to the asset class. The reasons for this are clear: PE funds require steep investment minimums, typically $5 million or more, and most managers have focused on big-ticket institutional investors that understand private equity and do not require any education. In addition, the effort involved in evaluating a PE investment opportunity is significant and usually exceeds the resources available to individual investors. Comprehensive diligence is particularly critical in PE, where the spread between the best and worst-performing managers is substantially wider than in other asset classes, making manager selection a paramount issue (Figure 2).
Private equity provides an opportunity to significantly enhance portfolio returns, but only if investors select the right managers.
Now we’ll explore the elements of a private fund investment opportunity that should be carefully researched and considered before investing:
Value Creation
One of the most crucial factors in evaluating a PE opportunity is understanding how a manager has created value in past investments. Value creation is derived primarily from three factors, which are not exclusive of one another: financial engineering, which typically involves increasing a company’s leverage ratio to boost equity returns; multiple expansion, which means the manager sold its portfolio companies at higher multiples than they were acquired for; and operational improvement, usually reflected in increased revenue or EBITDA during the hold period.
Financial engineering and multiple expansions are often market-related factors and can expose an undisciplined manager when market conditions deteriorate, as they did in 2008 and 2009. In contrast, portfolio companies that consistently show improved financial performance during a manager’s ownership is strong evidence that the manager is skilled at making the right bets and has real value-creation abilities. These managers are often able to implement fundamental business improvements, such as rationalizing costs and making accretive add-on acquisitions that will generate superior returns over time.
Track Record
Once it has been determined that a fund manager’s returns are the result of sound investment selection and true operational improvement across the portfolio, it becomes important to understand how the manager achieved those results, and whether the necessary elements are present or likely to be replicated in the next fund. At the quantitative level, prior fund cash flows can be disaggregated to analyze historical performance by attributes such as sector, equity check size, source of investment, geography and lead investment professional. This track record analysis reveals qualitative insights such as whether a fund manager’s overall returns were driven by a particular industry or secular trend, whether an individual partner was responsible for sourcing a disproportionate number of past successful investments and whether the highest performing deals were sourced on a proprietary or non-proprietary basis. These analyses enable investors to ask the right questions, such as whether a particular sector will be more or less of a focus going forward and whether key investment professionals are still with the firm.
A particularly important track-record analysis involves digging into the fund manager’s loss ratio and dispersion of returns. Firms that have consistently doubled their money across most of their deals tend to deliver more attractive results in the long term than managers who have comparable overall returns, but who produced those results with a few home runs alongside numerous write-downs.
Unrealized Portfolio
A meaningful proportion of a manager’s past investments are typically still unrealized when the firm begins raising its next fund, which can sometimes mask deterioration in the overall track record. It is not entirely uncommon for managers to be more aggressive in the valuation of their unrealized investments immediately before they launch a new effort to raise funds. Prospective investors should gain an understanding of a manager’s unrealized deals and whether they are on track to generate returns that compare favorably to the realized portfolio. One important measure of this is to compare the multiple that the manager paid for each company to both the multiple that is currently used to value it and the multiples at which comparable companies are trading.
Benchmarking
While a manager’s track record may be attractive on an absolute basis, it is crucial to compare the firm’s historical performance to that of its peers. Certain vintage years (a fund’s “vintage” is the year in which it first deployed capital) have outperformed others because of favorable market conditions, such as attractive prices for target assets. As a result, a private equity fund’s returns must be compared with those of funds in the same vintage year that pursued a similar investment strategy. Increasingly, investors are also performing public market equivalent analyses, or PMEs. This process involves the creation of a hypothetical investment vehicle that mimics the relevant fund’s cash flows, with the resulting performance measurement representing the returns investors would have achieved if they had sold or bought the equivalent amount of a public index whenever the PE fund made a capital call or a distribution.
Investment Strategy
In addition to quantitative factors, investors must assess a manager’s strategy and how it fits with the expected market environment over the investment period of the fund. It is also important to confirm that the go-forward strategy is consistent with the past practices. A common concern of institutional investors is “strategy drift,” or deviation from the manager’s past investment approach. While opportunistic strategies can be attractive, these should be characterized as such from the outset so investors can make informed decisions about how they are allocating their capital.
Investment Team
The capabilities of the team that will be sourcing, negotiating, monitoring and exiting the firm’s investments are clearly a critical determinant of ultimate returns. Prospective investors should investigate the backgrounds and experience of the firm’s investment professionals, as well as the team’s continuity and experience working effectively together.
The team’s relationships and networks are also crucial in terms of the volume and quality of the manager’s deal flow, as well as the firm’s ability to identify strong management teams. Reference calls, which are a standard component of institutional diligence, are particularly useful in terms of confirming the attribution claims of individual team members and making sure that the professionals responsible for the past successes are still with the firm. Those individuals must also be properly incentivized to remain at the firm.
Many PE firms have failed to implement effective succession plans that transition leadership to capable professionals. It is also important to assess how the firm’s profits (also known as carried interest) are distributed in order to ensure that the entire investment team is motivated to maximize the fund’s returns, aligning their interests with those of investors.
Finally, investors should assess the size and quality of the current team in the context of the new fund’s size, relative to the last fund and to the unrealized portfolio, to ensure that the firm’s resources are sufficient to successfully deploy the new fund’s capital within the investment period. There are many instances of successful PE firms that raised much larger funds and then stumbled because they were under pressure to put too much money to work and, as a result, abandoned prior disciplines.
Deal Sourcing
A manager’s ability to source a large enough volume of high-quality investment opportunities is key in the increasingly competitive PE landscape. Managers who rely on auctions to find investments are at risk of paying inflated prices for assets. Certain firms maintain cold-calling programs to canvas the market for deals, while others rely primarily on the strength of their networks. It is critical that a manager has a structured process for identifying which companies are best positioned for future growth or the best candidates for a turnaround strategy.
In summary, investors interested in diversification and higher returns should consider incorporating private equity into their portfolios. However, because the primary driver of returns in PE is not market beta but rather the manager’s ability to successfully find, improve and exit their investments, it is critical to have a thorough manager diligence process in place. Essentially, investors must develop an informed view of whether the manager’s returns are attractive on an absolute and relative basis, how the manager produced those returns, and whether it will be able to replicate those results in the next fund.
