2: Private Equity Flashcards
Bailey’s criteria for an appropriate investment benchmark
Unambiguous Investible Measurable Specified in advance Appropriate (for what is being measured)
RPVI (residual value to paid in ratio)
Measures how much of investor’s capital is still tied up in the fund.
RPVI = NAV / paid-in capital
TOPSCAN framework
Team building Operations Perspective Skill building Customer development Analysis Network
Key performance drivers for PE
Selection of fund manager
Management of diversification
Management of capital commitments
What are the resources that VCs should assess in terms of their value proposition?
- Brand resources
- Cash resources
- In house expertise
- Network resources
Benefits of FoF investing (4)
Diversification and intermediation
Resources and information
Selection skills and expertise
Incentives, oversight and agreements
Hurt money
GP’s contribution
Type 1 conflict
Conflict between firm’s and client’s interests. Mitigated by aligning interests
Type 2 conflict
Firm favors one client to detriment of another. Worse than type 1
Steps of PE investment process (6)
Portfolio objectives Portfolio design Liquidity management (over commit) Fund selection Monitoring Actions and implementation
Bottom up
Find best manager
Drawback: can result in unbalanced/risky portfolio
Top down
Focus on sector or strategy
Drawback: strict allocations may be impractical to attain
Advantages of core satellite
Diversification
Customization
Target risks
Focus on satellite portfolios
Effects of diversification
Lowers risk, return, skew and kurtosis
20-30 funds diversifies 80% of SD; 5 funds diversify 80% of K
Market timing
Predict vintage years that will perform well
Issues: PE markets over react to news
Cost averaging
Invest consistently in each fund type each vintage year (ie vintage year diversification)
Fund manager selection process
Wish list
Deal sourcing
DD
Decision and commitment
Drawback of IIRR
Assumes distributions reinvested at IIRR. Solution is to use modified IRR as it assumes a different investment rate and accounts for cost of capital
Drawbacks of paid in ratios
Ignore TVM and requires estimates of NAV
Potential actions for poorly performing funds
Do not commit to follow on funds Negotiate for change Petition for lower management fees Threaten action against or terminate managers Investor default
Pro for using NAV
Investors prefer valuation based on current (not future) information
Cons for NAV
Private funds cannot be divided up into underlying portfolio companies
Aggregate NAV does not reflect economic value
NAV does not reflect economic value. why?
It doesn't account for: Undrawn commitments Value add provided by managers Future fund expenses Capital constraints
Shortcomings of CAPM
Assumes the following: No transaction costs Fully informed buyers and sellers Tradable assets Markets always in equilibrium
4 methods of estimating PE betas
1: Estimation based on quoted comps
2: Relative risk measures
3: bottom up beta
4: beta based on data corrected for staleness and smoothing (not recommended)
Why is bottom up beta better than simple regression
1: averaging regression betas reduces noise
2: estimates reflect current fund
3: leveraged betas calculated using current leverage
Drawbacks: difficult to find quoted comps and assumptions needed for future cash flows
Sources of funding/liquidity for PE investors
1: follow on funding
2: liquidity lines
3: maturing treasury investments
4: realizations of other investments
5: sell off LP shares
6: distributions from PE fund
7: LP default
Estimation (CF projections)
Short term (3-6m)
Based on current market conditions
Data gathering and analysis
Forecasting (CF)
Medium term (1-2y) Based on specific market environment Quantitative (ie regression) modeling
Scenarios (CF)
Long term (2+yrs) Based on uncertain market environment
Automatic conversion
Pref stock automatically converted (based on trigger price) to common stock at IPO, if IPO price is high enough
Higher automatic conversion hurdles better for investors
Bad leaver clause
- enables removal of GP with a simple majority vote (for cause)
- suspends investments until replacement is found
- in extreme situations, fund can be liquidated
Sidey: In contrast to good leaver clauses, bad leaver clauses provide no entitlement to carried interest, but provide a vesting schedule so that part of the carried interest remains available as an incentive for the new manager
Good leaver clause
- “without cause” removal; allows LPs with a qualified majority (a vote of more than 75%) to stop funding a partnership
- enables LP to end a failing partnership and is especially important for funds that do not have a track record
- sometimes provide compensation in the form of management fees for a period of time
Traditional asset allocation techniques should not be used in private equity markets because:
- there are issues with private equity data (such as scarcity of data and exposure to survivorship bias),
- non-normality of private equity data, and
- the implicit correlation that exists between private equity data and public equity data.
