Exposed to the J-Curve: Understanding and Managing Private Equity Fund Investments

How can institutional and private investors safely invest into private equity?

Two experienced market practitioners provide you with a review of the private equity fund industry and a description of all the relevant management issues of fund investments, from a day-to-day and a portfolio persepective to indirect investment vehicles like funds of funds and securitised notes.

Learn how to think independently and avoid succumbing to the traps of private equity.

This book includes:

A discussion of private equity as an asset class and its place within an alternative investment programme.
Guidance on investment into funds, including a behind-the-scenes look at the relationship between the fund investor and the fund manager.
Portfolio management of fund investments including the latest cash-flow models and their use to avoid liquidity squeezes and over-allocation.
An examination of the different types of risks faced by private equity investors and how these can be minimised.
An explanation of how investors can outsource these tasks - the relative merits of funds of funds and CFOs, listed products or secondary transactions.
This is the first book to discuss the relationship between the limited partners and the general partner, providing an undisguised and independent look behind the scenes, and explain the core aspects of this industry from the perspective of two insiders.

An indispensable reference for institutional practitioners and private equity lawyers, as well as students and academics who seek to understand the dynamics of the complex world of private equity.

Author Biographies

Ulrich Grabenwarter is head of division for Venture Capital Operations at the European Investment Fund (EIF), and responsible for a portfolio of nearly 100 private equity funds and €1 billion under management. Prior to EIF, he worked for several years at the European Investment Bank in the Directorate for Financing Operations in Germany and Austria, executing structured finance operations in the corporate and financial sector and private equity fund of fund investments. He was the personal adviser of the Austrian Management Board Member at EIB. He began his career at PriceWaterhouseCoopers in the Audit and later Finance Consulting Department, specialising in derivatives for investment and risk management purposes including their use in hedge funds.

Dr Tom Weidig is the author of several works on private equity funds, funds of funds, and the impact of Basel II. His study ‘The Risk Profile of Private Equity’ has been publicised and endorsed by the European Venture Capital Association, and translated into German and French. He holds a Master of Science in Theoretical Physics from Imperial College London, and a PhD from the University of Durham. He was a postdoctoral researcher at the University of Manchester, and a visiting researcher at Trinity College, University of Cambridge. Leaving physics behind, he then worked as a risk analyst in derivatives for the US investment bank Bear Stearns in London. He is currently an independent consultant, and also worked for the European Investment Fund researching and modelling private equity funds.

Table of Contents

Introduction
 
Part I: Private equity fund investments: an alternative asset class
 
Chapter 1: The private equity fund as the intermediary in an expert market
The private equity fund as the intermediary
Investing into private equity funds
Risk levels of private equity investments
Direct investments
Private equity funds
Private equity funds of funds
Securitisation and structured products
Publicly traded private equity
 
Chapter 2: Why invest in private equity funds?
Who should invest in private equity funds?
Private equity as part of an alternative investment strategy
Institutional investors seek exposure to alternative investments
The attractiveness of alternative investments
Reasons to invest in private equity funds
Investing in private equity – a critical look
Challenging the reasons to invest in private equity funds
Disadvantages of investing in private equity funds
 
Chapter 3: The private equity fund industry
Origin of the private equity fund industry
The formalised private equity industry takes off in the 1970s
The size of the private equity industry
Market prospects
The main markets
The US market
The European markets
Asia Pacific and other emerging markets
The main private equity players
The fund manager or general partner (GP)
The fund investor or limited partner (LP)
Prospects
 
Chapter 4: The investment focus of private equity funds
The sub-segments of private equity – an overview
Characteristics and risk of venture capital and late-stage PE segments
Risk–return comparison
 
Chapter 5: Performance of private equity funds
Sources of return for private equity funds
Performance measurement in private equity
Finding a meaningful performance measure for private equity funds
The multiple
The internal rate of return (IRR)
Why public market performance measures fail
The public market equivalent (PME)
Problems with the PME
Vintage year-weighted performance?
Leaving out young funds due to the J-curve
The risk (or uncertainty in returns) of private equity funds
The public market concept of risk fails
Using the standard deviation as risk measure
The bias of the standard deviation as risk measure
Empirical studies of risk–return of private equity funds
 
Chapter 6: Asset allocation to and within private equity
Correlation between private equity and other asset classes
Why is correlation important?
What are the problems when determining correlation?
How strongly correlated is private equity to public indices?
Asset allocation to private equity
Standard asset allocation and its problems
How much capital to allocate to private equity funds?
Correlation between private equity funds of different investment foci
Asset allocation within private equity
Investing in a broad range of funds across several vintage years
Implementing the asset allocation goal
 
 
Part II Being a private equity fund investor
 
Chapter 7: Evaluating an investment opportunity
The set-up of a private equity fund
Evaluating an investment opportunity from a limited partner perspective
Private equity – a people’s business
Business ethics in private equity
Professionalism – the backbone of the industry
Evaluating the market opportunity
The factors involved in evaluation
Market opportunities due to political or macroeconomic change
Generalist funds versus specialist funds
Evaluating the quality of a private equity fund’s management team
Assessing a management team’s track record
Evaluating the fund management individuals
Assessing the deal flow of a team
First-time teams versus experienced teams
What is the better choice?
Evaluating first-time teams
 
Chapter 8: Assessing terms and conditions – what to watch out for
Management fee structures
What does it cover?
Budget-based assessment of management fee levels
Step-down structures
Scaling fee levels to the fund size
Other partnership expenses
Broken deal expense
Set-up cost
Fee offset
Operating costs and capital invested
Investment periods and fund duration
Equalisation premia
Hurdle return – does it matter?
Catch-up mechanism
Two concepts
Alignment of interest and the sharing of profits
Carry distribution based on repayment of full contributed capital
Protection for limited partners in the case of overdistributions
Carry distribution based on repayment of full committed capital (full-fund-back concept)
 
Chapter 9: The legal documentation – how to protect your investment
The legal structure
Limited liability for limited partners
Tax transparency
Regulatory constraints
Cost efficiency
Creating an industry standard
Protective clauses
Key-man clauses
Removal clauses for cause and without cause
Defaulting investors
 
Chapter 10: Avoiding or managing conflict of interest
Conflicts of interest within the scope of a general partner
Exclusivity clauses
Overlapping investment activities
Conflicts of interest involving limited partners
Best market practice corporate governance
Limited partners’ involvement in the management of the fund
Limited partners’ place in the corporate governance of a fund
 
Chapter 11: Investment monitoring and crisis management
Warning signs in monitoring a fund investment
Unusually slow or fast investment pace
Quality of reporting
General partner’s transparency on valuation
Lost investments
Reserve policy in early-stage funds
Stability of the management team
Decreasing commitment of co-investors
What if everything goes wrong? – How to react in a crisis
 
Part III Managing a portfolio of private equity fund investments
 
Chapter 12: The challenges of portfolio and risk management in private equity
Goals and tasks of portfolio management in private equity
The portfolio manager’s goals
The portfolio manager’s tasks
Identifying and reducing the risks of private equity fund investments
Undiversifiable risks
Diversifiable risks
Reducing diversifiable risks
Quantitative risk management in private equity
Reluctance towards the use of quantitative risk management
practices
Trend towards more quantitative risk management
Applying risk management techniques to private equity
Implementation challenges
Challenges to modelling
Active portfolio management is difficult
 
Chapter 13: Information for risk and portfolio management
The information deficiency in private equity
Sharing of information and agency problem
Pressure to disclose
Lack of information exchange standards
The demand for information exchange standards
Developing reporting and valuation guidelines
Overcoming the information deficiency
The importance of information management systems
The quality of information
Which information to trust
Information from own funds
Information from personal networks
Information from private equity publications
Information from external sources
Private equity databases
Can private equity databases overcome the information deficiency?
VentureXpert (from Thomson Venture Economics)
Cambridge Associates
Venture One
Fund investors’ portfolios
 
Chapter 14: Monitoring a portfolio
Portfolio measures
The importance and type of portfolio measures
Measures at portfolio level
Measures at fund level
Measures at company level
Monitoring diversification
Monitoring the value of the portfolio
The importance of valuation in private equity
Valuation methods for companies
Special considerations when valuing portfolio companies in private equity
How fund managers compute the NAV
The nature of the private equity NAV
Monitoring performance using a benchmark
Benchmarking the fund management team to its peer group
Do too many teams claim to be top quartile?
Is past performance a good indicator of future performance?
 
Chapter 15: Forecasting the future portfolio
Forecasting the distribution of future cash flows
The need for cash flow modelling
Important issues on the use of cash flow models for forecasting
Monitoring risk numbers
Forecasting the performance of the portfolio
Using the interim IRR
Improving the forecasting power of the interim IRR
 
Chapter 16: Steering the portfolio
General issues
Liquidity reserves
Overcommitment
Diversification
 
Chapter 17: Advanced cash flow modelling
Cash flow modelling
The importance to fund investors
Public disclosure
The challenges
High model risk
Cash flow patterns as a guide to fund investors
The pattern of fund cash flows
Studies on historical patterns
Different types of cash flow models
Models of a fund as a portfolio of direct investments
Model based on manager cash flow estimates
Model based on company grading
Non-probabilistic models at fund level
Simple approach
Takahashi and Alexander’s model
Weidig’s interim IRR model
Probabilistic models at fund level
Fitch Ratings model
Standard & Poor’s model
Weidig internal age model
Partners Group model
Malherbe model
Kaserer and Diller model proposal
 
 
Part IV Alternative private equity investment vehicles
 
Chapter 18: Helping institutional investors to access private equity
The role of the alternative investments
Outsourcing
Exiting private equity
 
Chapter 19: Funds of funds
Advantages
Outsourcing
Larger networks
Accessibility
Increased diversification
Deal flow availability
Greater bargaining power
Disadvantages
Additional layer of fees
Less control
Illiquidity
Hard to find perfect match
Overcrowded market
Selecting a fund of funds management team
Ability to access the best fund management teams
Investment strategies as differentiating factor
Other selection criteria
The risk profile of a fund of funds
 
Chapter 20: Secondary transactions
Motivation and considerations on the sell-side
Reasons to sell
Disadvantages to selling
Motivation and considerations on the buy-side
Advantages
Disadvantages
Outsourcing the investment into secondary transactions
 
Chapter 21: Securitisation and structured instruments in private equity
Securitisation of private equity funds
Benefits
Disadvantages
Prospects
Structured instruments and hedge funds
Other products: publicly traded private equity
 
Chapter 22: Conclusion
 
Glossary
 
Bibliography
 

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