Copyright permission from and originally published on PrivateEquityCentral.net
During the early part of this summer, we were waiting to conduct the review of private equity funds' annual reports for our clients. With the advent of Sarbannes-Oxley, increased scrutiny from limited partners and a general wariness of market conditions in the private equity world, we saw some changes in the way G.P.s value and report on their portfolio. In one sector, the Euro markets - particularly in the U.K. market - those changes were largely dictated by the wholesale adoption of a new alternative reporting standard advocated by the British Venture Capital Association (BVCA). But underneath the reporting, we continue to see a shift in how G.P.s play out the end game of their current partnerships - one that has significant implications for the cash returns that L.P.s expect to receive in the last quarter of their investment's life cycle.
The Findings on 2003 Reporting by Private Equity Firms
It seems the bigger the fund, the slower the reporting. Funds with more than $1 billion in assets showed the shadow of Sarbannes-Oxley added one fiscal quarter to the time required to review and release results. That meant mid-June reports rather than early April in most instances. In one case, a private equity firm housed in an investment banking operation, the difference between release dates was more than 100 days. They cited two different levels of review internally and an additional cycle by their auditors as the reasons for the delay. This means limited partners should expect reports, particularly from buyout funds, in May or June as opposed to March or April. You may have less than one quarter to fully digest 2003's results before some firms come calling to raise their next fund, especially once the election is over.
The BVCA's Impact
This was also the first required season for BVCA reporting. A look at the BVCA site indicates the complexity and time involved in formulating and explaining this standard of valuation to its members. The whole exercise reminds us mightily of the accounting industry's cycle of adoption of "inflation accounting" in the 1970s. There was much gnashing of teeth, much additional calculation, some informational value but eventual extinction.
Across the 13 funds we examined that use the BVCA valuation standards, there was an average 15% increase in the valuation of portfolios vs. the traditional methodology of marking to market. The largest increase was 32% over the traditional valuation methodology. We see some potential, particularly in the U.K. market where funds tend to do deals among themselves more than other markets, to build in a gradual increase in valuations that may not be warranted. Higher BVCA values create higher offer prices and so on. The attempt to create more clarity may add another valuation standard but little guidance for investors.
Inflation accounting reporting had certain similarities to the BVCA type of programmatic, mechanical valuation of private equity. First, by its choice of certain formulas to value assets, it favored certain types of companies in that company's presentation of the balance sheet. Second, it tended to make different companies in the same sector - with the same business model and performance - look inexplicably better or worse, even though the probable economic prospect for the two was very similar.
Inflation accounting faded due lack of interest by analysts and, as inflation waned in the early 1980s, it sank without a trace. It did so because the market condition that was alleged to be distorting investment performance - and hence needed to be reported - was on its way out. Inflation accounting as dodo? Quo vadis, BVCA?
One wonders if the BVCA-type reporting - which has certainly been proposed within the U.S. private equity industry as a way to "more fairly" present the economics of a private equity portfolio - does not have its origins in the needs of private equity managers to show "progress" in a stagnant valuation environment. In the U.K. development capital and buyout market, will BVCA-style valuation become the benchmark for valuation? We have seen three new funding presentations since June for U.K. funds and two of them have used the BVCA valuation as their measurement of progress. Investor, be wary. Will U.S. and Asian funds adopt this method to "keep up" in the eyes of investors?
We do not think so. The U.S. market has different concerns. The largest institutional private equity investors expect their most successful G.P.s to mark portfolios down, not up, to prove that conservatism is all around. I suspect if we compared the top and bottom quartile funds from 1995 on, we would find the top group over time wrote down their positions more rapidly and the bottom group less so.
More importantly, the relationship between L.P.s and G.P.s may be changing. All year, we've heard talk of an "L.P. overhang" - a continuing need by U.S. institutional L.P.s to put money into private equity, resulting in the established partnerships in the market seeking less money for new partnerships and gathering it at a record pace. The overhang that most industry players have referred to is the funded one - the $60 billion-plus in the coffers of private equity as compared to an annual usage of 1/3 to ¬ of that amount. We think the supply of and demand for capital will have far more to do with valuation practices than a mathematical exercise at reaching a "truer" method of valuation. After all, it is the end result, not the interim reporting, that the investor is paying for.
The Drawdown Slowdown and the Late-Cycle Liquidity Gap
With a few exceptions, particularly among the most successful buyout funds, we have encountered the beginnings of a phenomenon that can seriously affect latecycle portfolio returns. Typically, the advertised scenario for a fund (Fund A) is that it will draw 90% to 95% of its committed capital and retains a reserve of 5% for follow-on investments and the odd late-cycle deal. When drawn capital reaches the 80% to 90% level, the firm begins raising its next fund (Fund B).
But we're seeing a new scenario emerge. We call it "The Drawdown Gap". It works as follows: A firm raised a fund (Fund A) in 2000 that is now 75% invested and has returned less than 50% of the capital to its L.P.s. It seems apparent that the G.P. will either miss or barely make the minimum hurdle return. The decision is made by the G.P., perhaps communicated to the investors, that they will start raising a new fund. The G.P. then stops calling capital on the first fund, allowing it to sit at the 80%- to 85%-called level. The result is the last 15% of the investors' committed capital accrues fees and expenses but does not get invested.
We've seen this "Drawdown Gap" among our clients' portfolios. One case is a venture firm that went as follows: Fund A is 78% invested, with an announced 5% capital reserve. There is no indication of what percentage of Fund A will ultimately be invested. Fund B, which is 60% the size of Fund A, is simultaneously raised and begins investing - and both Fund A and B can invest together.
Obviously, the investors in Fund A are at a disadvantage. They have committed to funding 100%. They have presumably allocated capital to this G.P. vs. another G.P., or another asset class entirely. They are paying fees and expenses.
We have run simulations for a number of potentially underdrawn funds which indicate the aggregate shortfall for a portfolio assuming a portfolio-wide 15% undercall.
|Column I||Column II|
|Private Equity Commited||Effect on Portfolio C Flow - Based on 15% underdraw|
|Portfolio A||$160 million||$23-30 million|
|Portfolio B||$60 million||$12-15million|
This chart shows for two portfolios (A and B) with total private equity commitments (Column I) and the shortfall in portfolio cash flow (Column II) caused by the underdrawing of commitments by G.P.s in the last three or four years of the fund's life. That shortfall is the result of capital not being drawn and employed on behalf of the L.P. by the G.P. In many cases, where capital invested during the first five or six years of a partnership may not yet have returned to the 100% level, this underdrawing all but guarantees the partnership will underperform.
Investors need to question their assumptions about their G.P.'s drawdowns, run the calculations and compare them to the original and revised objectives for cash flow. Certainly, a shortfall of up to 20% in the late-cycle cash flow of a portfolio will seriously affect both the willingness of investors to reup with a firm, as well as unbalance an allocation scheme based on the original G.P. assumptions.
Update on Private Equity Metrics
There is a great deal of interest, including from large data management companies, in becoming more involved in the private investment data business. There has been an increase in the number of papers and trade articles that look at metrics and their application to examining and predicting private equity performance. My sixth-grade daughter simplified our own approach to metrics when she presented me with a set of Duplo plastic building blocks emblazoned with the output of her prized labeling machine.
Those Private Equity Analytics metrics (and her respective block colors) along with some representative indicators that build up to the metrics are:
VINTAGE (Green): The collective experience of the investing principals during a time sequence. The key attributes are the years of investing experience and the years as a team.
EFFICIENCY (Yellow): Our own PEA measurement that takes into account cost and expenses to deliver investments and the ability to generate cash flow. We track, among other things, total expenses as a percentage of cash on cash returns and time-weighting of cash returns.
VALUATION (Blue): The bottom-up, tested adjusted private market value measurement. We track write-offs and adjusted Private Market Value - our proprietary valuation measurement.
CASH FLOW (Red): Our metric of performance for individual entrepreneurial investors and family offices investing for individuals in private equity.
When we look at evaluating a partnership, we examine it using the characteristics of this set of "building blocks" for a measurement of an overall ranking of a partnership for our individual clients. This allows us to compare our own "blocks" with the other industry benchmarkers that were described in an earlier article.
Want your own set of blocks? Email me with your mailing address and I'll get you your own set of PEA metrics building blocks. And, by all means, suggest your own approach and metrics to build your own blocks.
Tom Darling is the founder of Private Equity Analytics, a New York-based research and advisory business dedicated to serving the entrepreneurial investor and family office management client who seeks to optimize their private equity portfolio. PEA provides valuation, remediation through secondary interest sales and strategic portfolio advisory services. PEA's proprietary "V Curve " analysis, Adjusted Private Market Value valuations and Private Equity Forensics reflects the over 40 years of experience among the PEA principals.
Tom can be contacted at 212-407-9185 or TCD4SAIL@aol.com
The views expressed in this article don't necessarily reflect the views of PrivateEquityCentral.net or Channel Capital Group Inc..
This article was originally published on PrivateEquityCentral.net. PrivateEquityCentral.net is a division of Channel Capital Group Inc.