Concepts, historical evidences and impacts on portfolio constructions

Measuring returns in Private Equity

PierreYvesMathonet
Luxembourg, 3 May 2011 Sacred Heart University Luxembourg CFA Institute

Measuring returns in Private Equity 1

EIF at a Glance

Aaa/AAA/AAA ratings (Moodys/S&P/Fitch) Multilateral Development Bank (MDB) status EIB specialised institution for SMEs, risk financing Venture Capital and Mezzanine (fund of funds) Structuring and Guaranteeing portfolios of SME Microfinance loans/leases and equity Authorised Capital 3bn EIB: 62% EC: 29 % Fin. institutions: 9 % To be issued: 1% Staffing, Culture and Values Leading-edge modern institution Adapting to changing market conditions Attracting talented staff High standards of compliance and integrity
Measuring returns in Private Equity 2

Geographic Focus / Intermediaries EU 27, EFTA, Candidate Countries

PE market landscape
VENTURE CAPITAL BUYOUT & MEZZ PUBLIC EQUITY

Tech transfer, incubators

Seed Stage

Start-up Stage

Expansion Stage

Buyout & Mezzanine

Public to Private & PIPEs

Early stage

Later stage

Public equity

Broad landscape but not in all countries/regions.

Measuring returns in Private Equity 3

Success Stories Funded by EIF

Measuring returns in Private Equity 4

Private Equity Return and Risk vs. Other Asset Classes Using Public Indices
Annualised Statistics (1993-2010) FED ESTX SP500 RU2000 NASDAQ JPMUSB MSCIW LPX50TR LPXETR LPXVTR
* Bloomberg data to 31 November 2010

Asset Class US Risk Free European Stocks US Stocks US Small Caps US Technology US Inv.Gr. Bonds World Stocks Global PE & VC European PE Global VC

Mean 3.60% 5.71% 6.96% 8.50% 10.66% 5.89% 5.45% 9.90% 10.63% 6.45%

Std. Dev. 0.00% 19.53% 15.67% 20.14% 25.30% 9.91% 15.55% 25.04% 21.60% 29.18%

Sharpe N/A 0.11 0.21 0.24 0.28 0.23 0.12 0.25 0.33 0.10

Federal Funds Target Rate US Euro Stoxx 50 Pr S&P 500 INDEX RUSSELL 2000 INDEX NASDAQ COMPOSITE INDEX J.P. Morgan U.S. Aggregate Bond MSCI WORLD LPX50 Total Return LPX Europe Total Return LPX Venture Price Index

Return potential: the primary benefit of Private Equity is return enhancement. Based on listed Private Equity indexes, Private Equity is a high return asset class, with a high Sharpe Ratio but it is also high risk. However, because Private Equity is by definition an unlisted asset, listed Private Equity may not be adequately representative. Private Equity data are in general of poor quality and cannot be easily compared to public equity (or other asset classes) without modifications and biases corrections. Based on historical data, available research does not draw definitive conclusions of the over or under-performance of Private Equity vs. public equity.
Measuring returns in Private Equity 5

Private Equity Return Fund Cash-flows and Residual Values

2,500 2,000 1,500 1,000 500 0 -500 -1,000 -1,500 1 2 3 4 5 6 7 8 9 10 11

Distributions

NAV

Paid-ins
Year

Private Equity Funds normally have during their first years negatives cash-flows, i.e. Draw-downs or Paid-ins, followed by positive cash-flows, i.e. Distributions or Reflows and, when the Fund is not yet liquidated, its remaining value, i.e. the NAV (or Fair Value) which is used as a terminal positive cashflow to measure the Fund performance.
Measuring returns in Private Equity 6

Private Equity Key Performance Measures

IRR - Internal rate of return - measures the efficiency In a Private Equity fund, the net return earned by investors from the funds activity from inception to a stated date. The IRR is calculated as an annualised effective compounded rate of return, using monthly cash-flows and annual valuations. TVPI - Total Value to Paid-In - measures the effectiveness TVPI is the sum of the DPI and the RVPI. TVPI is net of fees and carried interest. This is also often called the multiple. DPI - Distribution to Paid-In measures the paid (i.e. certain) portion of the effectiveness A measure of the cumulative distributions returned to the limited partners as a proportion of the cumulative paid-in capital. DPI is net of fees and carried interest. This is a relative measure of the funds realized return on investment, also often called the cash-oncash return. RVPI - Residual Value to Paid-In measures the unpaid (i.e. uncertain) portion of the effectiveness A realisation ratio which is a measure of how much of a limited partners capital is still tied up in the equity of the fund, relative to the cumulative paid-in capital. RV/PI is net of fees and carried interest. This is a relative measure of the funds unrealized return on investment.
Source: EVCA Glossary.

1 IRR 1 IRR
i 0 i n n

CFi

NAVn

TVPI n DPI n RVPI n

DPI n

Dist
i 0 n i 0

Paid in
NAVn

RVPI n

Paid in
i 0

Private Equity performance is traditionally assessed using one of the four measures mentioned in this slide. Each measure has its merits (e.g. assessment of the efficiency), but each also has its drawbacks (see next slides). Normally performance is best measured net of fees and carried interest but gross performance are also normally reported. The IRR (Flows) and XIRR (Flows, Dates, Guess) functions of Excel make it easy to calculate an IRR.
Measuring returns in Private Equity 7

Limitations of The Key Performance Measures

Private Equity classical performance measures (IRR, i.e. cash-flow-weighted rate of return) differ from the measures traditionally used for other standard asset classes (time-weighted rate of return or TWRR), making not only comparisons but also portfolio construction more difficult. In mutual funds, the investor is responsible for the timing of cash additions and withdrawals, with an immediate and full change in exposure. This makes the TWRR more relevant. In Private Equity, the GP is responsible for calling and distributing capital with a delayed and partial change in exposure. This makes the IRR more relevant. The only ways to make the IRR and the TWRR comparable is to revalue the investment at the time of each cash-flow, which in the case of Private Equity is proven to be problematic or to use the Public Market Equivalent approach. The IRR, which may have multiple correct mathematical solutions, makes a reinvestment assumption, which in some cases may not be realistic and if removed may have a significant impact on the total program return. Between the inception and the termination of a Private Equity fund, its interim returns follow the socalled J-curve pattern reducing the relevance of early performance figures (see slide #10).

The best suited performance measures for Private Equity funds (i.e. IRR) make direct comparison with other asset classes (normally measured with a TWRR) and portfolio construction difficult.
Measuring returns in Private Equity 8

Reinvestment Assumption - Modified IRR

Modified IRR: IRR calculated taking into consideration the investors cost of capital and reinvestment opportunities. The modified IRR removes the assumption that positive cash flows are reinvested at the same rate of the fund that generated them. Fund 7: Net IRR=164.9% TVPI=2.6x Assumptions
20,000,000

Cost of Finance = 5% Reinvestment Opportunity=12%

15,000,000

10,000,000

Fund 4
Net IRR = -15.9% Modified IRR = -8%

5,000,000

0 1 -5,000,000 2 3 4 5 6 7 8 9 10 11 12 13

-10,000,000 Paid-in in EUR Distributed in EUR

Fund 7
Net IRR = 164.9% Modified IRR = 19%

Fund 7: Net IRR=164.9% MIRR=19%

90,000,000 80,000,000 70,000,000 60,000,000 50,000,000 40,000,000 30,000,000 20,000,000 10,000,000 (10,000,000) (20,000,000) PV of Negative Cash Flows FV of Positive Cash Flows 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Fund 9
Net IRR = 33.3% Modified IRR = 20%

Measuring returns in Private Equity 9

J-curve
Classical fund performance J-curve
15% 10%

300 275 250 225 200 175 150 IRR % 125 100 75 50 25 0 -25 Q0 -50 -75 -100 Q4

Real fund performance J-curves

5%

IRR

0% 0 1 2 3 4 5 6 7 8 9 10

-5%

Q8

Q12

Q16

Q20

Q24

Q28

Q32

Q36

Q40

Q44

Q48

Q52

-10%

-15%

J-curve: the curve generated by plotting the returns generated by a private equity fund against time (from inception to termination). The common practice of paying the management fee and start-up costs out of the first drawdowns does not produce an equivalent book value. As a result, a private equity fund will initially show a negative return. When the first realisations are made, the fund returns start to rise quite steeply. After about three to five years the interim IRR will give a reasonable indication of the definitive IRR. This period is generally shorter for buyout funds than for early stage and expansion funds. Source: EVCA Glossary. The classical fund performance J-curve is also caused by the fact that valuation policies followed by the industry and the uncertainty inherent in private equity investments allow revaluing upwards promising investments quite late in a funds lifetime. As a result private equity funds tend to demonstrate an apparent decline in value during the early years of existence the so-called valley of tears before beginning to show the expected positive returns in later years of the funds life.
Measuring returns in Private Equity 10

Years

Quarter

Performance of Portfolios of Funds

Portfolio performance = aggregation of the ones used for the funds (IRR, TVPI, DPI or RVPI) according to one of the following method:
Average IRR: The arithmetic mean of the internal rates of return (IRRs). Source: EVCA Glossary. Median IRR: The Value appearing halfway in a table ranking funds by IRR in descending order. Source: EVCA Glossary. Capital weighted IRR: The average IRR weighted by fund size. Source: EVCA Glossary. Pooled IRR: The IRR obtained by taking cash flows from inception together with the Residual Value for each fund and aggregating them into a pool as if they were a single fund. Source: EVCA
Glossary.

Time-Zero IRR: a pooled IRR calculated assuming that all the investments start at the same date. The Time Zero IRR is used to prevent the order of investments from affecting a portfolio IRR.

Measuring returns in Private Equity 11

Portfolios of Funds Pooled vs. Time-Zero IRR

Fund 4: Net IRR=-15.9% TVPI=0.4x
16,000,000 14,000,000 12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 0 -2,000,000 -4,000,000 -6,000,000 Net Cash Flow 2003 2004 2005 2006 2007 2008 2009 2010

Fund 7: Net IRR=164.9% TVPI=2.6x

16,000,000 14,000,000 12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 0 -2,000,000 -4,000,000 -6,000,000 Net Cash Flow 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

*Rebased to Eur10m commitment as Fund 7

Pooled Net IRR Funds 7;4=162.3%

16,000,000 14,000,000 12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 0 -2,000,000 -4,000,000 -6,000,000 Fund 7 Fund 4 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 16,000,000 14,000,000 12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 0 -2,000,000 -4,000,000 -6,000,000 1 2

Time 0 Net IRR Funds 7;4=56.3%

10

11

12

13

Fund 7

Fund 4

Measuring returns in Private Equity 12

Private Equity Key Risk Measures - Risk vs. Uncertainty

Economists typically differentiate between risk and uncertainty. Risk exists when a probability based on past experience can be attached to an event, whereas uncertainty exists when there is no objective way to determine its probability. In large public markets, access to information tends to be better and more uniform, and therefore uncertainty tends to be lower and practically the same for all participants.

In Private Equity markets, beyond risk investors are exposed to different degrees of uncertainty, which for some of them (see next slide) is quite significant and therefore cannot be ignored.
Measuring returns in Private Equity 13

Private Equity Key Risk Measures - Risk vs. Uncertainty (Contd)

Venture Capital funds target new or recently created companies, often operating in the new economy. Therefore, as less or no data exist, investors are rather exposed to uncertainty than risk. Buyout funds target established companies, often operating in the old economy. Therefore, as data exist and companies are closer to public markets, investors are rather exposed to risk than uncertainty. Portfolio diversification will help to reduce both risk and uncertainty, but while the improvement can be measured for risk, the final uncertainty level will remain by definition unknown.
R&D

True Uncertainty Uncertainty (not measurable)

Public markets

Innovation

Risk
Founding of company Seed

( measurable ( measurable uncertainty ) uncertainty )

Early stage Expansion

Mature company Buyout

Measuring returns in Private Equity 14

Private Equity Key Risk Measures How to Measure Risk?

For standard asset classes the historical (or implied) volatility of time-weighted return is often used to assess (future) risk. But, Private Equity return measures (cash-flow-weighted) differ from the ones used for standard asset classes. Alternatives are:
Volatility of NAV, but this measure has limited relevance due to valuation issues. Volatility of quoted proxies (e.g. publicly quoted private equity vehicles or indices), but may not be always representative of the private equity portfolio held by the investor and may pose idiosyncratic risks that are in addition to the risks incurred by the portfolio held. Terminal wealth (i.e. final TVPI or IRR) standard deviation is commonly used. Capital risk: P(IRR) 0% or P(TVPI) 1.0. Return risk: P(IRR) or P(TVPI) Target return. Value at Risk (VaR). Measure portfolio concentrations by key risk dimensions/sources, e.g. by quality of fund managers, operational status, stage focus, vintage year, geography, industry sectors, or currencies.

It is important to not only measure risk but also to track its changes.

Measuring returns in Private Equity 15

The Risk Profile of Private Equity US VC Investments

30%
P R O B A B I L I T Y (of a multiple occuring)

30% of direct investments are total losses! 25% Fund-of-funds is highly centered around the mean and has no probability of total loss.

20%

15% Fund is less skewed and wide spread. 10% Extreme profits for direct. Healthy profits for fund.

5%

0% 0 1 2 3 4 5 and more
M U L T I P L E (received divided by invested or return)
Direct Fund Fund-of-Funds

Copyright: Weidig and Mathonet 2003 Sources: VentureXperts, Cochrane

This chart represents the return (multiple) distribution for direct (blue), fund (red) and fund-of-funds (green) Venture Capital investments. The fund (i.e. portfolios of one fund) and the fund-of-funds (i.e. portfolios of 20 funds and investment period of four years) were obtained using a the Monte Carlo simulation. The main conclusions are mentioned on the chart.
Measuring returns in Private Equity 16

The Risk Profile of Private Equity Main US & EU U.S. funds European funds Markets
Linear (U.S. funds) Linear (European funds)

2.5 2.4

US Funds
Seed/Early Stage

2.3 2.2

Average multiple

2.1 2.0 1.9 1.8 1.7 1.6 1.5 0.0 0.5 1.0

Buyouts Balanced Later Stage

Balanced

EU Funds
Mezzanine Buyouts Early Stage
1.5 2.0

Later Stage
2.5 3.0 3.5

Source: Mathonet & Meyer (2007)

Standard Deviation

This chart represents the average return (multiple) vs. its standard deviation for Private Equity funds by geography and stage focus. These results were also obtained with a Monte Carlo simulation but using a more recent data set. The results show a classic risk-return relationship in the US market, but more puzzling results for the EU market highlighting the historically challenging Venture Capital segment in Europe. Note that, as for previous results, these are based on historical data and investors should based their decision on future expectations.
Measuring returns in Private Equity 17

How To Measure Private Equity Allocations?

Beforedescribingtraditionalallocationtechnique,itisimportanttofirstdiscuss howtomeasureaninvestorsexposureinregardtoPrivateEquityfunds. Therearefourmainoptions:
Commitment NAVplustheundrawncommitment NPIplustheundrawncommitment NAV

TheNAViffairlyvaluedistherightmeasureofwhatisexposed tomarketrisks, butarefundsfairlyvalued? Theundrawnnotyetbeingpaidinisnotexposedtomarketrisks,buttospecific fundrisks(e.g.qualityofthemanagerormarketinefficiencies,suchasoveror underpricing).

NAV plus the undrawn commitment is often used as a measure of exposure by Private Equity practitioners and by regulations such as Basel II. Traditional allocation techniques (see slide #20) are based on market values and as these are not observable for PE the NAV is used as a proxy.
Measuring returns in Private Equity 18

How To Reach a Private Equity Allocation?

Amount Distributions

Re-investment Target allocation

Constant allocation to Private Equity funds

Typical fund-of-funds

Based on Matter (2005)

Years

Private Equity funds are self-liquidating, i.e. exposure is naturally reduced over time. This combined with the denominator effect, makes it challenging to reach and maintain a target allocation and therefore also portfolio construction.
Measuring returns in Private Equity 19

Traditional Investment Allocation Techniques

Strengths
Mean-Variance (or Markowitzs Modern Portfolio Theory MPT) Resampled Efficient Frontier Black-Litterman Identifies portfolios with the highest expected return at each level of risk and Sharpe ratio. Easy to implement, widely understood and accepted. More stable than traditional Mean-Variance. Portfolios tend to be better diversified than traditional Mean-Variance. Produces stable efficient frontiers and well diversified portfolios.

Limitations
Can yield under-diversified portfolios. Due to issues with access to information and valuations, forecasting future risk and return metrics for Private Equity is particularly challenging. No theoretical support. Same as MPT although less severe. Relies on historical standard deviation and covariance. Requires knowledge of each assets weight in a global index. No such index exists which would include a Private Equity allocation. Can be complex to implement. The output is only as accurate as the inputs, which is a challenge when dealing with Private Equity due to limited access to information and valuation issues. Not based on sound investment theory. Few investors have been active in Private Equity for decades, but probably still the best suited for Private Equity.

Monte Carlo Simulation

Overcomes the static nature of the typical MPT analysis. Can be used to calculate the probability of meeting liabilities. Incorporates decades of asset allocation experience. Easy to implement.

Experienced Based

Measuring returns in Private Equity 20

Modern Portfolio Theory (MPT) Private Equity Limitations

ModernPortfolioTheory(MPT)suggeststhatforefficientmarkets allocationchoicesaresimple. Investorschoosetheappropriatecombinationoftheriskfreeassetand themarketportfoliothatisinlinewiththeirlevelofrisktolerance. Problems:
UnderlyingassumptionsdonotholdforPrivateEquity(seenextslide). LackandnatureofdatainPrivateEquitymakesitdifficulttomeasure(orrather assessexpected)risk,returnandcorrelationasdoneforotherassetclasses. PrivateEquityilliquiditymakesitdifficulttoadjusttheallocation. Limitedscalability largeinvestorsmaynotfindsufficientPrivateEquityfundsto deploylargeallocationsandsmallinvestorsmayhavedifficulty creating sufficientlydiversifiedportfoliosduetohighminimumticketsizes. Difficulttogetaccesstohighperformingfunds expectedreturnmaydifferfrom oneinvestortotheotherandaveragemarketstatisticsmaynotbe representativeoftheinvestorsaccessiblemarket.
Measuring returns in Private Equity 21

MPT Assumptions
TheframeworkofMPTmakesmanyassumptionsaboutinvestorsand markets(see http://en.wikipedia.org/wiki/Modern_portfolio_theory#Assumptions). ManyofthemdonotholdforPrivateEquityassets:
Assetreturnsarenormallydistributed(seeslide#16). Allinvestorshaveaccesstothesameinformationatthesametime(i.e.efficient markets) WhiledisclosuretoinvestorsinPrivateEquitycanbehigh,disclosure tothenoninvestorsisverylimitedorinexistent.Furthermore,notallinvestors haveaccesstoallPrivateEquityfunds(e.g.oversubscribedfundsorsimplynot knowingtheexistenceofsomefunds). Allsecuritiescanbedividedintoparcelsofanysize forPrivateEquityfractional sharesusuallycannotbeboughtorsold. Allinvestorsaimtomaximizeeconomicutility inPrivateEquitysomeinvestors mayhavenonfinancialobjectives(e.g.publicinstitutionssupportinginnovation viaVentureCapitalinvestments)orindirectfinancialobjectives(e.g.abank investinginaBuyoutfundinordertoprovidetheleveragetotheportfolio companies).

Measuring returns in Private Equity 22

Allocations Within the Asset Class

Usuallyportfoliosareconstructedtopdown,bottomuporcombining thetwo. Atopdownapproachisstrategyresearchbased,i.e.wheretheinvestor focusesonstrategiesandthedeterminationofallocationranges. Thebottomupapproachisfundmanagerresearchbased,i.e.wherethe emphasisisonscreeningallinvestmentopportunitiesandpickingthe bestmanagers. Whileappearingtobeeachothersopposite,thebottomuporatop downapproachesarecomplementaryandarethereforetypicallyusedin tandem.

Measuring returns in Private Equity 23

The Combined Approach

Followingabottomupapproach,investorswillidentifytheirwishlistoffund managersandthereforearesultingallocation. Followingatopdownapproach,investorswilldeterminetheirwishedallocation. Thenthewishallocationhastobecomparedtotheresultingone andtradeoffs havetobemadeinordertodeterminetheportfoliostructure. Finally,duringthemonitoringphase,monitoringfindingsshould beusedtofeed boththetopdownandbottomupapproaches.

Measuring returns in Private Equity 24

The Top Down Approach (Contd)

Attractivefeatures
Enhancetheportfolioreturnbyallocatingresourcestothenextbig thing (e.g.cleantech). Sanitychecktoavoidhypes,(e.g.toomuchcapitalinvestedinatoo narrowsectorortoohighvaluations). Improvetheefficiencyoffrontofficeresourcesbyfocusingonmost interestingmarketsegments.

Potentialproblems
Complex,difficulttoimplement(seeslide#21 onMPT). Strictallocationsarenotpossibleinrealityas:
Somequalitymanagersmaynotexistforsomewishedallocations. Somequalitymanagersmayexistsforunwishedallocations.
Measuring returns in Private Equity 25

The Bottom Up Approach (Contd)

Attractivefeatures
Thebottomupapproachissimple,easytounderstandandrobustbeing basedonranking. Enhancesportfolioreturnbyconcentratingonthehighestalpha fund managers. Controlforriskbysufficientnumberoffundmanagersandmaximum perfund/manager(e.g.minimumof20funds/managersandmaximum 10%perfund/manager).

Potentialproblems
Canleadtounbalancedportfolios(e.g.toomuchmegabuyouts). Canmissmacroeconomicchangesoropportunities(e.g.cleantech).

Measuring returns in Private Equity 26

The Impact of Diversification on Risk (Contd) Diversification Benefitsventure capital funds and Limitations Portfolio of US
100 90 80

Index (1 fund = 100)

70 60 50 40 30 20 10 0 1 2 5 10 15 20 25 30 40 50

Number of funds in portfolio Standard deviation Source: J Curve exposure, Mathonet & Meyer (2007). Skewness Kurtosis

The figure above shows the evolution (basis 100 for a portfolio of one fund) of the standard deviation, skewness and kurtosis of US VC funds portfolios composed of 1 to 50 funds. As illustrated by the figure above, based on the standard deviation, with about 20 positions, most of the diversification benefits for a specific risk dimension are obtained.
Measuring returns in Private Equity 27

Market timing versus cost-averaging

European PE funds pooled IRR by vintage year
50% 44% 40% 31% 30% 22% 19% 10% 20% 16% 12% 7% 7% 6%
Funds within J-Curve Period

Pooled IRR (%)

20% 12.8% 10% 14%

17%

0%
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

-1%

2006

2007

-2%

2008

-10%

-6%

-5%

-20%

Source: Thomson Reuters VentureXpert database. Performance to Q4-2010.

-30%

Recession

Non-recession

This chart above represents the pooled by vintage year (VY) for European PE funds (e.g. VY 1991 has a pooled IRR of 12.8%). Recession (non-recession) VY have been defined as year during which the EU GDP growth was below (above) the average GDP growth during the observation period. This chart suggest a market timing opportunity, i.e. PE investments made during downturns have generated superior performance.
Measuring returns in Private Equity 28

Market timing versus cost-averaging (contd)

European PE Fundraising and Investment Actitivity (Eur bn - left scale) Vs. Vintage Year Pooler IRR Performance (right scale)
120 25%

100

20%

15% 80 10% 60 5% 40 0% 20

-5%

0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Q3 2010*

-10%

Latest update as of March 2011

This chart above represents the same performance data as the previous chart (yellow line) complemented by the yearly fundraising and investment activities in European PE funds. This illustrates that it is difficult to time the market and that most investors and GPs got it wrong, increasing (decreasing) their investment during relatively weaker (stronger) vintage years. This, complemented with the facts that 1 a fund commitment is an exposure for the next 10-12 years and 2 that the quality of projections significantly decrease with the increase of the projection horizon, explains why investors generally favour time cost-averaging over market timing.
Measuring returns in Private Equity 29

Fundraising

Investments

Vintage Year Pooled IRR Performance

Fundraising (Trendline)