The Myners Review of institutional investment has increased discussion regarding the role of the institutional investor in private equity. If, as expected, the report favours increasing the institutional exposure to this asset class then it is important that institutional investors understand, and are comfortable with, the various performance indices.
Firstly, the illiquid nature of a private equity investment means that the institutional investor must accept a longer-term time horizon before realising those returns. However, private equity funds do provide interim valuations of their portfolios, following British Venture Capital Assocation (BVCA) and European Venture Capital Association (EVCA) valuation guidelines. Therefore it is only fair that returns on private equity be measured against other asset classes over a more realistic time period.
A recent BVCA performance measurement survey demonstrated that as an asset class private equity out-performed the UK, Europe and world indices (see chart).
A more in-depth analysis of the figures will show the institutional investor the private equity segments which are longer-term plays (start-up funds) or shorter-term plays (pre IPO funds), the risk return profile of each fund being different. Indeed, just as an institutional fund manager has a plethora of fund types to invest in so he will have a similar choice in the private market. Similarly, he can choose between those funds that provide an element of ongoing income and those that provide capital growth. As most funds are limited partnerships it may make for interesting and more flexible tax planning on the part of the institutional investor.
A question frequently asked is whether internal rate of return is the best measurement of private equity fund performance. The answer is probably yes. IRR as a measurement tool is understood by the financial community and is a good measurement of performance over time. If private equity wants to take its position as a major asset class in the portfolios of institutional fund managers the performance measurement must confirm to accepted norms. There are experienced fund managers that look for an absolute return – that is, a multiple of money invested. However, they already have a good handle on the time horizons the private equity fund is working to and in reality they are looking for the same returns as fund managers who track IRR indices.
Where we are looking at a realisation the IRR calculation is objective, in that we are working with discrete numbers. The valuation of an unrealised asset is much more subjective. Interim fund IRRs follow the so called ‘ J-curve pattern’. That is to say that in the formative years of a fund the IRR is likely to be negative as the fund meets start-up cost, management fees and the write downs of any failed or poorly performing investments.
Investing in private equity funds can be more complex than investing in quoted funds. The time horizons are longer, you are often required to contribute to the start-up costs of the fund, management fees tend to be significantly higher in the private equity market and poorly performing investments tend to manifest themselves early on. Clearly, this is a complicated set of variables that needs a simple uniform method of performance measurement so that institutional investors with competing demands for their capital can quickly identify the private equity opportunities most likely to maximise their returns. Institutional investors are well versed in IRR calculations and it would disadvantage the private equity market if there was an alternative, though equally valid, performance measurement that was not readily understood by our fund providers.
Overall, private equity as an asset class has outperformed most of the quoted indices. This has been proved with reference to comparable performance measurements – that is, the use of IRR as a performance indicator.
George MacRitchie is head of investment at nCoTec Ventures in London