The private equity world
The private equity world sometimes moves at a different pace to the rest of the investment world. The European Private Equity and Venture Capital Association (interestingly still best know by the abbreviation of its old name – EVCA) has just published (in its mid- September newsletter) a summary of the results of its 2002 Annual Survey of Pan-European Private Equity and Venture Capital. The pan-European Survey of Performance from Inception to 31 December 2002 has also been published and again a summary of the results is provided by the EVCA in its newsletter. This latter independent study is undertaken, on behalf of the EVCA, by Thomson Venture Economics.
Albeit late, the figures still make interesting reading. However, the headline figure, which shows an overall 10.8% pooled net internal rate of return (IRR) for all stages of private equity from inception to the end of 2002 is somewhat misleading.
As one might expect, net returns vary considerably across different classes of private equity, from 4.9% in early stage to 12.9% in buyout. That, though, is only part of the story, as these apparently reasonable headline figures disguise more worrying median returns such as a return of 1.8% for all private equity funds (and as little as zero for venture funds).
Of course, private equity professionals always tell you to ignore medians and concentrate on upper quartiles. The latest figures confirm the warnings often given by consultants that private equity returns show a high dispersion by setting the upper quartile overall return at 12.2%. The dispersion of results shows across all asset classes, with buyouts showing a median return of 7.1% and an upper quartile return of 17.8%.
Shorter-term performance figures, not surprisingly, are unimpressive but that is to be expected, given the ‘J-curve’ effect. However, recent poor economic conditions have clearly not helped and must be held responsible for most of the negative return of 30.7% over last year for early stage funds.
This must be pretty depressing, though not unexpected, reading for all investors in the sector, especially as the median IRR for all early stage funds since their inception is zero.
I am sure, in the long run, that private equity can and will deliver, but there is no doubt that timing is important, sector selection significant and manager selection absolutely crucial. Unfortunately, without the right help it is difficult to see how the majority of pension funds have any chance of finding those fund winners for the future. It is therefore not a surprise that a large number of pension funds give private equity investment a miss.
But how can those pension funds brave enough to enter the arena find the private equity fund winners? A simple answer is use a fund of funds but the same question arises – can you find a good fund of funds? Or better still, can you find good funds of funds?
There are many traditional factors that a good consultant will look for in managers. Noel Grant of Watson Wyatt has summarised them as follows: logical process; clear competitive advantage; superior research; evolution of process; strong portfolio construction; transaction cost monitoring; talented and experienced people; small decision-making teams; depth of resources; cultural alignment, and a healthy staff turnover.
The way these factors are applied to private equity firms may not be the same as with traditional equity or bond management. Different considerations apply but it should help pension funds assess private equity or indeed any other alternative asset manager if these factors are considered. Remember past service performance on its own is probably just as irrelevant in assessing private equity managers as it apparently is in assessing traditional managers.
As John Shearburn of Goldman Sachs Private Equity Group says, there are real challenges with private equity data or, as he so succinctly puts it: “It’s hard to tell your boss how you are doing with your private equity assets.” Problems include the fact that assets are usually held at cost unless there is a new financing, bankruptcy or sale; reported valuations are not true economic values, and there is no ‘mark to market’ so one cannot reliably calculate periodic returns, volatility or true correlation. In addition, it is extremely difficult to benchmark such a highly varied asset class. One cannot really ‘buy’ the market or even see the opportunity set. Even if one could, transaction costs would be horrendous.
Clearly the private equity market is inefficient. Although statistics are poor there is no doubt that money can be made in the sector and not just by the private equity manager. Private equity managers may have made considerable sums from their expertise, but at least did so after putting their own money at risk – unlike the recently departed chief executive of the New York Stock Exchange. But that, as they say, is another story.