After the emerging markets, institutional investors are turning to venture capital, and more generally to private equity. Three avenues are open to institutional investors willing to invest in private equity. First, they can invest directly in individual companies. Secondly, they can become limited partners in a limited partnership, and thirdly they can buy shares of a fund of funds. One aspect that is often overlooked is related to the problem of performance comparisons particularly with regard to investments in limited partnerships.
In this context, a number of difficulties can be attributed to two factors. The first is the lack of market valuation of the investments. Investments are largely valued on the basis of the net asset value – which, however, is not easily determined given the leeway in structuring it. This creates serious and economically unjustified differences between the partnerships. These differences are important for the comparison of partnerships during their life. The second problem is that of determining the amount of capital invested. Unlike conventional investments, investors do not commit a fixed amount of capital from the start, nor does the repayment follow a pre-determined pattern. The actual capital flows in limited partnerships are far more complex.
The first basic difficulty is due to the fact that private equity is by definition an unlisted and highly illiquid investment, making a “fair” market valuation at any given point in time impossible. Only in the rarest of cases can performance calculations be based on profits realised. Therefore, the respective investments of the partnerships in individual young companies need to be appraised regularly and systematically (“net asset value”). Given the great imbalances in information between the investor and the general partner of the partnership, this question is of considerable importance. The venture capital associations have therefore stipulated the following basic rules:
p The valuation approach should be consistent over time.
p Investments must be valued prudently and verified by an independent party.
p Dilution by options etc must be taken into consideration.
p Also loans should basically be treated like shares.
p Any revaluation relative to the cost price of the investments may only happen if one of the following conditions is met: a third party is willing to pay a higher price in the context of a new financing effort; the net asset value of the company in question considerably exceeds the cost price; the company is making significant profits so that an industry-specific p/e ratio can be applied, taking into consideration the lack of market liquidity and the high vulnerability of the profits.
p A reduction in value should always take place if the operating results are considerably below the original plans, if additional difficulties have arisen which necessitate additional funding, or if a lower price has been obtained in a transaction with a third party. It is recommended to devalue in big steps, that is to write off 25%, 50%, 75% or the entire amount to avoid glossing over the valuations.
Those basic rules generally ensure a highly prudent valuation policy. But one needs to verify with regard to every partnership whether it conforms to those rules entirely, only partly or not at all. The resulting yield differences might be considerable. Additionally, it must not be forgotten that even such prudent valuation is no guarantee for the avoidance of further massive price concessions in the event that an investor discontinuing a partnership fast and at an untimely moment.
Even the application of the same rules by the partnerships to be compared does not in itself allow a comparison of the yields obtained. This is due to a further peculiarity of the market: an investor generally does not commit a fixed amount of money in a partnership but undertakes to commit a certain overall amount. The total sum is only drawn gradually. That leads to two problems: Firstly, it is not clear on which amount of capital to calculate the yield for a performance calculation. Should it be the amount committed or the amount drawn? Secondly, planning the investments becomes a more daunting task for the investor, since his limited partnerships will hardly ever call the entire commitment simultaneously. To optimise his yield the investor will thus need to establish an efficient cash management.
The most obvious choice for the capital basis is the amount committed. In signing the contract, the investor loses discretionary power with regard to this sum. It is not in his interest if a partnership only gradually calls the invested amount, causing him opportunity losses. It is therefore a hallmark of a good partnership for the entire commitment to be rapidly invested in excellent start-ups. If a partnership is slow to draw the amount the investor can place the amount not drawn on the money market. As said above, good cash management (‘over-commitment’) can considerably increase the actual amount invested. If, for example, it is known how soon and according to what pattern the partnerships in question invest and repay, an investor may enter commitments above the total capital to be invested. Yield calculations on the basis of the actual capital flows are therefore of great importance at least for those investors who have the possibility to actively manage the temporary excess liquidity described above. The following example serves to clarify the difference between those two calculation options.
Investor A has committed an amount of Sfr4m to each of two partnerships, B and C. Partnership B draws the first half (Sfr2m) immediately and the second half after two years (see table 1). After four years it repays the partner Sfr7m. Partnership C, however, only draws Sfr1m at once, another Sfr1m after one year, and never calls the remaining amount. It pays back Sfr4m after four years. The investor now faces the task of comparing the performance of the two partnerships.
To weight the inflows and outflows correctly the private equity industry often applies the internal rate of return (IRR) as a yield measure. The IRR is the average yield on an investment taking into consideration the inflows and outflows of capital and compound interest.
Table 2 reveals that partnership B shows a considerably higher yield than partnership C, taking the entire commitment (Sfr4m) as the basis of the calculation. Even the consideration of potential money market yields on the amount of money not drawn would not change the ranking. If the yields are compared on the actual cash flow basis, partnership C shows a higher yield, with 21.7%, than partnership B.
This means for the investor that partnership C has invested in more successful projects whilst being under-invested. The decision whether an investment in partnership B (without overlay) or in partnership C (with overlay) is more favourable thus depends upon the ability of the investor to successfully manage an overlay programme (ie, a commitment of more then 100% of the capital at hand).
A further difficulty needs to be addressed. If the extrapolation of historical yields in equity markets to the future needs to be handled with care, this is even more true with regard to the private equity segment. The difficulty here lies in the need to analyse carefully the underlying causes for the yields obtained and to question their predictive value. Thus, the success of a partnership greatly depends on its general partners who select and manage the individual projects. If a partnership relies on one single successful partner, this will lead to a considerable cluster risk. Carrying forward past yields into the future can then only be done with great caution.
A second source of problems often lies in the origin of the yields of the partnership, as the following example shows. Partnership D has achieved top yields, which stem, however, almost exclusively from one project. All other projects fared poorly. Partnership E has had fewer shortfalls and shows more evenly spread individual project yields. It goes without saying that historical yields of partnership D have a lower predictive value than those of partnership E, forcing the investor to calculate more prudently.
It has been shown that the comparison of performances of limited partnerships during their life can be difficult due to valuation problems. Even after the distribution of all results and the repayment of the capital invested, comparisons are still difficult to make since the appropriate basis for calculation, commitment versus actual capital flows, is not easily determined or depends on the actual context. The investor can avoid the dilemma of lower-yield money market investment resulting from uncalled capital if he, or his adviser, has sufficient know-how to establish a solid investment plan with overcommitments. He will have to take into consideration, for example, that seed money partnerships specialising in early company development draw money rather slowly and that partnerships in the MBO area generally proceed to relatively early repayments.
Hansruedi Scherer and Alfred Bühler are partners of PPCmetrics in Zürich

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