As you may know, PE use borrowed funds to buy companies, so typically these investments are riskier than the public markets and are mostly illiquid.
Private equity cash flows are typically described by the “J-Curve ”, with investments generally being made in years 1-5 (negative returns) and realizations generally occurring in years 4-11 (positive). The years when a partnership is closing to new investors are called vintage years.
But what about returns from PE investments? The returns are the excess IRRs or alphas.
Alpha is the increment to market rate that equates the out-of-pocket cost of the investment to the Present Value of its gross return. Studies have shown that PE excess IRRs are between 5-8%, even (and more particularly so) in a down economy.
Excess returns are calculated after correction for the leverage effect.
The IRR is the return (discount rate) that will equalize the present value of all invested capital with the present value of all returns, or where the net present value of all cash flows (positive and negative) is zero; CFi is the cash flow for period i (negative for takedowns, positive for distributions).
The targeted IRRs may hover around 25%, which can be a decent investment.
Benchmarks:
• Cumulative IRR
• Cumulative Realisation Multiples (DPI and RVPI, and their Sum)
• Time Weighted Return
• Investment Horizon Return
• Public Market Comparables – Index method
• DPI = Distributions / Paid-In Ratio, a.k.a. realized multiple
• RVPI = Residual Value / Paid-In Ratio, a.k.a. unrealized multiple
More on Alphas at Morgan Stanley, PE at K@Wharton
What makes for an attractive investment (in general) ?
1. Strong Brand Name: ("attractive portfolio of content and leading brands") - This corporate attribute is key from an exit opportunity perspective as well as an overall risk perspective. The lower the risk a company presents the more stable cash flows are likely to be and the more likely a beneficial exit is likely to be. Both components are critical for private equity deals and thus brands make a target that much stronger should these brands be highly recognizable and powerful.
2. Growth Profile (CAGR)
3. Opportunities for Multiple Expansion: ("highly scalable business ") Multiple expansion occurs when a company is worth 7.0 times EBITDA when first purchased (i.e. 7x TEV/EBITDA) but then 10.0x upon exit. The increase in multiples is driven by either increased growth, strengthening brand positioning, a decreasing risk profile, or all three in some combination.
4. Strong Management Team
5. Strong CFs
Recent trend: An increase in PE secondaries activity
This year we have seen an uptick in PE secondary market activity (PE-to-PE sales). Typically private equity firms hold onto companies for three to seven years. Sometimes, however, a PE firm will sell a portfolio company to another PE firm rather than hold on to it. According to Mergermarket this year so far there have been 38 of these so-called secondary transactions disclosed, with values totaling $28.9 billion.
FYI -- Private Equity returns: http://www.cambridgeassociates.com/pdf/Private%20Equity%20Index.pdf
I'm not convinced that the PE is producing excess returns (after fees). You can't calculate an alpha without calculating a beta (which are inherently unknown for PE since the assets are not publicly traded).
Furthermore, most PE firms employ some form of leverage, so it's very likely the higher returns are just due to higher betas.
Additionally, the fact that PE outperforms the most in down markets is not surprising, since assets are not marked to market. There's essentially a lagged effect to the realization of the fund's beta in their stated returns.
Statistical Alpha is typically not used to evaluated private equity. PE is indeed market-to-market since ASC 820. Yes, they are illiquid assets and more difficult to mark, but marking with comps has dramatically increased correlation with public markets. To generalize, buyouts are typically a leveraged play on the S&P benefitiing from the tail-winds of a bull market. This is not to say leverage is the only driver of value -- operational improvements have probably dominated in recent times, especially in middle market -- but an evaluation of returns has revealed this pattern.
Typically pe returns are quoted net of fees, as can be seen in the CA benchmarks above, and have certainly generated alpha. Timing PE strategies is of particular importance as a particular environment may be better for buyouts, distressed, growth...
PE is worth the illiquidity and risk if you can construct a portfolio of solid managers and time the right strategies, which many institutional investors have done successfully.
Schwartzman describes PE's sources of return as 1) Operational improvements, 2) multiple expansion, 3) leverage, and 4) paying down debt. As you can see leverage is only one of the ways PE generate returns.
Alpha is not a term normally associated with PE because, as mentioned, calculating betas is guesswork at best for PE funds.
Also, another common way of benchmarking PE returns is by comparing them to a representative peer group.
Howard Mark's, one of the greatest high yield investors, has IRR's around 19%, so 25% IRR is more than good. That is killing it. If you have a 25% IRR you are doubling your money ~ every 3 years which means that if a typical PE fund lasts 7 years you are getting 2.3x money. That is a homerun.
It is true that the median PE fund has historically under-performed public comps, however, top quartile funds do outperform public markets, hence the obsession with picking the best managers. Also, one has to be wary with using backtested data as it's likely to be unrepresentative of the industry as a whole. In general, alternative aggregate indices suffer from a number of biases that make generalizations difficult(self-selection bias, look-back bias, etc)
Timing PE returns is unlikely to be a useful exercise for most investors for 2 reasons. 1) It's incredibly hard to do, 2) manager selection matters much more than being in the right sector. This can be shown by seeing that the dispersion between top and bottom quartile mangers> dispersion between the median performance of different sectors.
Schwartzman describes PE's sources of return as 1) Operational improvements, 2) multiple expansion, 3) leverage, and 4) paying down debt. As you can see leverage is only one of the ways PE generate returns.
Alpha is not a term normally associated with PE because, as mentioned, calculating betas is guesswork at best for PE funds.
Also, another common way of benchmarking PE returns is by comparing them to a representative peer group.
Howard Mark's, one of the greatest high yield investors, has IRR's around 19%, so 25% IRR is more than good. That is killing it. If you have a 25% IRR you are doubling your money ~ every 3 years which means that if a typical PE fund lasts 7 years you are getting 2.3x money. That is a homerun.
It is true that the median PE fund has historically under-performed public comps, however, top quartile funds do outperform public markets, hence the obsession with picking the best managers. Also, one has to be wary with using backtested data as it's likely to be unrepresentative of the industry as a whole. In general, alternative aggregate indices suffer from a number of biases that make generalizations difficult(self-selection bias, look-back bias, etc)
Timing PE returns is unlikely to be a useful exercise for most investors for 2 reasons. 1) It's incredibly hard to do, 2) manager selection matters much more than being in the right sector. This can be shown by seeing that the dispersion between top and bottom quartile mangers> dispersion between the median performance of different sectors.
True.
Manager selection is paramount, if not the most important.
Let us remember that probably 10-20 % of your investments will make 80 % of your money. Illustration: we are told that 10 of roughly 67 major deals by Bain Capital during Mr. Romney’s stay at the firm produced about 70 percent of the firm’s profits.
All these funds market their double digit compounding IRRs over a decade or two, none of which is relevant in what is clearly a different and much more challenging market
Manager selection is much more important in VC than PE. Yes, it is important, but the market is much more competitive and efficient than it was in the early 2000's and in the '90s. An investor can perform relatively poor compared to peers but still be investing with top quartile clients because of bad vintage years. It is extremely difficult to time the maket, but you obviously need to be investing witht top quartile managers in strong vintage years as opposed to top quartile managers when the median return is ~
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