Modelling LP position in funds
Hi - Firstly, not sure if this is the correct forum, so please redirect if required. Posted here as assuming Hedge Funds take LP positions (which is why I haven't posted this in PE/RE/VC as the topics are focused on LBO's/Assets/Start-Ups)
I currently work in real estate investment, typically single asset and small portfolios and have this down in terms of underwriting/modelling.
However, we are going to look at taking an LP position in some smaller RE and VC funds and I am at a bit of a loss as to how to model them.
At a high level, the capital is going to be locked up for circa 5yrs, before possibility of distributions. In that time there will be the periodic fees, cap calls, tax etc.
Resultantly, How would you model an LP position? How simple/complex does it get, or really have to be? Given the risk exposure and unpredictability of something like VC, is the focus more on fund manager, track record and that kind of DD rather than plugging a million assumptions into model?
Any suggestions and guidance welcome!
Thanks
I don't think there are too many hedge funds buying these kinds of interests - but there's a universe of specialized private equity funds that buy them.
Step number 1 is to forecast the gross cash flows. Are these funds fully drawn? If so, you don't need to worry about capital calls, if not, you need to make an estimate of how much/when the remaining unfunded commitments will be called. You'll then need to forecast the distribution profile - the best way to do this can vary a lot depending on how much information you have on the underlying assets in each fund. But the general vibe is you want to try and estimate when each underlying investment will exit, and what MoIC it will exit at.
This is where the level of detail can influence things a lot - for example if the quarterly report gives you the NOI and LVR for an underlying real estate asset, you can use a cap rate for that market to estimate property value and then an equity value. And you'll need to know how the funds value their assets and what reference date the reporting is from - for example VC funds tend to hold their investments at the value of the last round that was raised, so right now the NAVs of those VC investments are massively inflated given the tech markets have sold off and the comps are down (because the valuations are stale).
Once you have forecast cashflows - you need to model a fund waterfall to account for the fees and carry. Again this depends on a lot on the individual terms of the funds you're looking at. But generally you want to forecast the management fees (noting that depending on how mature the funds are, the management fees can switch from being charged on committed capital to invested capital after the investment period ends), along with any other large fees/expenses charged by the GP (for example closed end real estate funds sometimes charge asset management/leasing/acquisition/disposal fees on top the management fees, whereas other funds will offset other fees against the management fee).
Then you'll need to look at the carry waterfall to determine who gets paid when, this can vary between funds, but the common order is (i) LPs get invested capital plus management fees paid back first, (ii) LPs get their hurdle return paid back second, (iii) the GP gets a 'catch-up' paid third, which brings the ratio of prior cashflows paid to GP/LPs back to intended ratio (i.e. if 20% carry, then the catch-up will pay the distributions to the GP until they are at a 80:20 split), (iv) cash flows are then paid out in line with the intended carry split.
The carry waterfall is a pretty important part to get right - because that can swing the IRR of your cashflow stream massively, especially the catch-up portion (because as an LP there becomes a long period of time where you don't receive any distributions as they all go to the GP). VC funds commonly have carry rates that increase if they achieve certain return hurdles (i.e. 25% carry if the MoIC is above 3.0x) - but just treat these as another level in the waterfall with another catch-up period.
Once you have your net of fees cashflow forecasts, you then either calculate an IRR based off your purchase price, or you back out a NAV you're willing to pay (by discounting the cashflows at your required rate of return). Prices are then typically quoted as a percentage of the current NAV, for example if the LP interest has a $100 NAV as of 30 June, and you're model calculates a price of $80, it's 80%.
If you're able to give any extra detail on the LP interests you're looking at - I might be able to be more specific?
That's helpful thanks. It's still a bit unclear to me the carry waterfall step following the LBO analysis at the portfolio level, once I get the exit values of the underlying portfolio companies. Is the calculation of the carry waterfall done one single time at a particular exit year starting from the sum of all the exit proceeds i.e. the sum of the fund's profits (calculated as the sum of all the exit equity values minus the sum of all the entry equity values per each portfolio company) or is it done at every single exit year based on the exited companies? I guess it must be the latter type of calculation cause I would need to have the various net cash flows as a stream across the fund's forecast period and then calculate the IRR or implied Price given a target IRR to get the implied NAV discount right?
So to summarise the steps to take in a LP-Secondaries case study scenario - please correct me if I'm wrong:
1. LBO Model of the underlying portfolio companies and find the Exit Values for each one of them
2. Carry Waterfall: Adjust the Exit Values for Mgmt Fees and Carry to get the Net Proceeds to the LP at the various exit years of the portfolio cos. Where management fees will be calculated as a % of AuM while Carry as % of Fund's Profit (in this case I would assume fund's profit = exit equity value - entry equity value for each portfolio company)
3. Use these values as the Fund's Cash Flow and discount to today at the target IRR
4. Calculate the Implied discount based on the Fund's NAV (which should be given as an assumption, or could be calculated if a BS of the fund is provided)
I guess in a case study scenario there won't be a lot of time to do several LBOs for lots of portfolio companies, so they might give you to do just one and then adjust/add the net exit value to the respective year Fund's Cash flows which will be given as assumption
thank you so much in advance!
Step 2 would depend on the fund terms that you're looking at. For example, typically a closed end fund will charge fees on invested capital not NAV (so for each portfolio company you need to know the invested capital of the investment (sometimes the management fee will also reduce following the end of the investment period - but a case study might not need you to go into that much detail).
But the carry is where it becomes quite complex, they will tell you if it is an American waterfall (where carry is calculated on a deal-by-deal basis) or a European waterfall (where carry is calculated on a whole-of-fund basis).
American waterfalls are fairly simple because you're just applying the carry rate to the exit proceeds (assuming the fund is above it's hurdle rate). European waterfalls are more complex because you need to build a waterfall that accounts for fund proceeds where LPs receive their capital contributions back first, then receive their preferred return second, then there will be a catch-up where the GP receives a higher share of the distributions (until the fund profits are split 80/20 or whatever the carry split is), and then lastly after that all distributions are split in-line with the carry. This can be quite tricky to get right, I'd suggest practice it a couple of times before you do a case study (the first time will probably take you a while to figure out, then once you get it going it'll become easy to do quickly).
Step 3 and 4 are correct - make sure you're using net cash flows and I would use the Fund's NAV (the balance sheet sometimes doesn't have LP specific adjustments).
Not sure what your interviewer will expect regarding LBO's on each company (will depend on the time you're given and the depth the firm normally goes into on their underwriting). You don't have much information on each company, so the LBO will be very simple (probably only ~50 rows, but it can be even less if you don't have much information or keep it efficient). Then once you have it done for one portfolio company, just use the same template for the others (the key assumptions you need are revenue growth, EBITDA margins and an exit multiple/date).
The other way to speed it up is to just do the large portfolio companies, for example if there are 20 portfolio companies and 10 make up 75% of NAV, you can just do those and apply a rough estimate of the MoIC and exit date for the others.
Perfect thank you so much for clarifying, that's really helpful. So when I get the Fund's Gross Cash Flow from the various portcos LBOs and/or exit assumptions I would need to deduct Management Fees - as a fixed amount every year as a % of the LP's Total Invested/Committed capital per each exit year used by the GP to buy portcos - and then run a Carry Waterfall for each year throughout the forecast right? Even if it was a European waterfall where carry is computed at the fund level, I would need to do that EU Waterfall for each year in order to have the stream of Net of Fees Cash Flows to the Fund to be discounted at the target IRR (if provided). At this point, I would use the LP's Total Invested Capital (the same figure used previously to calculate the Gross IRR out of the Fund's Gross CF stream) as a negative number and the stream of Fund's Net Cash Flows as positive numbers to calculate the Net IRR or the implied NAV discount at a target IRR. Is that correct?
Also, I had a few more questions please:
1) how would you deal with a scenario where you would need to value the LP stake and put a Price on it where there are several LPs committing to the Fund. How would you treat let's say a 15% stake owned by the individual LP you are trying to buyout? I guess it would only be a matter of multiplying the various exit values of the portcos by the specific LP stake (e.g. 15% in my example) and then summing these up for each exit year to get the Gross Cash Flows. Or is this done at the very end of the model, i.e. when you get the Fund's Net Cash Flow per each year, multiply these by 15% each year?
2) How would you deal with any unfunded portions of the LP commitments? Should this be added to the Total LP invested/committed capital in the calculation of both the Gross and Net IRR? Or is this valued at the end by using certain MoM assumptions and then summing it up to the price resulting from the NPV calculation done at the Fund's Net Cash Flow level? Should it be taken into account at all in terms of pricing the LP stake given it's not a CF generating item?
Sorry for the long form and thank you so much in advance for bearing with me !
That's right, once you have gross cash flows, you need to calculate the management fees (typically 2% of committed capital during the investment period, then often 1.75% or 1.50% of invested capital after the investment period ends). Not sure what you mean by fixed amount, it's a fee charged every year, and the amount varies across the life of the fund.
You then run the gross distributions through the carry waterfall. The easiest way to do a European waterfall would to set it up in the same way as you would for a debt schedule. (I.e. an opening balance, increases, decreases and a closing balance) But you would have four of them for the different levels of the waterfall, for example the first level would be capital contributions, which would increase as LPs pay capital calls and reduce as the LPs receive distributions, then once that level hits zero, there would be residual distributions that flow into the next level. The second level would be the preferred return, which increases each period by the hurdle rate multiplied by the invested capital (that hasn't already been returned to LPs), and would be reduced by distributions to LPs. Then same for the catch-up level. Then once you get to the fourth level all distributions are split between LPs and GPs in-line with the carry split (typically 80/20).
You've then got a breakdown of where all the cash flows go (and which ones go to LPs), so you can work out the net cash flows for LPs. This is then where you can do a couple of different things such as discount at a target IRR (which will give you an implied NAV/value for the LP interest), use the negative NAV as starting outflow and find the forward IRR of the fund or calculate an implied value and represent it as a % of the current NAV. All secondary buyers have slightly different metrics they look at, but it's all essentially the same thing just represented slightly differently.
For your first question, in practice it tends to be done on a fairly case-by-case basis, but both of the ways you mentioned could work. I would be surprised if they throw you anything to tricky here in a case study. But the common things that make a difference would be if the LPs have different fee rates (for example, some LPs will get fee or carry discounts for large commitments or being in the first close, but the rights to these fee discounts don't necessarily transfer if the interest is sold). Or another one could be if any of the LPs have elected to be excluded from certain investments, which would mean that LPs could have slightly different stakes in the portfolio companies (i.e. if one LP is excluded from investing in a portfolio company, they have no exposure, and all the other LPs can have a slightly higher weight to that company to make up for it).
For the second questions, some people will just apply a MoM assumption and back it into the price (which is fine if you're tight on time or the unfunded is relatively small). But more commonly you would forecast it out and make some assumptions about when you think the remaining unfunded commitment will be called, and what return it will generate. The thing to consider is how much uncalled commitment there is left, and if you have a sense of what it will be used for (i.e. it could be reserved for future management fees, follow-on investments in existing portfolio companies or investing in new portfolio companies).
Amazing that's super clear thanks a lot! So to clarify, please correct me if I'm wrong:
1. Fund's Gross Cash Flows are basically the sum of entry vs exit values of the portcos, respectively to each entry/exit year they are (as a simplification, thinking of it in a case study scenario). For instance, if the GP invested $1,000 in 2021 to buyout portco ABC, which exited in 2023 for $2,000 - then the Fund's Gross Cash flow would be (1,000) in 2021 and +2,000 in 2023. Is that right or I should only account for the profit of 1,000 in 2023? 2. With mgmt fees of -$20 each year from 2021 to 2023 (i.e. 2% of Entry value)
3. Carry waterfall - this will be laid out as a debt schedule throughout the various distribution levels as you clearly pointed out. This analysis will be done in each year of the forecast period to get the Net Cash Flows to the LP for each year in the forecast. Correct?
4. Unfunded portion - that's understood thanks a lot! When you say I could back it into the price, do you mean just adding it up to the NPV calculation based on its assumed MOIC? Assuming the unfunded is relatively small
Again thanks a lot for all this!
In question 1, for that example the second cash flow would be +$2,000 in 2023. And with the management fees, they would be 2% of entry value (invested capital) post-investment period, but if the fund is still in it's investment period the management fee would be charged on the committed capital (i.e. if the overall fund is $10,000, then it would be $200 for the whole fund).
Question 3 is correct. Just remember that if you're starting midway through the fund life, you'll need to find where in the carry waterfall the fund is already (assuming it's European). Most funds will give you the realized carry and the accrued carry in the capital statement or the fund financials, or else you'll need to start your analysis from the beginning of the fund life to find the current point (by inputting contributions/distributions from the beginning of the fund).
To back it into the price, you would typically assume a MoM and a hold period, which will give you an IRR. Then you compare that IRR to what you are underwriting to (plus you'll need to add the extra return to your MoM). So for example, if you assume they invest $100 and it returns 2x gross in 4 years, that would give you an 18.9% IRR, and if you were underwriting to a 16% IRR, if the contribution is a year after you start your forecast, by discounting those cash flows at 16% you'll end up with and extra $9 which needs to be added into your price (as the sum of the discounted cash flows). Then you add $100 to your investment, and $200 to your distributions which will change your MoM. Historically, secondary buyers have tended to put a low return on the unfunded (as they couldn't underwrite unfunded with much conviction), although given the current market people are placing a higher return on unfunded (although I think in a case study if you're conservative you'll be fine).
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