Measuring and Benchmarking Private Equity Performance

1 An EMPEA Professional Development Webcast Measuring and Benchmarking Private Equity Performance An EMPEA Professional Development Webcast with Capital Dynamics, HEC School of Management and Siemens Venture Capital Measuring and Benchmarking Private Equity Performance 1. An EMPEA Professional Development Webcast 11 March 2014. Upcoming EMPEA Events Save the dates . 12-15 May 2014: EM PE Week in Washington, 12 May 2014. 4th Annual Institutional Investors-Only Summit (by invitation only). EMPEA's Annual Members-Only Reception 13-14 May 2014. 16th Annual IFC/EMPEA Global Private Equity Conference Limited Partners-Only Breakfast (15 May). 15 May 2014: EMPEA's Fundraising Masterclass in Washington, , presented with the support of Debevoise & Plimpton LLP and MVision Private Equity Advisers Get the full details at 14-15 October 2014: EMPEA and FT Live Present EM PE Week in London 14 October 2014: Private Equity in Emerging Markets 2014.

2 15 October 2014: Private Equity in Africa 2014. Measuring and Benchmarking Private Equity Performance 2. Confidential An EMPEA Professional Development Webcast 11 March 2014. EMPEA FundLink Measuring and Benchmarking Private Equity Performance 3. Confidential An EMPEA Professional Development Webcast 11 March 2014. Presenter Ivan Herger Managing Director and Head of Solutions Capital Dynamics Measuring and Benchmarking Private Equity Performance 4. Confidential An EMPEA Professional Development Webcast 11 March 2014. Contents Measuring Performance Benchmarking Measuring Absolute and Relative Aggregate & Annual Returns A Concept for Measuring Risk: The PERACS Portfolio Risk Curve How to Empirically Identify 'Relevant Competitor Funds . Intuitive Validity of the Empirical Approach Hypothetical Example: Relevant Peer TVPI Benchmark Panel Discussion and Audience Q&A. Appendix Measuring and Benchmarking Private Equity Performance 5.

3 Confidential An EMPEA Professional Development Webcast 11 March 2014. Money Multiples Definitions DPI: Distributed to Paid In DPI = distributions / draw downs TVPI: Total Value to Paid In TVPI = (distributions + NAV) / draw downs Properties Easy to understand and calculate Buys you lunch . Doesn't give information about timing of cash flows Measuring and Benchmarking Private Equity Performance 6. Confidential An EMPEA Professional Development Webcast 11 March 2014. Taking Into Account Timing: Internal Rate of Return (IRR). Definition ! The IRR of an investment is the discount rate at which the net present value of the capital calls (negative cash flows) plus the net present value of the distributions (positive cash flows) equals zero Properties Annualized rate of return Accounts for the amount of money and the length of time it has been invested Early cash flows have a bigger influence than later cash flows Bigger commitments have a bigger influence than smaller commitments (for portfolios).

4 Doesn't buy you lunch . Measuring and Benchmarking Private Equity Performance 7. Confidential An EMPEA Professional Development Webcast 11 March 2014. Applications of IRR. Since inception IRR. Take all cash flows of a fund/portfolio since inception Treat the ending NAV as a distribution (portfolio is sold at NAV at the end). Calculate the IRR. Depending on ending NAV. Horizon return Chose a horizon, 5 years, 10 years Treat the initial NAV as a capital call (portfolio is bought at NAV at the start). Take all cash flows of a fund/portfolio between initial time and ending time Treat the ending NAV as a distribution (portfolio is sold at NAV at the end). Calculate the IRR. Depending on starting and ending NAV. Measuring and Benchmarking Private Equity Performance 8. Confidential An EMPEA Professional Development Webcast 11 March 2014. Periodic Return, Time Weighted Return (TWR). Calculation Treat the initial NAV as the initial value Treat the ending NAV as the end value Take into account interim cash flows by placing them at start, end or in between (Dietz).

5 Calculate return for the period Properties Simple analytic calculation Heavily dependent on valuations Compounding possible, but may be problematic Measuring and Benchmarking Private Equity Performance 9. Confidential An EMPEA Professional Development Webcast 11 March 2014. Why IRR Makes Sense for PE Fund Managers Fund managers of publicly quoted assets: periodic returns Average periodic return shows the average Performance over time, independently of the amount of assets under management Fund managers have no control over the cash-in (new investors) and cash-out flows (redemption) from the fund, so that IRR does not represent the manager's skill Private Equity fund managers: internal rate of return Timing of investments and divestments is a major component of the value generation with Private Equity investments and this does not get captured with periodic returns Investors have no control over the term of their investment Measuring and Benchmarking Private Equity Performance Confidential 10.

6 An EMPEA Professional Development Webcast 11 March 2014. Why Are You Benchmarking ? Direct comparison Compares the investments that were made to similar investments. Given a precise asset allocation, how good were the investment choices we made? . Opportunity cost comparison Compares the investments that were made to other possible investments (opportunity costs). If we had chosen a different asset allocation/commitment pacing/ticket size, what would our returns have been? Measuring and Benchmarking Private Equity Performance Confidential 11. An EMPEA Professional Development Webcast 11 March 2014. What Are You Benchmarking ? Single fund Fund of funds Portfolio Asset class Measuring and Benchmarking Private Equity Performance Confidential 12. An EMPEA Professional Development Webcast 11 March 2014. Direct Comparison With Peer Group Example KKR 2006 Fund, Performance as of September 30, 2013*: IRR , multiple: Peer group Performance (all US buyout funds with vintage year 2006): IRR Multiple Top quartile (75th percentile): Median (50th percentile): Bottom quartile (25th percentile): KKR 2006 is in the 3rd quarter for IRR (48th percentile), and in the 2nd quarter for multiple (50th percentile).

7 Application For single funds Source: quarterly Performance report of Washington State Investment Board, Measuring and Benchmarking Private Equity Performance Confidential 13. An EMPEA Professional Development Webcast 11 March 2014. Portfolio Replication Method randomly build similar portfolios from a database of single funds, replicate the portfolio Compute Performance of the replicated portfolio Benchmark own portfolio against distribution of Performance of replicated portfolios Example Top Quartile Second Quartile Large institutional investor, IRR: Third Quartile Bottom Quartile Top quartile: Replicated Portfolio Median: Bottom quartile: -> Institutional investor has a 2nd quartile portfolio (71st percentile). Application For fund of funds and portfolios Peer group: direct comparison: similar portfolios (same number of funds; for each funds same commitment size, geography, strategy, vintage year as in the portfolio). opportunity cost comparison: similar portfolios, with certain constraints relaxed ( keeping the commitment amounts constant, but relaxing the strategy allocation).

8 Measuring and Benchmarking Private Equity Performance Confidential 14. An EMPEA Professional Development Webcast 11 March 2014. Common Pitfalls Connected With Private Benchmarks Pooled vs. median Single fund benchmark vs. portfolio benchmark Gross vs. net Measuring and Benchmarking Private Equity Performance Confidential 15. An EMPEA Professional Development Webcast 11 March 2014. Public Market Equivalent (PME). Private Equity investment pattern is different from investments in public markets Direct comparison between Private Equity returns and public market returns not possible PME is a method to compare returns by building a public market investment with a Private Equity investment pattern Can be used for single funds, fund of funds, portfolios and the asset class as a whole PME (Bannock, Long, Nickels, Coller, Reyes). Invest into the public market whenever a capital call occurs Divest from the public market whenever a distribution occurs Compare ending NAV of Private Equity investment with value of public market investment Problem of shorting PME+ (Capital Dynamics).

9 Same as PME, but distributions are scaled such that the ending value of the public market investment is the same as the NAV of the Private Equity portfolio No shorting Measuring and Benchmarking Private Equity Performance Confidential 16. An EMPEA Professional Development Webcast 11 March 2014. PME Cash Flows Are Identical to PE, With the Exception of the Final NAV. 700. 600. 500. Same Distributions IRRPE = Cash Flows in USD million IRRPME = 400. 300 Different NAV. 200. 100. 0. 1998. 1999. 2000. 2001. 2002. 2003. 2004. 2007. 2008. 2009. 1994. 1995. 1996. 1997. 2005. 2006. -100. -200. Same Capital Calls -300. Source: Capital Dynamics, conceptual Measuring and Benchmarking Private Equity Performance Confidential 17. An EMPEA Professional Development Webcast 11 March 2014. PME+ Scales Distributions to End With an Equivalent Final Valuation 700. 600 Same NAV. 500 Different Distributions IRRPE = Cash Flows in USD million IRRPME+ = 400.

10 300. 200. 100. 0. 1998. 1999. 2000. 2001. 2002. 2003. 2004. 2007. 2008. 2009. 1994. 1995. 1996. 1997. 2005. 2006. -100. -200. Same Capital Calls -300. Source: Capital Dynamics, conceptual Measuring and Benchmarking Private Equity Performance 18. Confidential An EMPEA Professional Development Webcast 11 March 2014. Other Variants of PME. KS-PME. Calculate a multiple of future values (FV), FV of distributions / FV of capital calls Discount rate of each cash flow is the return of the public market during the same time period PME > 1 indicates a better than market Performance , PME < 1 is below market Used in academia Modified IRR. Invest the Private Equity commitment into the public market Pay capital calls by selling parts of the public market holding Reinvest distributions into the public market Compare return of blended (public market / Private Equity ) strategy with public market Measuring and Benchmarking Private Equity Performance Confidential 19.