Measuring private equity returns and benchmarking ... - BVCA

1 1 Measuring private equity returns and benchmarking against public markets Colin Ellis, University of Birmingham, Sonal Pattni, BVCA, Devash Tailor, BVCA, Executive summary private equity is still a relatively young asset class, with some unique characteristics. One feature is the very irregular timing of cashflows, and a consequence of this is that private equity relies on measures of returns that are not standard in other asset classes. As such, new investors can be unclear or unaware of the differences between the common methods for Measuring private equity performance and comparing it with returns from other asset classes. This paper sets out different methods for Measuring private equity returns that are commonly used in the industry and constructs aggregate indices for the UK asset class.

2 It also considers methods for comparing private and public equity returns and demonstrates the importance of considering cross$sectional variation between public and private equities. Keywords: private equity ; performance measurement; aggregation; public market comparison Acknowledgements We are very grateful to Mark Drugan of Capital Dynamics, members of the BVCA s Research Advisory Committee, and BVCA colleagues for their comments and advice. All remaining errors are our own. The views expressed in this paper are those of the authors and do not necessarily reflect those of the BVCA. 2 Contents Page no. 1. Introduction 2. Methodological discussion Key PE multiples Advantages and drawbacks of multiples The internal rate of return (IRR) Advantages and drawbacks of IRRs Modified IRR (MIRR) and isolated MIRR Aggregation issues Constructing PE indices 3.

3 Making comparisons with public markets The Public Market Equivalent (PME) method Short positions and PME+ Choosing the appropriate public index Correlation analysis: time series vs. cross section 4. Summary & conclusions References 3 4 4 6 6 7 10 12 14 18 18 19 20 21 25 26 3 1. Introduction A key concern for financial investors is deciding how to allocate their assets, or where to put their money. Central to this is the risk$reward trade$off that is offered by different asset classes. For mainstream financial assets, such as bonds or equities, measures of returns are relatively simple to construct and well$understood. The current or historical yield (and sometimes the expected yield) is fairly easy to calculate, although the ex-ante risk of default can be less clear.

4 Where possible, risk$adjusted measures of returns are often used. But gauging the financial performance of private equity (PE)1 funds is more difficult. Unlike bonds and equities, which have defined markets and good liquidity to enable investors to buy and sell assets, commitments to PE funds are typically held for long periods of time. Furthermore, the time profiles of the investments are very different. For bonds and equities, investors invest money at the point of purchase, receive regular dividends or coupons, and receive final proceeds at the point of sale. Depending on whether market prices have risen or fallen over time, the sale price could be higher or lower than the initial purchase price. Cashflows for private equity are rather more irregular. For instance, once an investor has made a commitment to a fund it may not be called upon for many months or years, but then will be called upon many times over the life of the fund at unpredictable intervals.

5 This irregular timing of cashflows between PE funds and their investors is one of the defining characteristics of the asset class. In light of these distinctions, Measuring PE returns requires a different approach to Measuring the performance of more traditional asset classes. There are two widespread measures in the industry, namely money or cash multiples and the so$called internal rate of return . Both measures have advantages and disadvantages, and have sometimes been criticised as unrepresentative of real returns . In addition, the comparison of PE returns with public markets can be fraught with difficulty. This paper contributes to this debate, first by describing and explaining the different measures of PE returns , and then examining the different weighting and aggregation approaches that are used to produce industry$wide estimates of returns .

6 We also construct indices of UK PE returns using data from the BVCA s Performance Measurement Survey (PMS). Finally, we examine the nature of cross$correlations between PE funds and public equity markets, highlighting some potential concerns with an aggregated time$series approach. 1 Throughout this paper, we use private equity to refer to the whole universe of private equity investments, notably including both venture capital and buyout investments. 4 2. Methodological discussion When Measuring PE returns , investors must consider a number of issues that also affect other asset classes. These include whether to look at gross or net performance ( once fees, and in the case of PE carried interest, are subtracted), and comparisons with the alternatives that are on offer.

7 However, in the case of PE, due to the irregularity of cashflows the standard time$bound return measures are inappropriate. In its simplest form, the buy$and$hold return on a zero$coupon bond would be given by: In the case of coupon$yielding securities, or dividend paying equities, the calculation becomes a little more complex. Coupons and dividends are typically assumed to be re$invested into the fixed$income security or equity at the prevailing market price when they are paid. However, the basic structure of the return calculation final cash returned as the numerator and initial investment as the denominator broadly remains the same. private equity , however, is somewhat different. Due to the irregularity of PE cashflows, and the lack of a genuine re$investment option, this sort of return calculation is not appropriate for the asset class.

8 Instead there are currently two widely accepted approaches for calculating PE returns . The first is to present so$called multiples , and the second is the internal rate of return (IRR). We will consider each in Key PE multiples Simply put, multiples are typically calculated as the ratio of cash paid out (also known as distributions) to total funds that the investors supplied to the PE fund manager (also known as draw downs or capital calls). The main disadvantage of this approach is that it does not consider the timing of those cashflows. Depending on the precise multiple used, unrealised returns may also be included in the calculation. There are three key measures of Distributions to Paid In (DPI) capital 2 Talmor and Vasvari (2011) offers a good guide to performance measurement, and indeed private equity more generally.

9 3 Another ratio, of Paid In to Committee Capital (PICC), measures the proportion of money that has been drawn down from all the funds that investors have committed. However, it does not measure returns . 5 The DPI simply tells us what proportion of money that has been drawn down by GPs has so far been paid back. If this figure were one, then investors would have so far received back exactly the same amount that they had initially paid. Typically, over the life of a PE fund, the DPI will start at zero, and gradually rise as the fund matures. As such, the DPI is not a good measure of returns in two situations. The first is where the fund is not yet at the end of its life as, by definition, this measure of returns excludes all unrealised returns ( the value of equity stakes and other instruments in unsold companies).

10 The second is where a fund has yet to invest all of its capital, which can result in an interim DPI that may be unusually volatile as early investments potentially exit and/or new money is drawn down. Real returns will even be negative in the short term, as fees are drawn before investments are made. Residual Value to Paid In (RVPI) capital The RVPI measures how much of a fund s return is unrealised, relative to the money that investors have paid in. This unrealised or residual value often referred to as a net asset valuation is subjective and may be calculated using a variety of methods. However, previous research suggests that there is little sign of systematic bias in valuations, at least for relatively mature funds (Ellis and Steer, 2011). The RVPI measure excludes any previous distributions the PE fund may have made, so again represents an incomplete picture of returns .