I received a great suggestion (thanks Etienne, from Preqin) to consider the J-Curve created by fund IRRs (opposed to the J-Curve created by net cash flows). This could apply to an individual fund or an aggregation of funds based on vintage year, fund size, etc.

Without thinking too deeply about it, using IRRs allows you to compare the J-Curves of multiple funds on a like-for-like basis. This is because IRR is a relative measure, whereas net cash flow is an absolute measure.

The accompanying chart (thanks again Etienne) plots the median IRR for each vintage between 2000 and 2008. However, due to this blog being stuck in the 1950s and sans colour, the chart is a little difficult to interpret. But, let me give it a try via narration.

The X-axis is year of operation and the Y-axis is IRR. The longest line obviously represents the 2000 vintage, since funds of that vintage have approximately nine years of performance data. But, rather than deciphering each line, let me divert your focus to a few high-level observations.

All vintages recorded negative median IRRs in the first year of operation. Most were still negative in the second year and by the third year, most were at 10%, which is quite respectable. Other than the 2000 vintage, all other medians were above 0% by year 3 and in the 15-30% range by year 4 (and they stayed there). The J-Curve effect is quite clearly represented, but not as protracted as the net cash flow J-Curve; it accelerates quickly and then stabilises.

The most surprising takeaway for me is that the median IRR for each vintage stabilises at quite a high level (approx. 20%) after only a few years of operation. While I acknowledge that these are median IRRs (hence, not representative of the performance you would receive from a dollar invested in a single fund), I still find it an insightful statistic. The data may become skewed with new financial reporting standards (I’m thinking FAS157), but if anything, we may see a more defined J-Curve from fund IRRs.

We all know multiples have fallen, and, we know that for most businesses, earnings have fallen too (see correlation vs causation: industry analysis if you’re hearing otherwise). But, the problem is that vendors don’t always have to sell and so it isn’t so easy to make cheap investments in a downturn. Sure, distressed businesses may not have a choice, but solid quality businesses often do have a choice and they can wait and trade back to previous levels before selling.

For vendors still eager to sell now (for whatever personal reasons), they seem prepared to take a haircut, but not always in the order of the buyer’s expectations. This raises an issue with the typical private equiteer. Do I pay the higher price because the business has traded very well for the past 5 years, or do I pass on the deal since the performance hit could be indicative of other problems? Maybe earnings will be back to $50m next year, but just maybe they’ll drop further to $10m and stay down there.

I don’t have any hard and fast answers, but I will say that great businesses can experience arrhythmias too. If due diligence (DD) on the business is favourable, it’s a great opportunity to get in at an unprecedented price. I’m the first to acknowledge private equity is all about risk mitigation, but there’s something said for buying a great business at an average price compared to an average business at a great price, especially when the average price would represent a great price in normal economic conditions.

We’re looking at three separate deals like this now, two in the States and one in Europe, and we’re currently pondering this very issue. The vendors want more than we’d normally pay for the latest earnings (and sure there’s some room for negotiation), but conceivably the most recent earnings don’t represent maintainable earnings. There’s great potential here, enough to make a material difference to fund performance, but there’s also a lot of risk, which is hard to stomach for an ultra-risk-averse firm.

How do all of these professions/careers/livelihoods fit together? A quick definition of each is as follows:

• Private equiteers - active financial investors in established businesses that use  gearing to amplify their returns and off-market strategies to grow their portfolio businesses (typically using M&A)
• Venture capitalists - active financial investors in earlier-stage (growing) businesses that use their contacts, prestige and experience to help businesses commercialise and monetise their concepts
• Bankers - deal originators and organisers; often the middlemen between PE deals and other M&A activity; mostly in the public arena, though some deals involve private companies exclusively 
• Entrepreneurs - the people with the imagination and the risk appetite to pursue ideas through to concept, then pursue their concept through to commercialisation and profit

I believe there is a closer connection between a) bankers and private equiteers, and b) venture capitalists and entrepreneurs. I say this because private equiteers spend a lot of time sourcing deals, just like bankers. Whereas, venture capitalists spend a lot of time short-listing deals (in which entrepreneurs have approached them) and are therefore much more concerned with the business concept (rather than the sale of capital). 

So what’s the implication of this? Well, it potentially explains what the ideal skills are for PE and VC firms. I’m not saying the best private equiteers are bankers, just that their skills are more suited to the role of a private equiteer compared to a venture capitalist. For venture capitalists, I believe it’s more important to have people with real entrepreneurial experience, not only to evaluate deals, but to help commercialise concepts. Comments welcome.

First off, a lot of private equiteers are resenting deals done at the peak of the market. The peak was characterised by abnormally high earnings and abnormally high multiples. Since both of these characteristics are inputs into price, the prices paid recently were doubly inflated. So, now many of us are trying to fix deals that represent retrospective multiples of over 10x earnings. 

Put that negativity to one side for a moment (which isn’t very easy in practice) and we have a market ripe for great deal-making. Earnings in many industries are at cyclical lows, multiples are also at cyclical lows, plus there are a few distressed sellers trying to sell good assets to support bad assets. All of this makes for great deals; it’s just a matter of managing this process while managing the rest of the portfolio.

With both of those points made, it’s a great time for newly formed funds that don’t have the baggage of underperforming investees. For the rest of us, I think it is crucially important to understand how valuable this landscape is for our funds. We’re all so worried about our current investees (and rightly so), but the opportunities available now could conceivably have much more impact on our overall performance. Just to make the point again, I’m not suggesting that we leave our existing investees to twist in the wind, just that we should not let once in a lifetime opportunities pass us by.

There’s a great opportunity now for private equity firms to differentiate themselves in their response to the current global economic unpleasantness. (I’m talking about the way we react to investee underperformance.) But, what is the right response? Is it to provide passive guidance and let the entrepreneurs do what they do best? Is it to seize control and implement a strict regime of cost cutting? Or, is it to be as profligate as ever and increase investment to flummox, bewilder and bemuse the competition?

The diplomatic answer is that it’s probably a little of all of the above. But, that’s not what you want to hear and it’s certainly not what I think is helpful.

For my investees, I believe it’s about keeping it simple and focusing on tangible results. In a high-level conceptual sense, it means ditching the bureaucracy, working within the bounds of the existing culture and empowering people to create and share positive outcomes. On a lower-level tactical plane, it means being disciplined about granular financial monitoring, it means attacking problems with pragmatic solutions, it means keeping abreast of opportunities in depressed markets, and it means being honest with oneself about what is essential spending and what is profligacy. 

I’m a strong believer in building great companies first and watching shareholder value grow as a result, not the other way. So, let’s throw the idea of shareholder value out the window for the moment and commit to building great companies, built to last (as Jim Collins would say).

If I personally purchased a business as an investment, for wealth creation and as some sort of plan to create passive income, I would want to know it inside-out. I would hope to have access to every scintilla of data available, and even the data unavailable. I would expect to know the people personally, to know the advisors (finance, legal, etc) and be able to recite the key drivers of the business and their latest metrics. This isn’t an obsession, it’s just par for the course considering the obvious consequences of relinquishing control of such an important asset.

I attended a private equity conference recently and spoke with a number of general partners, mostly just idle chatter, but also a tête-à-tête or two on the topic of investees. I was somewhat startled to hear GPs forgetting the name of their investee’s CFO, or not knowing whether revenue last year was $300m or $400m, or not being sure whether an investee has an online e-commerce presence. There could be many reasons for this; I just hope it’s not a sign of what’s to come. By this, I mean private equity continuing the trend along financial engineering and not doing much for the long-term value of companies with a lot of potential.

Most private equity firms look to invest in only 7 to 10 portfolio companies over the 10-year life of each fund; fewer portfolio companies means more value-add per investee (a resource allocation argument). Keeping this in mind, it is quite important that each investment represent a great opportunity. One failed investment won’t necessarily bring the whole fund down, but it may materially impact overall returns. So, how speculative is investment selectivity?

When a private equity firm evaluates a potential investee, firstly they prognosticate potential returns and the likelihood of meeting their target return (often 25%+ pa). If presented with five potential investees simultaneously, the question becomes, which investees will meet our target return and do we have the resources to engage them all.  If resource constraints limit the number of simultaneous deals, focus is constrained to deals that present the most opportunity on a risk-adjusted basis. 

However, even with very detailed analysis, many assumptions underpin all of this prognostication and in the end, it is all highly speculative. Moreover, even if there is a real science to assessing current deals against each other, how do you compare these deals to future deals. What would a firm do if presented with 10 great opportunities all at once? Would it invest in all of them if analysis showed they’d all meet the target return? There must be some thought given to the deals of tomorrow. Maybe the 10 great deals today will pale in comparison to the 10 great deals tomorrow. So, how does one decide that a deal today is one of the best opportunities that the firm will see over the life of the fund?

Of course, there is no real answer to this. I just wanted to bring this topic to light to show how subjective and speculative the investment decision really is. But, this is what private equity firms value themselves on; their ability to remove as much speculation as possible and to make essentially profitable decisions. On the other hand, maybe this discussion sheds light on why we’re seeing so many write-downs of late. Maybe funds were too busy trying to get their money out the door and weren’t focusing enough on the comparative value of future opportunities. Of course, everything is clear in hindsight.

Following on from my post about listed private equity (LPE), the LPX50 is an index that is commonly referred to in the LPE industry. From the LPX website:

The LPX50 is a global index that consists of the 50 largest liquid LPE companies covered by LPX.

The LPX50 has been absolutely smashed over the past year or so. Some attribute this to the public nature of LPE, some attribute it to the state of all private equity, and some attribute it to the size of these funds (and hence relating the LPX50 performance to that of mega-buyout funds). Either way, you could do a lot worse than buying the LPX50 right now (such as buying it in mid-2007).

Listed Private Equity (LPE) refers to private equity funds (and sometimes management companies) traded on public stock exchanges. Like any listed business, capital for an LPE is first raised through an initial public offer (IPO) and then shares are traded on an exchange. Since private equity contains the word private and the equity underpinning an LPE fund is public, at first glance, the term LPE appears to be an oxymoron.

But, if you consider the term private equity to represent an investment methodology, rather than the source of the equity, LPE doesn’t seem like such an oxymoron after all. For example, do you think that a wealthy individual investing $100k into the local boulangerie represents private equity? The source of the equity is certainly private, but most of us understand private equity to be something else… a methodology perhaps. With that said, if the real value of private equity isn’t the source of funds, what difference does it make where the funds come from?

Maybe the more common argument against LPE relates to public reporting. The idea being that public reporting creates a short-term view and a short-term view is not always conducive to long-term value creation. That’s a valid argument, but valuation standards for traditional firms (such as the more recent FASB 157) also impose short-term reporting requirements. The difference is that traditional firms don’t have to report to the public, but is this such a big deal? I think the answer depends on regulation of LPEs and how managers of LPEs react to public pressure. If the LPE has equity exposure to its investments and plays an active management role based on a medium-term outlook, then no, I don’t think Listed Private Equity is an oxymoron.

The earlier English Kings operated their kingdoms mostly unfettered. Pre-13th century, if a king acted against the greater good or in an unethical manner, the response was more of an “oops” than a judicial hearing. But, as King John of England increasingly abused his power, the barons challenged him and the Magna Carta was written. While there may be more regulation around private equity in the 21st century, consensus is that they act in a similar invincible manner. Sometimes when they effect their power, companies collapse, people become unemployed, the banking system suffers, and the final result is chaos and catastrophe. With this in mind, do we need a form of Magna Carta for the private equity industry?

Well… with risk comes reward and without risk, companies and people resign themselves to mediocrity. With risk also comes failure, but it’s a failure that’s a byproduct of reaching for the sky. Particularly with venture capital, we wouldn’t see the innovation and advancement that we do if it wasn’t for people willing to take abnormally high risks. This is just a fact of life, but at times when there is more bad news than good, the scruples of private equity firms come into question. However, many private and public businesses are collapsing without private equity influence. 

This argument could easily go round in circles indefinitely, but I believe private equity is just another form of risk capital that… inherently has risks (sounds like a tautology, but it’s often forgotten). We should expect failures, but we shouldn’t bring the whole asset class into question as a result of a few. If anything, we need to learn from these failures and continue to support private equity by creating lasting value for shareholders, employees, the community and global economies. So in answer to the headline question: No, I don’t believe private equity needs its own Magna Carta.

From a legal perspective, a private equity fund can look like a complicated beast (see left). However, the structure of a private equity fund is quite easy to understand once properly explained. Additional complexity can arise from country-specific legislation, but all funds tend to have a similar premise; that is, to provide a vehicle whereby a private equity manager can facilitate investment into investees.

A few objectives lead to the structure being what it is. One major objective is to provide a flow-through entity for taxation purposes. This is to circumvent double-taxation, which leads to investors being taxed at the company level and the personal level if not handled correctly. Another major objective is to qualify for capital gain taxing on carried interest. In the U.S., this is at a maximum of 15%. 

Industry parlance often includes references to limited partners (the investors) and the general partner (the manager). The limited partners are simply the investors who provide money to take stakes in the investees (portfolio businesses). The general partner is the firm (and its staff), which manages the limited partnership (the investment vehicle) and facilitates investments into the investees. The legal theory is that the limited partners have limited liability, whereas the general partner does not.

The second arrow between the general partner and the limited partnership represents the general partner’s financial interest in the fund. This may refer to a direct investment of the fund, but it mostly refers to the right to carried interest. This article talks about “carry” in more detail. The partnership deed outlines the terms such as fees and carry.

Someone recently asked me what type of investors we have in our fund; that is, are they mostly pension funds, institutions, individuals, etc. Although I had a vague idea, it sparked the idea for this post. So, I went through our investor register, talked to a few other GPs and LPs, and came up with the following list of potential investors in a private equity fund:

1. Company pension funds: a fund managed by a company to fund pension payments for its employees.
2. Government pension funds: a fund managed by the government and invested in by various employees.
3. Sovereign wealth funds: state-based funds that invest a nation’s surplus for long-term growth.
4. Endowment funds & similar: used to support an organisation with its financial growth & income.
5. High-net-worth individuals: people with a high personal wealth.
6. Insurance companies: much of their profit is derived from investing the float.
7. Investment banks: non-traditional banks that look to outperform through higher risk activities.
8. Non-financial companies: any other business looking to invest a surplus for a moderate return.

Fund raising is all about contacts, marketing and reputation. The investor constituency will reflect the areas of capital raising strength in the team. Some funds benefit from friends at large institutions, some are supported by religious contacts, some are even just anchored by one major wealthy individual.

Private equiteers typically believe that venture capitalists invest in lossmaking businesses with a view to extraordinary growth (risky). Whereas venture capitalists typically believe that private equiteers invest in traditional businesses (boring) with a view to value creation through means other than just revenue growth (over-gearing). In practice though, there can be an overlap between the two.

With that in mind, I thought it would be helpful to  understand some of the venture capital lexicon and the different stages in venture capital investing. 

1. Pre-seed stage: this is the stage of idea inception. Capital is used to create the legal business structure, research the market, register patents and initiate prototyping. Providers of this capital are usually friends, families and fools (the “3Fs”), or sometimes angel investors.
2. Seed stage: this involves the commercialisation of products and services. Typical uses of funds include bolstering the management team and moving from prototype to production. Investors at this stage are usually angel investors and incubator programmes.
3. First stage: this stage is about establishing real revenue, opposed to revenue from trials and grants. From a corporate perspective, the business should be fully operational and able to scale to meet demand. This is where true venture capitalists enter a business and look to fund subsequent stages as part of a syndicate. 
4. Second stage: at this stage, revenue is about to take off. Capital is required to increase production, fund large marketing campaigns and enter new markets. Later stage venture capital specialists may invest at this point, or the original early stage firm will consider a second round of funding.
5. Third stage: the business is highly profitable now. Funding for working capital, increasing plant size, product diversification, more marketing, quality improvement and further revisions is required. For a high growth business, later stage venture capitalists will dominate funding. For lower growth and more traditional businesses, private equity firms will enter the fray. 
6. Pre-IPO stage: funding at this stage is called mezzanine or bridge finance. It cleans up the share register, pays down debt, prepares the company for IPO and ensures top quality management are at the helm. There are specialist funds that will come in at this stage, but private equity funds will also make an appearance. Often convertible debt will fund this round as the business will have the income to support the coupon payments.