The Definitive Guide to Private Equity Fund Investment Due Diligence

Private Equity Fund Investment Due Diligence Second Edition Perfecting your due diligence ability for top-quartile returns

Edited by Kelly DePonte, Probitas Partners

Published in October 2010 by PEI Media Ltd Second Floor Sycamore House Sycamore Street London EC1Y 0SG United Kingdom Telephone: +44 (0)20 7566 5444 www.peimedia.com © 2010 PEI Media Ltd. ISBN 978-1-904-696-81-0 This publication is not included in the CLA Licence so you must not copy any portion of it without the permission of the publisher. All rights reserved. No parts of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means including electronic, mechanical, photocopy, recording or otherwise, without written permission of the publisher. The views and opinions expressed in the book are solely those of the authors and need not reflect those of their employing institutions. Although every reasonable effort has been made to ensure the accuracy of this publication, the publisher accepts no responsibility for any errors or omissions within this publication or for any expense or other loss alleged to have arisen in any way in connection with a reader’s use of this publication.

PEI Media editor: Wanching Leong Production editor: Julie Foster Cover design: Joshua Chong Printed in the UK by: Hobbs the Printers (www.hobbs.uk.com) Cover image: Courtesy of iStockphoto

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Contents Figures and tables

vii

Foreword and appreciation

xi

Chapter three Emerging managers: How to analyse a first-time fund

19

By Kelly DePonte, Probitas Partners Introduction 19 Key points in the analysis of emerging managers 20 Conclusion 26

SECTION I: IN-DEPTH, INCISIVE CHAPTERS

Chapter one Private equity fund manager due diligence and selection

3

By Helen Steers, Pantheon Introduction The importance of private equity manager selection The challenges of private equity manager due diligence Private equity portfolio construction The typical due diligence process Challenging times – adjusting the due diligence process in the wake of the credit crunch Conclusion

Chapter two Track-record analysis as the foundation of due diligence

Chapter four Legal due diligence: The ILPA Principles 3 3 4 4 4 8 8

By Kelly DePonte, Probitas Partners Introduction Other efforts

29

29 30

Chapter five Legal due diligence: a Q&A session

31

Introduction The experts The questions

31 31 31

Chapter six Private equity benchmarks: Methods and meaning

45

11

By Atsushi Urushitani, Seiichi Saito and Melissa Banila, Alternative Investment Capital Limited Introduction 11 Analysis at fund level 11 Analysis of portfolio companies 15 Analysis of realised investments 15 Analysis of unrealised investments 16 Other factors affecting consistency of track-record performance 17

By Jesse Reyes, QuartileOne, LLC and Austin Long, Alignment Capital Group, LLC What is a benchmark? Opportunity cost and benchmarking Can private equity truly be benchmarked? Peer group benchmarks are not enough Searching for alpha Navigating the benchmark forest

45 45 47 51 54 54

The Definitive Guide to Private Equity Fund Investment Due Diligence

iv

CONTENTS

The need for additional benchmarks Public market equivalents Summary of PME methods Conclusion

61 61 69 71

Chapter ten Venture capital due diligence: Issues of analysis

97

By Janet Cheston, Lisa Edgar and David York, Paul Capital Investments

Chapter seven Doing due diligence on the next fund: The importance of portfolio monitoring

73

By Kelly Chaplin, British Columbia Investment Management Corporation Introduction 73 Annual meetings 73 Other meetings 74 Advisory board participation 75 Co-investments 76 Conclusion 78

Chapter eight Regional due diligence: A European perspective By Katharina Lichtner, Capital Dynamics Introduction Team Strategy and market Processes Quantitative analysis Conclusion

Chapter nine Due diligence in emerging private equity markets By Ernest J.F. Lambers, EMAlternatives, LLC Introduction The rise of the emerging markets Key elements in the selection of private equity managers Conclusion

79

79 80 84 84 85 88

89

89 89 90 96

Introduction Differences between venture capital and private equity manager evaluation Selection criteria and evaluation processes Investment performance Team Investment strategy Investment process Portfolio management Governance Conclusion

Chapter eleven Mezzanine funds: Risk, return and the equity mix By Matthias Unser Overview of the mezzanine market Different strategies of mezzanine funds Risk and return of mezzanine investments Due diligence for mezzanine fund managers Conclusion and outlook

Chapter twelve Sector-focused funds: Special considerations on due diligence By Jeffrey Mansukhani, Cambridge Associates LLC Introduction Team Strategy Performance Considerations for private equity industry sector funds


97 98 98 99 100 101 102 103 104 105

107

107 110 114 117 126

129

129 129 130 131 134

CONTENTS

Other sector fund strategies Conclusion

136 138

Chapter thirteen Co-investment due diligence

139

By Kenneth Van Heel, The Dow Chemical Company Introduction Why establish a co-investment programme? Issues to consider when developing a co-investment strategy Co-investment due diligence Conclusion

Chapter fourteen Private equity real estate: Factors of analysis By Hawkeye Partners, LP Introduction Real estate fund due diligence Legal fund terms Conclusion

Chapter fifteen Infrastructure fund investing By Nancy Duff Mangraviti and Scott Sinha, RBC Global Asset Management Introduction Infrastructure fund diligence: Beware the traps for the unwary Back to basics: portfolio construction Evaluating a manager’s infrastructure investment strategy First-time funds/emerging teams Fund terms and structure warranting special focus Conclusion

139 139 140 143 148

149

149 152 152 157

159

159 159 160 160 163 164 165

Chapter sixteen Secondary private equity fund pricing

167

By Ian Charles and Charlie Tingue, Landmark Partners Introduction Benefits of buying secondaries Secondary underwriting introduction and information needs Secondary DCF model set-up Public company projections Private company projections Future capital calls and unfunded capital return Converting gross cash flows to a purchase price Sensitivity analysis Conclusion

167 169

Chapter seventeen Publicly traded private equity vehicles: A different kind of model

179

By Adam Goldman, Red Rocks Capital LLC Accessing private equity: an overview What is listed private equity? Listed private equity vehicle structures Drawbacks What drives pricing?

Chapter eighteen Investing in fund management companies By Andrew L. Turner, Northern Lights Capital Group Introduction Asset management as a pure intellectual capital activity Evaluating investment fund managers and investment strategies

170 171 171 174 176 176 177 177

179 180 181 183 185

189

189 189 191


v

vi

CONTENTS

Converting investment success into business success Creating the environment for success Conclusion

Chapter nineteen Staffing for success: The human capital factor By Erik Hirsch, Hamilton Lane, with contributions from Michael Koenig and Grant Saul Introduction Sourcing Due diligence Legal Back office/reporting Monitoring Globalisation and private equity Models for deploying human capital to private equity Advisory model Separate account model Fund of funds model Hub-and-spoke model Conclusion

193 194 196

197

210 213 216 217 219 220 221

SECTION III: APPENDICES 197 197 197 198 200 201 201 201 202 202 203 204 205

SECTION II: 2010 PEI/PROBITAS PARTNERS PRIVATE EQUITY FUND INVESTMENT DUE DILIGENCE SURVEY Conducted June/July 2010

Private equity fund investment due diligence: A survey of institutional investors

Scope of investment activity Most important due diligence factors Terms and conditions Other key elements of the due diligence process Due diligence on first-time funds Due diligence on sponsored funds Summary

209

Survey devised and conducted by PEI Media and Probitas Partners; Analysis by Nicole Warren, Probitas Partners Introduction 209 Profile of survey respondents 209

Appendix I 225 Private Equity Investors Association Recommended Due Diligence Questionnaire

Appendix II 241 Private Equity Investors Association Legal Due Diligence Checklist

SECTION IV: FROM THE PEI ARCHIVES

Journalistic coverage of due diligence Year of the extension Planes, trains and due diligence Changing the equation Tales from the fraudulent frontline Who cares? The winds of change Lots of appetite, little follow-through Manager selection key for Asian PE

249 250 252 253 257 258 259 263

About PEI Media

268


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Figures and tables

Figures Figure 1.1: Figure 1.2: Figure 2.1: Figure 2.2: Figure 4.1: Figure 6.1: Figure 6.2: Figure 6.3: Figure 6.4: Figure 6.5: Figure 8.1: Figure 8.2: Figure 8.3: Figure 8.4: Figure 8.5: Figure 8.6: Figure 9.1: Figure 9.2: Figure 10.1: Figure 10.2: Figure 11.1: Figure 11.2: Figure 11.3: Figure 11.4: Figure 11.5: Figure 11.6: Figure 12.1: Figure 12.2: Figure 12.3: Figure 12.4: Figure 12.5: Figure 12.6: Figure 14.1: Figure 14.2: Figure 15.1: Figure 16.1: Figure 17.1:

US and Europe private equity returns, 1969–2009 Private equity fund investment process Example of investments with different multiples but same IRR (20%) Example of investments with different IRRs with same multiple (2.5x) Attitude towards the ILPA Private Equity Principles Four potential sources of private equity benchmarks Since-inception IRR timeline Time-weighted rate of return timeline Investment-horizon IRR timeline Time-zero IRR timeline Due diligence selection framework Example of an analysis of team development Example of a geographic analysis Example of a portfolio analysis Example of a performance benchmarking analysis Example of a value-creation analysis of individual components in a leveraged buyout investment Private equity fundraising in the emerging markets Private equity investments in the emerging markets US venture capital sectors of investment ($ invested) Venture capital fund selection process Basics of mezzanine financing Strategic profiles in the US and Europe Comparison of returns for US and European mezzanine loans Regional differences in risk (as of 31 December 2009) Sponsored vs. non-sponsored transactions (as of 31 December 2009) Due diligence process for mezzanine funds Financial services-focused private equity funds and total commitments, 2000–09 Dispersion of cash-on-cash multiples for healthcare-focused and generalist funds, 2000–09 Returns of US private equity-backed companies vs. relevant public indexes by sector Returns of media companies vs. US private equity and public equity Spectrum of private energy partnerships Returns on private distressed investments vs. US private equity and the S&P 500 Index of US commercial real estate values from 1978 to first half 2010 Historical quarterly total returns for the NCREIF Townsend Fund Index Considerations when mapping an infrastructure portfolio Example of a private equity J-curve LPE companies – premiums and discounts The Definitive Guide to Private Equity Fund Investment Due Diligence

viii

F I G U R E S A N D TA B L E S

Figure Figure Figure Figure

17.2: 19.1: 19.2: 19.3:

Secondary LP pricing vs. LPE discounts Dispersion of returns for public equity vs. private equity Due diligence process Hypothetical hub-and-spoke model

Survey figures Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure

1: 2: 3: 4: 5: 6: 7: 8: 9: 10: 11: 12: 13: 14: 15: 16: 17: 18: 19: 20: 21:

Profile of respondents Respondent firm headquarters Private equity investment experience Primary investment sector focus Primary investment geographic focus Interest in the secondary market Interest in directs and co-investments Due diligence staffing Key factors in due diligence Fund performance benchmarks utilised Attitude towards terms and conditions Attitude towards the ILPA Private Equity Principles Terms and conditions deal-breakers Due diligence on-site GP visits Due diligence on-site selected portfolio company visits Require the completion of a detailed due diligence questionnaire Require track-record data in electronic format Attitude towards first-time funds Key factors with first-time funds Attitude towards sponsored funds Position on sponsored funds

Tables Table Table Table Table Table Table Table Table Table Table Table Table

2.1: 3.1: 3.2: 6.1: 6.2: 6.3: 6.4: 6.5: 6.6: 6.7: 6.8: 6.9:

Example of an attribution analysis First-time private equity funds as % of market Average private equity fund sizes Example of a benchmark selection for a fund of funds Example of averaging IRRs vs. calculating a pooled-average IRR Comparison of benchmarks against BRT criteria Example of an original ICM PME calculation Example of an original ICM PME calculation resulting in a negative terminal value Example of an AICM PME calculation with a negative IRR Example of an AICM PME calculation with a positive IRR Example of a PME+ calculation Example of a PME+ calculation from a more successful investment


F I G U R E S A N D TA B L E S

Table Table Table Table Table Table Table Table Table Table Table Table Table Table Table Table Table

6.10: 6.11: 6.12: 11.1: 11.2: 11.3: 12.1: 14.1: 15.1: 15.2: 16.1: 16.2: 16.3: 16.4: 17.1: 19.1: 19.2:

Example of a K&S PME calculation Example of a K&S PME calculation from a more successful investment Summary of PME methods A short history of mezzanine financing Risk and return comparison among mezzanine deals by size Important factors for any due diligence Energy private equity performance compared to public indices Real estate fund due diligence checklist Infrastructure sectors Key considerations in evaluating risk in an infrastructure strategy Information required for secondary fund due diligence Common terms and attributes in secondary fund transactions Public company classification example Forward-looking operation projections Comparison of private equity vehicles Expected annual legal costs Cumulative reporting and cash flow administration cost of a private equity programme


ix

xi

Foreword and appreciation When the first edition of The Guide to Private Equity Fund Investment Due Diligence was published in 2005 we were at the beginning of a great bull market for publicly traded stocks and private equity. The bull market rapidly changed private, greatly expanding the market in size, in sectors covered and geography, in many cases moving private equity from the financial pages to the front pages. From 2005 through 2007, access to rapidly growing fund managers perceived to be top of the class became a focus for many investors, especially for those funds that raised money rapidly. Though the importance of proper due diligence never totally faded, the retrenchment in the industry that came with the global financial crisis has focused much more attention on the area. Many investors are limited in the amount of capital they can deploy, and manager selection is key in deploying those relatively scarce resources. Intensive due diligence is, of course, the basis of the selection process.

Though the fundamentals of fund due diligence have not changed, the expansion of the market have made things more complex. This second edition includes a number of entirely new chapters, including sections on sector-focused funds, secondary investing, infrastructure and real estate. Other chapters have been updated to ensure that they reflect current market practice, including an entirely new survey of institutional investors on key areas of due diligence focus. With a topic as complex as this, we have been fortunate to attract a group of distinguished industry practitioners to author the chapters of this book. Most of the material here has been written by individuals who have devoted their spare time in spite of busy professional schedules to share their knowledge of the market. This book would not be possible without their contributions, and the editors wish to express their profound thanks to all the authors. ■ Kelly DePonte, Probitas Partners Wanching Leong, PEI Media


CHAPTER ONE

3

Private equity fund manager due diligence and selection By Helen Steers, Pantheon

Introduction This chapter tackles the subject of private equity fund manager due diligence and is divided into three parts. First of all, we examine why manager selection is so critical in private equity. We go on to describe the challenges of conducting due diligence and constructing a well-diversified private equity portfolio, and discuss a typical due diligence process. Finally, we highlight the changes in this process over the past five years, since the first edition of this guide was published, and in the aftermath of the credit crunch.

The importance of private equity manager selection Unlike the ‘hire-and-fire’ world of public equity

manager selection, the choice of a private equity fund manager means making an investment decision that will endure for 10 years, and even longer. After making a commitment, an investor is unable to exit from a fund until it is completely liquidated, except under extremely unusual circumstances or unless it elects to dispose of the position in a secondary sale. Much more is at stake in the initial manager selection decision in private equity, hence the importance of getting it right on day one. What is more, the consequences of ‘getting it wrong’ in private equity are much more important than in the public markets. Dispersion in performance of private equity fund managers is significantly greater than between public equity managers. In fact, according to data from Thomson Reuters VentureXpert, the dispersion between the top-performing private

Figure 1.1: US and Europe private equity returns, 1969–2009 20 Upper: 17.0%

Net IRR (%)

15

Upper: 14.5%

10 5

Median: 3.6%

0 -5

Upper: 15.0%

Median: 6.6%

Median: 6.2% Upper: 3.3%

Lower: -0.4%

Median: -2.2% Lower: -2.7%

Lower: -3.1% Lower: -8.0%

-10 US venture

US buyout

Europe venture

Europe buyout

Source: Thomson Reuters VentureXpert to 31 December 2009, captured 19 May 2010.


4


equity managers and the bottom can be close to 20 percent, as shown in Figure 1.1. The dispersion of returns between managers emphasises the importance of comprehensive due diligence in identifying the top-quartile managers.

The challenges of private equity manager due diligence Another difference between the public and private investment worlds is that there is much less publicly available data to assist in private equity fund manager selection. Generally, the investor either has to build their own database or rely on outside sources that may be limited in nature. The investor has to ask for detailed information on each fund on which they conduct due diligence – there are no rating agencies to help, no standard documentation and no comprehensive published measures of individual funds’ performance. There are also no ‘investable’ private equity indices, so an investor cannot track a ‘standard’ portfolio of managers. As such, active asset allocation and active choice of managers are the only options in private equity. In addition, the investor finds that there is much less quantitative data available than in public manager selection, hence the importance of qualitative methods and ‘informal networks’ in assessing private managers (for example, reference checking takes on even greater significance). Even the quantitative data that is available may be open to interpretation and based on underlying valuation assumptions that the investor will need to question. The process of winnowing out the prospective finalists is also complicated by the fact that there are restricted ‘open-tobuy’ periods with private equity funds and inherent problems accessing the best managers. Finally, investors have to compare a private equity fund offering not only with other, similar funds currently on offer, but also with funds that may be

organised in the future by comparable managers, operating in the same sub-asset category, some of which may be very difficult to identify. This is clearly not the case in the public equity world.

Private equity portfolio construction There are over 4,000 private equity fund managers in the world and typically more than 500 funds which are open to buy at any one time. Typically, an investor will choose to build a diversified portfolio consisting of around 25 to 45 funds over a three to five year period drawn from a number of sub-asset categories. The exact number of funds will depend upon the investor’s geographic remit, target asset allocation and desired level of diversification. For example, one investor may be satisfied with a handful of managers covering Europe on a pan-European basis, as part of a small but globally diversified private equity portfolio, while another may build separate US, European and Asian portfolios, diversified by geography, stage and vintage. Having decided upon their investment strategy and level of diversification, an investor needs to map the universe of private equity managers thoroughly, to ensure that they are selecting funds from the broadest possible offering and not just restricting the choice to ‘available managers’ (that is, those that are readily accessible or have funds that are currently open). The investor must then categorise each manager, rating it against its peers in a rigorous manner, according to a range of criteria.

The typical due diligence process Every private equity investor develops his or her own methodology for selecting managers and has to comply with his or her own investment approval process. This can vary and may be more or less formalised, depending upon the investor. However,


P R I V AT E E Q U I T Y F U N D M A N A G E R D U E D I L I G E N C E A N D S E L E C T I O N

Figure 1.2: Private equity fund investment process

Private equity funds available in the market

Industry relationships

Research

Intermediaries

Fund relationships

Monitor and oversight

Exit and distribution management

Deal sourcing

Preliminary analysis

Does not fit criteria

Due diligence

Investment committee approval

Negotiation and legal review

Commitment

Source: Pantheon.

the decision-making flow chart shown in Figure 1.2 details the typical stages in a private equity fund investment process. The process starts with the sourcing of the fund opportunity. Typically, an investor will either be approached directly or indirectly (through a

placement agent) by the fund manager or will adopt a more proactive stance, targeting a manager because of an existing relationship or as a result of research and industry networks. Preliminary analysis usually involves a relatively high-level review of the essential elements of the


5

CHAPTER FIVE

31

Legal due diligence: a Q&A session venture capital funds and all types of investors in such vehicles. They are:

Introduction A thorough review of the terms and conditions of the partnership agreement is a vital part of the due diligence that any investor considering investing in a private equity or venture capital fund should undertake. As the financial crisis has slowed down the fundraising process and limited the amount of capital available for investment, the due diligence process has become more important as investors re-evaluate relationships and reconsider investment programmes. Examining the details of the partnership agreement, and negotiating with the general partner (GP) where necessary, is as much a step in the due diligence process as analysing the GP’s track record or taking references. In order to examine the area of legal due diligence in depth, PEI Media asked a group of distinguished fund formation experts to comment on a number of issues, ranging from whether investors were paying more attention to legal due diligence, through whether there are substantial differences between different classes of investors, to those areas that are causing concern to limited partners (LPs). Their responses are included below in a Q&A format.

The experts Our group consists of leading legal private equity and venture capital fund formation attorneys from the US, the UK, Germany and Asia. Between them, they have many years of experience in structuring funds and drafting terms and conditions in limited partnership agreements globally. Their experience relates to all types of private equity and

• Uwe Bärenz and Tarek Mardini of P+P Pöllath •

• • •

+ Partners, Berlin Dean Collins and Lawrence Sussman of O’Melveny & Myers, Singapore and Beijing, respectively Craig Dauchy of Cooley LLP, Palo Alto Robin Painter of Proskauer Rose LLP, Boston Duncan Woollard of SJ Berwin, London

The questions Given the turmoil of the last couple of years, are investors in general paying more attention to legal due diligence? Have they become more sophisticated in this arena? Uwe Bärenz (UB) and Tarek Mardini (TM): Yes, investors (even smaller investors such as family offices) have become more sophisticated over the last few years and spend more time and energy on analysing and negotiating legal terms as part of their increased overall due diligence. This is both a result and sign of the fact that private equity has matured as an asset class. While it is true that investor-friendly legal terms do not automatically make successful fund investments, the financial crisis has made investors aware that good fund governance is important as a downside protection of investors’ assets and can help prevent an unsuccessful investment from becoming a catastrophic one. Dean Collins (DC) and Larry Sussman (LS): There has undoubtedly been a greater emphasis among institutional investors on risk management generally


32


and this has led to increased legal due diligence for investors into Asia funds. This has been particularly marked among investors with a shorter history of making allocations to the asset class, including many Asia-based investors, who have increasingly started engaging external legal counsel to assist their fund reviews, although some such investors – even significant ones – still do not negotiate on terms. Large investors from the US and Europe already had fairly robust processes in place, and the failures in their portfolios were largely driven by market forces or insufficient commercial due diligence rather than legal issues.

Craig Dauchy (CD): Without a doubt, investors and their counsel have generally become more sophisticated on legal due diligence. In light of the economic climate over the last couple of years, investors are placing a high priority on legal due diligence and many investors are conducting more extensive due diligence than ever before. Many institutional investors have become more aggressive in commenting on fund partnership agreements and these agreements are often heavily negotiated. In addition, LPs are participating in multiple diligence meetings with fund management teams and are placing great importance on diligence on track records and references. Robin Painter (RP): The turmoil and the subsequent regulatory activity has led to an increased understanding of the legal and regulatory environment, such as for instance diligence by public pension plans concerning the use of placement agents. However, in my experience the focus of an investor is linked to the maturity of an investor’s portfolio, as well as the investor’s overall strategy in building that portfolio. An investor with a mature portfolio might only refine its approach slightly in light of recent flux in the market, while a new entrant to an asset class will be brought to consider a broader range of diligence issues as it develops its own investment strategy from a blank slate. It is therefore often more a question of

adapting the legal diligence to a particular investment model.

Duncan Woollard (DW): Investors are certainly paying more attention to legal due diligence than ever before. All investors will now undertake a legal review of a fund whereas as little as two years ago many investors would simply follow the larger and more sophisticated investors. We are also finding that the extent of the legal review has increased greatly. Investors are going into a lot more detail on the terms and conditions of funds and examining exactly how they work, rather than simply following a ‘box-ticking’ exercise. This has tended to make the closing process a far more drawn out and difficult affair and dealing with each investors’ requests with due consideration has become crucial as many investors are quite prepared to walk away from the investment if the key terms do not match their expectations. With respect to investors’ sophistication, LPs certainly have a greater understanding of the terms of fund documentation than in the past and what affect these terms might have in the future. Many LPs do not feel obliged to follow market terms where they think these do not provide them with sufficient protection and many pursue their own agenda on core issues, born from their own experience and previous mistakes.

The ILPA Private Equity Principles were released in September of 2009. Have they had a major impact in the structuring of funds going to market or in current limited partnership agreement (LPA) negotiations? DC/LS: The ILPA Principles are a manifestation of a change in the balance of power between GPs and investors, and it is this change, rather than the principles per se, that is having the real effect. Indeed, in an Asia context, the Principles, which are commonly regarded as having been created in response to the excesses of the large global


CHAPTER SIX

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Private equity benchmarks: Methods and meaning By Jesse Reyes, QuartileOne, LLC and Austin Long, Alignment Capital Group, LLC

This chapter examines private equity benchmarking by evaluating the methods in current use, analysing some of their shortcomings, providing guidance on their proper use and surveying new methods that have been developed to provide additional benchmarks.

What is a benchmark? Before the advent of modern power tools, craftsmen resorted to tradecraft to precisely build furniture. At the time, without accurate rulers or measuring tapes, they used trade tools such as ‘story sticks’ and for measurement would make marks on their workbenches as points of reference. For example, these ‘benchmarks’ might be used to make sure that all legs for a table were the same length. Thus, a benchmark is a point of reference. In investments the term has evolved to mean the use of indexes and other return statistics to evaluate the performance of financial securities. There is a large body of knowledge regarding the use of indexes as benchmarks in the public securities markets and an entire performance measurement industry has evolved for the express purpose of creating and using a bewildering variety of benchmarks. Benchmarks range from the trivial (for example, ‘what was the return last year’ or ‘I want a 10 percent real return’) to the extremely complicated (for example, a set of heuristics and algorithms that can be used to evaluate a complicated investment structure).

Opportunity cost and benchmarking The choice of a benchmark would seem to be trivial. After all, in the public markets there are stock indices derived from a seemingly endless supply of composites. However, the choice of a benchmark is actually quite complicated in that a true benchmark should be chosen on the basis of the investment decision being evaluated, whether the benchmark is intended for direct comparison or for what we call an opportunity cost comparison. Take the case of the ‘naïve manager’. Assume an investment manager has a choice of two securities, A and B. The manager can choose any proportion of investment in these two securities, for example, 70 percent A:30 percent B, 20 percent A:80 percent B, 0 percent A:100 percent B and so forth. Without superior knowledge, the naïve (passive) manager would have no basis for a decision between the two investments and would therefore select a 50:50 weighting. The investment weighting decision that the active manager actually makes should be superior to the returns of this ‘naïve manager’ decision. Given even a simple investment portfolio, there are myriad potential decisions to evaluate. For example, a portfolio manager might make a decision to invest in private equity versus another asset class; a decision to invest 30 percent in venture and 70 percent in buyouts; or a decision to invest in 2003 vintage year funds but not 2004. In each case a benchmark should be appropriate to the decision being evaluated.


46


For a relevant example in the private equity industry, take a buyout fund of funds manager who must make two critical investment decisions: which vintage years to invest in (a temporal allocation decision); and, within those vintage years, which buyout managers to invest in (a series of manager selection decisions). This manager forms a buyout fund of funds in 2001 and invests in underlying funds with vintage years 2001, 2003, 2004 and 2006. Note that the manager chose not to invest in 2002 and 2005. There are two different benchmarks for these two different decisions. The first benchmark would exactly mirror the manager’s temporal allocation decision by using return data from the exact same vintage years in which the manager chose to invest. The only difference between the manager’s series of investment selection decisions and the benchmark would be the relative performance of the funds the manager selected versus the performance of the funds in the benchmark. This direct comparison benchmark would measure only the manager’s selection prowess. Alternatively, the manager could select a composite benchmark made up of all the vintage years in the investment period, from 2001 through 2006. The manager’s decision not to invest in 2002 and 2005 should provide superior results when compared to

the benchmark that includes those vintages. In this second benchmark there are two potential differences between the manager’s investments and the benchmark: the vintage years selected and the managers selected within each vintage year. This benchmark thus evaluates both the vintage year timing decision and the series of manager selection decisions as well. This second benchmark comparison is what we call an opportunity cost benchmark – the manager had the opportunity to invest in all five years but did not do so, a decision the outcome of which should be measured against the benchmark and either rewarded or penalised. The investment decisions incorporated into this simple illustration are summarised in Table 6.1. Although many investment professionals believe the direct comparison benchmark – that is, one that exactly mirrors the manager’s actual investments – is the only viable benchmark, our example makes it clear that a direct comparison benchmark only evaluates one dimension of the investment decision. Just as in the public markets, which frequently use benchmarks involving a broad stock market index, a private equity benchmark should reflect what the manager did decide to invest in as well as what the manager did not decide to invest in. Of course, in addition to comparing returns to a private equity universe, the buyout fund of funds

Table 6.1: Example of a benchmark selection for a fund of funds Vintage 2001

Fund of funds manager’s portfolio

Direct benchmark

Opportunity benchmark

X

X

X X

2002 2003

X

X

X

2004

X

X

X X

2005 2006

X

X


X

The Definitive Guide to Private Equity Fund Investment Due Diligence

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