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					Center for International Securities and Derivatives Markets
Center for International Securities and Derivatives Markets

                   The Benefits of Private Equity
                          2004 Update

                                          Prepared by:

                            Thomas Kunkel, Research Associate

                         Barsendu Mukherjee, Research Associate

     Isenberg School of Management, University of Massachusetts, Amherst, Massachusetts, 01003
                               Tel: 413-577-3166 Fax: 413-577-1350
                        Email: WEB:
                                           The Benefits of Direct “Private Investment”

 I. Introduction

 For many investors, direct “long term” private investments are synonymous with alternative
 investment. Direct private investment covers a wide range of investment opportunities. It is
 important to point out that various sources define these investment opportunities differently. For
 some, venture capital is the proper term for direct private investment. That term may cover a
 wide range of investment opportunities including early stage investment (angel investors, seed
 capital), take off (venture capital), mid-growth investment (mezzanine finance) and later stage
 investment (private equity). In some cases, the investment industry refers to venture investing
 and buyout investing as "private equity investing” while others use the term "private equity" for
 buyout fund investing. Private investment can be anything from angel investment to buyout fund

 Angel investors mentor a company and provide necessary capital and expertise to help develop
 companies. They are either wealthy people with management expertise or retired businessmen
 and women who seek the opportunity for first-hand business development. The actual risk and
 return performance of the differing sections of the traditional investments area reflect the
 differing economic functions of the underlying investment. Since one of the sources of returns to
 this investment class is based on access to non-public information, it is not surprising that little
 information is available about the actual return performance.

 Exhibit 1

                                               Private Investment Return to Risk Tradeoff

                                                                                                                                                          Seed Capital
Targeted Annual Return on Investment

                                                                                                                                        Venture Capital Equity - Early

                                                                                                                     Venture Capital Equity - Late

                                                                                                      Private Equity (Buyout & Later Stage Equity)

                                                                                  Mezzanine Capital

                                                             Private High Yield

                                           Leveraged Bank Debt

 Source: Venture Economics

The basis for returns to direct private investment is similar to that for traditional stock and bond
investment: A claim on long term earnings, a return to risk (e.g., positive risk premium for risk
capital) and lastly, a return premium for providing capital to an illiquid investment as well as
positive alpha generated from unique trading strategies or private information. However, while
private investment vehicles have a net asset value, this value is not determined in a public market
but as an internal appraisal value. Actual returns are often measured as an internal rate of return;
cash disbursements relative to capital investment. As shown in Exhibit 2, these cash flows may
be less at the initial stage than later stages of the capital investment (known as the J curve effect).
It is also important to point out that private investors are generally active investors and typically
exit their successful investments by taking them public. While they rarely sell their shares at the
time of the IPO, they frequently sell the shares or distribute them to their investors within two
years of going public.

Exhibit 2
                               Traditional Rate of Return Process

Source: Venture Economics

The private investment vehicles are generally organized as partnerships; a fund made up of the
general partner and the investors or limited partners. Each fund is capitalized by commitments of
capital from the limited partners. Once the partnership has reached its target size, the partnership
is closed to further investment from new investors (or even existing investors) so the fund has a
fixed capital pool from which to make its investments. There are several types of private
investment firms, but most invest as limited partnerships in which the venture capital firm serves
as the general partner. Other organizations may include government affiliated investment
programs that help start up companies either through state, local or federal programs.

This article focuses on the academic evidence on the benefits of adding private investment
vehicles to a traditional investment portfolio. While it is impossible in a short synopsis to convey
all the details of the benefits of private investment, it offers the opportunity to enhance portfolio
returns when added to traditional stock and bond investments in combination with other
alternative investments (hedge funds), and participates in a wide variety of new investment
opportunities not available in public markets.

II.   Background

Introduction of Private Investment Benchmarks

Currently, there are several indicies that utilize different methods for their reports. Thompson
Financial Venture Economics and Warburg Pincus Counsellors developed the Post Venture
Capital Index (PVCI) in 1995. It is a true, market-weighted index of all venture-backed
companies. Thompson Financial includes a wide collection of venture-backed companies,
ranging from early stage start-up to reverse LBOs (Leveraged Buyouts).

The value of the PVCI is calculated using the Internal Rate of Returns (IRR) -- net of fees -- of
the asset. Cambridge Associates offers two indices: The Cambridge Associates LLC U.S.
Venture Capital Index and the Cambridge Associates U.S. Private Equity Index. The Cambridge
Associates LLC U.S. Venture Capital Index includes 80% of the total dollars raised by venture
capital managers. The index uses the pooled net time-weighted returns by quarter. The
Cambridge Associates LLC U.S. Private Equity Index includes 70% of the total dollars raised by
U.S. leveraged buyouts, subordinated debt and special situations managers. Unlike the PVCI,
which is reported on a daily basis, the Cambridge Associates indicies are available on a weekly

Assessments on the performance of Private Equity funds are based on a self-reporting procedure.
Managers report their investments and the estimated value of them to databases. Therefore, data
for Private Equity is collected using appraisals for the underlying assets. This procedure, as well
as the low reporting frequency, distorts the view on Private Equity. Specifically, missing data,
censored data and sample selection lead to a critical estimation bias in the indices. Solutions to
the problem implement statistical means to create a correct view on return developments in the
Private Equity market. Peng (2001) uses a method of moment repeated-sales regression (MM-
RSR) and a re-weighting procedure to overcome upward biased estimates. He finds an
impressive annual return of 55.18% from 1987 to 1999. John H. Cochrane (2001), on the other
hand, uses a maximum likelihood estimate to correct for selection bias. He finds that there is a
considerable amount of selection bias, which increases the mean logarithmic returns. Because of
the high volatility, arithmetic returns are 40-50%, underlining the high achievable rates of returns
of Private Equity investments.

Wilshire Associates uses three indices to benchmark the performance of their Private Equity
funds: The Wilshire Leveraged Buyout Index, the Venture Capital Index and the Mezzanine
Index. All three are factor-based.

The Wilshire Leveraged Buyout Index is constructed on the assumption that the market index is
bought out. A buyout is accomplished by restructuring the assets of the companies. Typical
transactions of a buyout include purchasing of the assets of the company. The transactions are
financed by debt. This index only accounts for structural changes. Intentions of the buyout or
changes in future companies due to a change in management are not valued. This method of
index construction generates analysis of data without the ability to perform statistical correction
techniques, as mentioned previously.

General Discussion of Performance

Research1 has shown that companies taken public might underperform in comparison to
companies that do not issue equity. This was explained with the overly optimistic attitude of
investors towards the prospects of firms issuing equity for the first time. A more recent analysis2
finds that venture backed IPOs outperform non-venture backed IPOs when using equal weighted
returns. Using value-weighted returns reduces this relationship.

A study3 conducted over the pre-NASDAQ era shows that IPOs return as much as the market for
a calendar-time analysis whereas they underperform the market when performance is measured
using value-weighted, event-time, buy and hold abnormal returns. This underperformance
disappears when using equal-weighted, event-time, buy and hold strategies or cumulative
abnormal returns.

Companies that were taken public do not seem to behave differently than SEO (seasoned equity
offering) companies4 when similar in size and in book-to-market value. The success does not
depend on the type of investors. Corporate investments show similar results to those from
independent venture organizations5. A strong strategic fit of corporate investments will increase
the success, though.

Returns of Venture Capital are dependent on the industry structure of the countries6 where they
are based. Venture capitalists are obviously not applying the same techniques to overcome the
problem of asymmetric information between themselves and the entrepreneurs. Businesses on
foreign soil are influenced by institutional, legal and cultural factors. Varying systems of
corporate governance should be taken into account as well. Because venture capitalist behavior
varies, one has to be careful to apply the same analyses across borders.

Because Private Equity funds have a long term investment horizon, lockup periods of more than
5 years are common. They are closed-end funds. Their high illiquidity means that a change of the
investment structure takes some amount of effort. In order to sell partnership shares before the
fund decides to return the money, investors have to turn to the secondary market. The process of
selling partnership shares can take quite an effort. Sales in the secondary market are also done at
a discount, forcing the seller to give up the upside opportunities of the portfolio.

III.    Data, Methodology and Empirical Analysis

The Wilshire Private Equity indicies were used to calculate the returns of Venture Capital,
Leveraged Buyouts and Mezzanine Financing. These returns are compared to those of traditional
assets, using the S&P 500 index as a representation for the stock market and the Lehman
Aggregate Bond index for the bond market. The returns of the GSCI as a commodity index and
the Hedge Fund Composite (an equal weighted average of HFR, CSFB-Tremont and EACM) as
a hedge fund index were used to represent the returns of other alternative investments. The data

  Ritter (1991) and Loughran and Ritter (1995)
  Alon Brav and Paul A. Gompers (1997)
  Paul A. Gompers and Josh Lerner (2001)
  Alon Brav, Christopher Geczy and Paul A. Gompers (1995)
  Paul A. Gompers, Josh Lerner (1998)
  Manigart, Sophie (2000)

source for the Wilshire Private Equity indicies was the Wilshire Private Equity Group.
Everything else was downloaded from Datastream.


Exhibit 3 shows the historical development over the past 14 years for Private Equity asset classes
as well as other alternative (commodities and hedge funds) as well as traditional (stocks and
bonds) investments. Private Equity, especially Venture Capital investments, offers high returns
but also has a high volatility. Thus Venture Capital should rather be considered a return enhancer
than a risk diversifier.

Exhibit 3
                                               Asset Performance 1990-2003
                                              S&P 500       Lehman     GSCI Hedge Fund    Venture    Mezannine         LBO      Pvt Equity
                                                           Aggregate         Composite     Capital                               Portfolio
Annualized Return                                     10.94% 7.94%    6.39%   13.87%      15.62%      10.20%           6.44%      11.80%
Annualized Standard Deviation                         15.05% 3.91%   19.08%    5.82%      45.98%      28.19%           44.73%     40.36%
Sharpe Ratio                                           0.43   0.88     0.10     1.61        0.24        0.20            0.04       0.18
Minimum Monthly Return                               -14.46% -3.36%  -14.41%  -6.92%      -32.80%     -27.22%         -40.75%    -32.78%
Correlation with Venture Capital                       0.69   0.00     0.05     0.66        1.00
Correlation with Mezzanine Financing                   0.79   0.13     0.08     0.75        0.85        1.00
Correlation with LBOs                                  0.78   0.11     0.08     0.73        0.85        0.99           1.00
Correlation with Private Equity Portfolio              0.77   0.07     0.07     0.73        0.95        0.97           0.97        1.00
Private Equity Portfolio consists out of 40% VC, 40% LBOs and 20% mezzanine
Hedge Fund Composite is an equal weighted average of HFR, CSFB-Tremont and EACM

Using Private Equity in a portfolio increases the returns, as exhibit 4 shows. The risk-adjusted
returns decrease, though. Higher returns are thus connected to higher volatility. Incorporating
Private Equity in a portfolio makes it possible to achieve higher returns. Diversifying the
portfolio with hedge funds and commodities can reduce the risk while having only little impact
on the returns.

Exhibit 4
                                             Portfolio Performance 1990-2003
                                                                      Portfolio I   Portfolio II      Portfolio III        Portfolio IV
Annualized Return                                                      9.74%          11.24%           10.03%               10.72%
Annualized Standard Deviation                                          8.07%          13.55%            6.99%               10.06%
Sharpe Ratio                                                             0.65          0.50               0.79                 0.62
Minimum Monthly Return                                                 -6.42%        -11.69%            -6.41%               -9.05%

Portfolio I: 50% S&P 500 and 50% Lehman Aggregate Bond
Portfolio II: 40% S&P 500, 40% Lehman Aggregate Bond, 20% Private Equity Portfolio
Portfolio III: 40% S&P 500, 40% Lehman Aggregate Bond and 10% Hedge Fund Composite and 10% GSCI
Portfolio IV: 40% S&P 500, 40% Lehman Aggregate Bond, 5% Hedge Fund Composite, 5% GSCI and 10% Private Equity Portfolio
Private Equity Portfolio consists out of 40% VC, 40% LBOs and 20% mezzanine
Hedge Fund Composite is an equal weighted average of HFR, CSFB-Tremont and EACM

Exhibit 5 shows the performance that can be expected based on the performance of the S&P 500.
The Private Equity portfolio shows a high average return (12.12%) in the best months of the
S&P 500. This underlines the ability to achieve higher returns than any other asset class. One has
to be aware of the risks, though. In the worst months of the S&P 500, the Private Equity
Portfolio shows very low returns (-10.03%). An investment in Private Equity bears a certain
amount of risk; the overall risk of the portfolio can be controlled through diversification, though.

In a risk-insensitive investment environment, adding Private Equity to a portfolio can increase
the returns significantly.

Private Equity is a long term investment having lockup periods of 5 years or more, it is more
reasonable to take the long term returns into account. A diversification across Venture funds
should be across different vintage (founding) years, rather than different geographical or industry

Exhibit 5

                                               Asset Class Ranking by S&P 500


              Average Return




                                            Worst            Low                             Highest
                                                                       High Perf ormance
                                         Perf ormance   Perf ormance                       Perf ormance

           S&P 500                         -4.73%         -0.07%            2.50%             6.15%
           Lehman A ggregate                0.18%          0.77%            0.76%             0.87%
           GSCI                             1.51%         -0.39%            1.43%             0.11%
           Pvt Equity Portf olio           -10.03%        -1.12%            5.51%            12.12%
           Hedge Fund Composite            -0.35%          0.99%            1.77%             2.00%

      Private Equity Portfolio consists of 40% VC, 40% LBOs and 20% mezzanine
      Hedge Fund Composite is an equal weighted average of HFR, CSFB-Tremont and EACM

Recent Research in Private Equity

Recent research in Private equity has concentrated on the creation of an appropriate benchmark
to measure and compare performance. While the IRR is the most prevalent measure of
performance, several drawbacks of the method such as the assumption of reinvestment of the net
asset value at the IRR prevent it from being an accurate barometer of performance7. An
alternative approach is to create a public market benchmark parallel to the private equity
portfolio where each contribution or realization to or from the private equity portfolio is matched
by an equal investment or sale of the benchmark portfolio. A positive final value of the
benchmark portfolio indicates that it would have outperformed the private equity portfolio and
vice versa.

    Frei and Studer (2004)

Performance smoothing as a result of stale prices has also received attention in recent research8.
Appraisal based pricing as a result of illiquid investments results in a reduced perception of
volatility. While Conner (2003) opines that much of the perceived diversification benefits
disappear after adjusting for stale prices, Emery (2003) finds substantial return benefits by
incorporating longer time horizons in performance computation. Nevins, Connor and McIntire
(2004) address the question of capital allocation to private equity. They feel that the allocation
target for committed capital should cause invested capital to converge to its target when
expectations for investment returns and private equity cash flows are met. New commitments
should be made if the prior committed capital falls short of its target while further commitments
should be delayed in case of excess capital. This allows for a systematic approach to allocate
capital to private equity and works better as opposed to a fixed annual commitment percentage.

IV        Conclusion

Private Equity investments offer high return but are risky. They are long term investments that
are generally not available to traditional managers. Investors have to increase their knowledge
and comfort level to realize the benefits of Private Equity. If added to a well-diversified
portfolio, Private Equity can increase the returns more than other asset classes. Since Private
Equity investments show a high volatility, the risk of this portfolio will increase, too. An investor
has to be aware of the amount of risk she wants to take in order to realize the maximum returns.

    Conner (2003) and Emery (2003)

                    Appendix I: From National Venture Capital Association

Stage of Private Equity Investment

Seed: Finance provided for the development of a business concept, perhaps involving the
production of a business plan, prototypes and initial research.
Start-up: Financing provided to companies for use in product development and initial marketing.
Companies may be in the process of being set up or may have been in business for a short time,
but have not yet sold their product commercially.
Other early stage: Financing provided to companies that have completed the product
development stage and require further funds to initiate commercial manufacturing and sales.
They may not yet be generating profits.
Expansion: Sometimes known as "development capital" provided for the growth and expansion
of an established company. Funds may be used to finance increased production capacity, product
development, provide additional working capital, and/or for marketing.
Bridge financing: Short-term venture capital funding provided to a company generally planning
to float within a year.
Secondary purchase/Replacement equity: Purchase of existing shares in a company from another
private equity firm, or from another shareholder or shareholders.
Rescue/turnaround: Financing provided to a company in difficulty or to rescue it from
Management buy-out (MBO): Funds provided to enable the current operating management and
investors to acquire an existing product line or business.
Management buy-in (MBI): Funds provided to enable an external manager or group of managers to
buy into a company.
Institutional buy-out (IBO): The purchase of a company by a private equity firm following which
the incumbent and/or incoming management will be given or acquire a stake in the business.
Leveraged build-up (LBU): When a private equity firm buys a company as principal with the aim
of making further relevant acquisitions to develop an enlarged business group.
Mezzanine finance: Loan finance sitting between equity and secured debt, often provided as part
of a private equity package.
Public to private: Finance provided to take a quoted company into private ownership.
Purchase of quoted shares: Venture capital firms prepared to take stakes and/or acquire shares in
quoted companies.


Brav, Alon, Chris Géczy and Gompers, Paul, “Underperformance of seasoned equity offerings
revisited”, Working Paper, University of Chicago and Harvard University, 1995.

Brav, Alon and Gompers, Paul, “Myth or Reality? The Long-Run underperformance of Initial
Public Offerings: Evidence from Venture and Nonventure Capital-Backed Companies”, Journal
of Finance, 52, 1997.

Cochrane, John H., “The Risk and Return of Venture Capital”, National Bureau of Economic
Research, January 2001.

Conner, Andrew, “Asset Allocation Effects of Adjusting Alternative Assets for Stale Pricing”,
Journal of Private Equity, Vol. 6, No. 3, Winter 2003.

Emery, Kenneth, “Private Equity Risk and Reward: Assessing the Stale Pricing Problem”,
Journal of Private Equity, Vol. 6, No. 2, Spring 2003.

Frei, Andre, and Studer, Michael (Partners Group), “Practitioner’s Guide To Private Equity
Benchmarking ”, Working Paper, February 2004.

Gompers, Paul and Lerner, Josh, “The Really Long-Run Performance of Initial Public Offerings:
The Pre-NASDAQ Evidence”, Journal of Finance, forthcoming.

Gompers, Paul and Lerner, Josh, “The determinants of Corporate Venture Capital Success:
Organizational Structure, Incentives and Complementaries”, Working Paper, National Bureau of
Economic Research, 1998.

Loughran, Tim and Ritter, Jay, “The New Issue Puzzle”, Journal of Finance, 50, 1995.

Manigart, Sophie and De Waele, Koen, “Venture Capitalists, Investment Appraisal and
Accounting Information: A comparative study of the US, UK, France, Belgium and Holland”,
European Financial Management, 2000.

McGlinchey, Monica C., Jeanne Metzger and Taylor John, “U.S. Venture Quarterly Returns Dip
into the Red for the first time since 1998 But Still Shows Healthy Return for the Year”,
Thompson Financial, 2001.

Nevins, Dan, Connor, Andrew and McIntire, Greg, “A Portfolio Management Approach to
Determining Private Equity Commitments”, forthcoming in the Journal of Alternative
Investments (Spring 2004).

Peng, Liang, “Building a Venture Capital Index”, Working Paper, Yale School of Management,
August. 2001

Ritter, Jay, “The long-run performance of Initial Public Offerings”, Journal of Finance 42, 1991.

Schneeweis, Thomas and Joe Pescatore eds. “The Handbook of Alternative Investment
Strategies: An Investor's Guide”, Institutional Investor, 1999


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