Inside Private Equity E-Book

James M. Kocis

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 354

Veröffentlichungsjahr: 2009

Beschreibung

Inside Private Equity explores the complexities of this asset class and introduces new methodologies that connect investment returns with wealth creation. By providing straightforward examples, it demystifies traditional measures like the IRR and challenges many of the common assumptions about this asset class. Readers take away a set of practical measures that empower them to better manage their portfolios.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Foreword

Preface

MEASURES MATTER

Acknowledgements

How to Use This Book

About the Authors

PART One - Setting the Foundation

CHAPTER 1 - Background

OWNING COMPANIES

VENTURE CAPITAL’S BEGINNINGS

THE VERY RECENT PAST

WHAT MAKES A VENTURE CAPITALIST?

PRIVATE EQUITY IS OWNERSHIP OF A COMPANY

COMMON FORMS OF PRIVATE INVESTING

WHY INVEST IN PRIVATE EQUITY?

FINALLY: THE BIG SECRET

CONCLUSIONS

CHAPTER 2 - Private Equity Perspectives

WORKING IN PRIVATE EQUITY

THE WORLD OF PRIVATE EQUITY

THE COMPANY PERSPECTIVE

THE FUND PERSPECTIVE

GETTING DOWN TO WORK

THE INVESTMENT PERIOD

OTHER GPs AND ROUNDS

LIFE AS A GP

HOW FUND MANAGERS MAKE MONEY

THE FUNDS OF FUNDS PERSPECTIVE

THE INVESTOR

THE INVESTOR’S PERSPECTIVE

DIFFERENT POINTS OF VIEW

MEASURING FROM DIFFERENT PERSPECTIVES

CONCLUSIONS

CHAPTER 3 - Managing the Investment Process

CYA OR PROCESS?

GAINING ACCESS

AN APPROACH TO PRIVATE EQUITY INVESTMENT

THE PRIVATE EQUITY INVESTMENT POLICY

GENERATING DEAL FLOW

SCREENING DEAL FLOW

QUALITATIVE DUE DILIGENCE

SCANDAL ROCKS INVESTMENT GROUP - Fourteen Indicted, Including You

MONITORING AS PART OF THE INVESTMENT PROCESS

CONCLUSIONS

BONUS SECTION! ANNUAL MEETINGS

CHAPTER 4 - Capturing a Portfolio

HUMAN TECHNOLOGY

MONITORING INVESTMENTS

PERFORMANCE MONITORING OR ACCOUNTING?

A Word on Standards

RECORDING THE COMMITMENT

CAPTURING TRANSACTIONS

CALLING CAPITAL IS ABOUT PREDICTING THE FUTURE

WHAT IS IT WORTH?

CAPTURING CURRENCY EFFECTS

BASE AND LOCAL CASH FLOWS

CAPTURING EXCHANGE RATES

WHAT IS COMMITMENT DRIFT?

THE SPREADSHEET PROBLEM

CONCLUSIONS

CHAPTER 5 - Tracking Portfolio Holdings

A BLIND POOL

FOREST AND TREES

NEEDED: FORENSIC ACCOUNTANTS

THE POSSIBLE AND THE PRACTICAL

VALUATION CHALLENGES

CALCULATING PRO RATA OWNERSHIP

CONCLUSIONS

BONUS SECTION! ADVICE TO GPs (JUDGE 1993)

PART Two - Measurements and Comparisons

CHAPTER 6 - Standard Measures

MULTIPLES ARE RATIOS

THE NAMING OF MULTIPLES

MAKING CASH FLOWS COUNT ... OR NOT

THE CHALLENGES OF MEASURING A PORTFOLIO

THE ADJUSTED VALUATION

NEGATIVE ADJUSTED VALUATIONS

CONCLUSIONS

CHAPTER 7 - The IRR

THE IRR CONUNDRUM

MEASURE FOR MEASURE

THE SINCE INCEPTION IRR

THE IRR SMELL TEST

SIMPLE START

PROVING THE RESULT

FOUR FLOWS: TIME FOR A COMPUTER

THE MICROSOFT EXCEL IRR AND XIRR FUNCTIONS

IRR ASSUMPTIONS AND ANOMALIES

THE IRR TRANSFORM

Total IRRs Exceeding Individual IRRs

THE J-CURVE

COMPOSITE CALCULATIONS

OTHER RELATED MEASURES

PRIVATE EQUITY AND THE TIME-WEIGHTED RATE OF RETURN

CONCLUSIONS

CHAPTER 8 - Universe Comparisons

HOOKED ON NUMBERS

UNIVERSE? WHOSE UNIVERSE?

WHY COMPARE?

WHAT IS SUCCESS?

THE HAVES AND HAVE NOTS

WHO ARE YOU GOING TO TRUST?

QUARTILES ARE RANKINGS

SUB-UNIVERSES

INDEXES THAT ARE NOT INDEXES

HOW THE SAUSAGE GETS MADE

MAKING A BENCHMARK

RETHINKING BENCHMARKS

EARTHLY MEASURES

FREEDOM OF INFORMATION EFFECTS

PUBLICLY AVAILABLE SOURCES

INDIVIDUAL FUND MEASURES

SUMMARIZING PERFORMANCE FROM PUBLIC DATA

HOW BIG IS BIG ENOUGH?

SAMPLE VERSUS CENSUS

CONCLUSIONS

CHAPTER 9 - Flawed Research Methodologies

ANALYTICAL RUTS

WHAT DOES THE STANDARD DEVIATION OF AN IRR SERIES MEASURE?

PLAINS, FOOTHILLS, AND MOUNTAINS

EXPLAINING IRR VOLATILITY

VOLATILITY OF THE MULTIPLE

THE TIME-WEIGHTED COMPARISON

CONCLUSION

CHAPTER 10 - Visualizing Private Equity Performance

PROSPECTING AND WORKING THE MINE

DRAW A PICTURE

RADAR CHARTS

PLOTTING OVERALL PRIVATE EQUITY PERFORMANCE

SAMPLE SCALING

PLOTTING A PRIVATE EQUITY FUND

ORDERING AXES

OVERLAYING CHART SERIES

CONCLUSIONS

CHAPTER 11 - The IRR and the Public Markets

MEASUREMENT INNOVATION

THE MODIFIED IRR

INDEX RETURN COMPARISON METHOD (ICM)

END OF INVESTMENT LIFE

NEGATIVE VALUATIONS

ANOTHER RADAR MEASURE

CONCLUSIONS

PART Three - Topics on Risk

CHAPTER 12 - Performance Attribution

WHAT ABOUT HARRY?

WEIGHTING DECISIONS

Example of Neutral Weighting

PORTFOLIO CHANGES

FOR THE SKEPTICS

MULTIDIMENSIONAL ANALYSIS

NEUTRALLY-WEIGHTED, TIME-ZERO IRR ANALYSIS (LONG AND NICKELS 2002)

CONCLUSIONS

CHAPTER 13 - The Concentration of Wealth

WHERE IS THE WEALTH?

DISTILLING PERFORMANCE

THE LORENZ CURVE

CONCENTRATION OF WEALTH

ADDING A PUBLIC MARKET COMPARISON

CONCLUSIONS

CHAPTER 14 - The Diversification of Portfolios

COUNT MATTERS

WARNING: SOME PROGRAMMING AHEAD

ONE FUND, TWO FUNDS, THREE FUNDS, FOUR

THE OUTCOME OF A PORTFOLIO OF ONE

ADVANCING THE ART

CONCLUSIONS

CHAPTER 15 - Cash Management Models

ALL THAT GLISTERS IS NOT GOLD

WHY NOT CASH FLOW FORECASTING?

NONPROBABILISTIC: THE YALE MODEL

EXPLANATION OF THE YALE MODEL

CASH MANAGEMENT: OUR EXPERIENCE

SPECIAL NOTES

OTHER USES FOR MODELS

YOUR MODELS

COMPENSATION

COMMITMENT PACING

CONCLUSIONS

PART Four - Conclusions

CHAPTER 16 - The Private Equity Professional

THE PROFESSION

NEW SKILLS

CEDING THE GLORY

LOOKING AHEAD

FINALLY

CHAPTER 17 - Summary

INSIDE PRIVATE EQUITY

APPENDIX A - Proposed Venture Capital Portfolio Valuation Guidelines

APPENDIX B - On-Site GP Audit Program Guide

APPENDIX C - Qualitative Due Diligence: Structured Interview

D - Qualitative Due Diligence: Structured Reference Calls

APPENDIX E - Request for Information (RFI)

APPENDIX F - Advanced Topics: Duration of Performance

APPENDIX G - Advanced Topics: Correlation and Opportunity Costs

APPENDIX H - Patent Summaries

References

Index

Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding.

The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more.

For a list of available titles, please visit our Web site at www.WileyFinance.com.

Copyright © 2009 by James M. Kocis, James C. Bachman IV, Austin M. Long III, and Craig J. Nickels. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

Quote from The Silicon Boys and Their Valley of Dreams, David A. Kaplan, Perenniel, 1999. Used with permission of the author.

Two articles by Tom Judge copyright.

Microsoft Excel is a trademark of Microsoft Corporation. PowerPoint is a trademark of Microsoft Corporation.

For more information about the patented methodologies referenced this book visit http://www.alignmentcapital.com.

This book and its content are for information and educational purposes only. You alone will need to evaluate the merits and risks associated with methodologies depicted in the book. Decisions based on information obtained from the book are your sole responsibility, and before making any decision on the basis of this information, you should consider (with or without the assistance of an advisor) whether the information is appropriate in light of your particular investment needs, objectives, and financial circumstances. Investors should seek financial advice regarding the suitability of investing in any securities or following any investment strategies.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at [phone], outside the United States at [phone] or fax [phone].

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Inside private equity : the professional investor’s handbook / James M. Kocis [et al.].

p. cm. - (Wiley finance series)

Includes bibliographical references and index.

eISBN : 978-0-470-47115-9

1. Private equity. 2. Venture capital. 3. Portfolio management. 4. Investments.

I. Kocis, James M.

HG4751.I57 2009

332.63’22-dc22

2008045556

To Nick Vallario and in memory of Shao Xin Kai

Foreword

I started to invest in venture capital partnerships on behalf of the AT&T pension fund in 1980. Please note that I referred to venture capital and not private equity. It was not until the late 1980s that Stan Pratt and Steven Galante, then of Venture Economics, and Ned Regan, former Controller of the State of New York, coined the phrase “private equity.” Three unrelated events urged me to venture into venture investing in 1980. In 1979 the Department of Labor issued final regulations applying “the prudent man rule” to the investment of corporate pension fund monies in alternative investments. On Labor Day 1974, President Gerald Ford signed into law the “Employee Retirement Income Security Act” (ERISA), which governed the administration of corporate pension plans and assets. However, it was not until “final regulations” were issued in 1979 that corporate pension funds felt comfortable making investments in venture capital. The second event related to the consolidation of all pension funds held by the 23 telephone operating companies owned by AT&T. All of the assets of those funds were transferred to the Bell System Trust. One of my responsibilities was to examine the individual holdings in every publicly traded stock portfolio transferred into the Bell System Trust. Much to my amazement I found about six investments listed at the very end of one of those portfolios with an “L.P.” following the name of the investment. Meeting Ray Held, then of the Manufacturers Hanover Trust Company, was the third event. Ray taught me a great deal about investing in venture capital including the knowledge that “L.P.” meant “Limited Partner.” I like to think that I taught Ray a little about what makes institutional investors tick. Those three events led me to start investing in venture capital partnerships.

During 1979 about $160 million in total was committed to venture capital partnerships. To the best of my knowledge only five institutions were making such investments in January of 1980. Morgan Stanley and J. P. Morgan had made commitments to venture capital using “Partners” money and three endowments, from east to west, Harvard, Yale, and Stanford had invested in venture capital in the late 1970s. I am aware of a few other “venture” events during the late 1970s. Ned Heizer, one of the founders of the National Venture Capital Association (NVCA), had raised an $80 million fund from insurance companies and banks to invest in start-ups, and some wealthy families like the Bessemer, Rockefeller, and Whitney families had supported venture-like investments for many years. I believe that “Jock” Whitney gave Eddie Rickenbacker, the most decorated American combat pilot of World War I, the funds to create Eastern Airlines back in 1938.

During 1980 I discovered that there was very little information available about venture capital that I could get my hands on. There were no performance numbers available. In fact, it was almost impossible to get my hands on any information. I did have the opportunity to chat with a handful of venture capitalists, and two names kept coming up in those telephone calls: Stan Pratt and Dick Testa. Stan was the owner of Venture Economics and the publisher and editor of the Venture Capital Journal. Dick Testa was a founder of the Boston law firm of Testa, Hurwitz & Thiebault. Dick was instrumental in working with the Securities and Exchange Commission to create one of the country’s first high-tech initial public offerings, Digital Equipment Corporation. I knew that I needed to talk with both Stan and Dick. I called each of them, and both men graciously agreed to meet with me. I flew to Boston early one morning, met with both, and flew back in the evening. Both of these gentlemen were a wealth of information. Not only did they know every venture capitalist in this country, they knew all of the entrepreneurs and chief executive officers of every start-up that had been created by venture capitalists. The next day back in my office the telephone started ringing off the wall. The word was out. The AT&T pension fund was making investments in venture capital partnerships.

A general partner would call me and say that they were raising a venture capital fund. If they said they were raising “a fund,” I learned to conclude that they were raising their first “institutional money” fund. If they were raising a second fund they would proudly say, “We are raising our second fund.” The general partner asked if he and his partners could visit me in my office. I, of course, said “yes.” After all, I was trying to invest, and the more general partners I could meet the better. At the appointed time and place all of the general partners arrived. This usually meant two or three people. They would present a “hard copy slide show.” Keep in mind that this was before PowerPoint. They would begin by discussing their individual backgrounds and experiences. This would be followed by their deal flow and investment strategy. Then a discussion of their investment decision-making process and, finally, the size and scope of the fund they were hoping to raise. At that point they asked for a commitment. I probably should not admit this, but my strategy and due diligence process were as simple as simple can get. My strategy was to invest in venture capital. Since all of the funds being raised during the early 1980s were seed, start-up, and early-stage partnerships, that turned out to be my strategy. Here is the part I probably should not reveal, but I have nothing to lose now. If I could understand their strategy and investment decision-making process and if both made sense, I mean common sense, then I was halfway home. During that meeting I also looked into the eyes of each of the general partners and asked myself, “Do I trust this person?” If the answer to all of the above was “yes,” then I made a commitment to their partnership. There was none of this nonsense that they would get back to me with my allocation. The general partners and I had a golden handshake, and they were on their way to the next fundraising meeting.

In 1981 IBM introduced the personal computer, and for quite a few years venture capitalists invested in computer hardware. In fact they put so much money into hardware that they created over 70 Winchester drive companies. This might be referred to as the first bubble in venture capital. As the personal computer became a commodity, venture capitalists began investing in software. The mid to late 1980s was not a good time for venture capital. And the stock market crash of 1987 created very chilly conditions, and a good venture firm was lucky to have one IPO a year.

Asset allocation is a crucial aspect of managing institutional money. It probably accounts for 90 or 95 percent of the total performance of an institutional portfolio. As soon as we started investing pension fund money in venture capital I was under pressure to come up with an expected return for venture capital that could be used in the algorithm that was used in asset allocation. I finally decided to look at the historic long-term return of large capitalized public stocks and discovered that the average annual return of that asset class since the Great Depression was 10 percent. I decided that if venture capital could provide a 50 percent premium, or 15 percent, that would be attractive enough to attract investors. To check my theory I looked at the return on small capitalized stocks, the closest public investment to venture capital. That average annual return was 12 percent, and I decided that a 25 percent premium would be adequate. Amazingly that number is also 15 percent. I felt pretty good about my discovery and mentioned my new expected return of 15 percent at a Venture Economics conference a few months later. Since most of the conference attendees were general partners, I was taken to task for trying to ruin the venture industry. They were talking about returns of 25 to 35 percent. If you look back at the average annual return on private equity since 1980, I think you will find it is very close to my expected return.

In 1983 we made our first venture capital investment in Europe. It was a commitment to Alta-Berkeley in London. In those days many venture firms in England created an investment vehicle in the form of a “unit trust” and registered that trust on the Isle of Jersey in the Channel Islands to avoid the taxation of partnerships in England. The Isle of Jersey has its own parliament and is not subject to English law. My friend, Sir Ronald Cohen, fought successfully to change the tax law in England so that today partnerships are widely used not only in England, but on the continent as well. Two years later we made our first investment in Japan. It was called Japan America and was managed by Japan Associated Finance Companies (Jafco). Their first investment was in a 150-year-old, family-owned, high school textbook publisher. I wondered what I had gotten myself into until they took the company public about three years later at a multiple of around 20.

By 1987 I knew that I needed a method to evaluate each of our partnership investments against some sort of benchmark. I decided to calculate the return for all of the partnerships that we had committed to in one single year, using all of the cash flows and values as if they were one partnership. I could then compare the returns on each of the individual partnerships with the return for all of the partnerships for that year on the assumption that all of those partnerships were investing in the same economic and venture capital environment. Hence, the “vintage year” concept was born.

When 1989 rolled around, we were receiving quite a few distributions of newly issued common stock in venture-backed companies. Distributions did not become meaningful until the late 1980s. Remember, this was a primarily venture capital portfolio consisting of seed, start-up, and early-stage investments. I did not know whether to hold or sell these stocks. Beth Dater of Warburg Pincus Counselors had a terrific track record of managing small stock mutual funds. I asked her if she would manage all of the venture capital distributed stocks for the AT&T venture portfolio. When she and I met with Lionel Pincus, he agreed to take the assignment because he was friendly with my boss. However, I think that he said that managing distributed stocks would never be “a business.” About five years later Warburg Pincus was managing around $8 billion worth of “distributed” stocks.

Bart Holaday was managing the venture capital portfolio at First Chicago. He and I were concerned that venture capital firms were placing a very different valuation on exactly the same venture investment where there were a number of different partnerships invested in the same company. We came up with a one-page valuation policy for the industry. We were getting nowhere until Stan Golder, a highly respected venture capitalist, and a founder of Golder, Thoma, Cressy, publicly supported our effort. In fact, that gave us an entre’e to the NVCA, which promptly said they were not interested in our proposed valuation policy. It is interesting that within six months both the European and British Venture Capital Associations adopted our one-page policy. It also started to appear in offering memorandums and even in textbooks. I do not think that the NVCA ever adopted our policy. All of this took place in 1990.

That same year Bob Black of Kemper Investments and I decided it would be a good idea if limited partners got together periodically like the venture general partners did as part of the NVCA. We drew up a list of a dozen or so limited partners on a cocktail napkin and invited them to a meeting in November 1990. We met at a Marriott Courtyard just outside O’Hare Airport near Chicago. Everyone we invited showed up, and we got a meeting room for no cost because at least 10 of the attendees spent the night at the motel. We all chipped in for a buffet lunch and agreed to meet again. A few months later I was an attendee at a Venture Economics Forum and several general partners accused me of trying to form a “cartel” to control terms and conditions. Anyone associated with the private equity industry knows that never happened. I understand that now the Institutional Limited Partners Association (ILPA) has a couple of hundred paying members and an executive director with a staff of 8 or 10. I never visualized that happening.

In 1993 I was at my wits’ end trying to keep track of well over a hundred partnerships. Then I met Jim Kocis. He had approached Mitchell Hutchins about developing a Windows version of a private equity system to little avail. Then Jim came to see me and I said that AT&T would put up $25,000 a year for a few years to develop such a system. The rest is history. Today the Burgiss Group helps over 200 clients monitor and manage billions of dollars of private equity assets.

By late 1995 the AT&T pension fund had received all of its paid-in cash calls in the form of cash or stock distributions and still held a venture portfolio worth billions of dollars

Why am I telling you all of this? Because I wish I had this book, Inside Private Equity, in January of 1980. However, that would have been impossible at that time. Today four knowledgeable, experienced authors, James M. Kocis, James C. Bachman IV, Austin M. Long III, and Craig J. Nickels have created this very helpful and informative handbook on private equity. I urge every current and future investor in private equity to read this book. So, read on.

Tom Judge

Former Investor in Venture Capital

Tom Judge was inducted into the Private Equity Hall of Fame in 1995 and was considered the dean of institutional investors during his 15-year private equity tenure at AT&T. During those 15 years, he created and managed the AT&T venture capital portfolio that grew from zero in 1980 to commitments of $1.5 billion in 180 partnerships formed by 90 firms. He retired from AT&T in September 1995. He is an honorary Kauffman Fellow. Tom also co-founded the Institutional Limited Partners Association, which has grown to a membership of over 200 institutions.

Prior to managing the venture capital portfolio for the AT&T Investment Management Corporation, he was involved in all aspects of the administration of employee benefit assets at AT&T for 17 years. Tom has been a frequent speaker at private equity and pension fund conferences and seminars worldwide. He holds an undergraduate degree from the Pennsylvania State University and earned his MBA at Seton Hall University.

Preface

MEASURES MATTER

This book focuses on a particular form of investing, the ownership of private assets, which we simply refer to as private equity. This once-sleepy backwater is now a raging river, overflowing its banks and flooding the marketplace. Newspapers now often refer to private equity as if it were something of importance to everyone. And indirectly it may be, but investing in private equity is primarily done by specialized firms and wealthy individuals or institutions with long-term horizons, with tens of millions or even billions to invest. Private equity has nothing to offer the casual or short-term investor.

There are fascinating books that weave tales of venture capitalists building great companies from scratch. There are fast-paced accounts of the buyout of the century. There are guidebooks for entrepreneurs seeking venture capital. There are detailed private equity case books that use proprietary data to explain the more general behavior of the asset class or to defend a particular theory. This book is none of these.

This book was primarily written for those with the most at risk, those that supply the money, a great deal of it, the limited partners. Whether you are the head of a pension group, an administrator at a fund of funds, an investment officer at a foundation or endowment, or an analyst charged with monitoring a portfolio of private equity assets, we expect that you will find something of interest here. But Inside Private Equity may have interest for others. If you are a fund manager, doing the work of investing in companies and reporting back to your limited partners, you may benefit from seeing the world from their perspective. We believe that this text also has something to offer those who provide specialized services to the private equity industry, such as accountants, attorneys, and consultants.

The authors have a broad range of experience and exposure to private equity. Two of us, Messrs. Kocis and Bachman, design, develop, and support large-scale, commercial private equity portfolio management systems at the Burgiss Group, whose clients include many of the largest private equity investors in the world. The other two authors, Messrs. Long and Nickels, are practitioners who run, have run, and have advised large private equity programs. Austin runs Alignment Capital, a private equity consultancy. Craig is Director of Private Markets for Washington University in St. Louis.

In our work we put particular emphasis on measurement. Inside Private Equity arose from our belief that the general understanding of how to invest in, monitor, and measure the performance and risk of private equity has not kept up with its scale and importance. In this book we focus on what you can measure. Our explanations and examples are meant to illustrate concepts and basic principles. Our examples use simple numbers and are broken down into steps. Critically, every analytical technique we write about has been put to the test of managing large portfolios of private assets. Some of them are tried-and-true and may be somewhat obvious, but we hope that much of what we present here is new to you.

Building a portfolio of private equity assets takes years or even decades. Since most private equity funds have a term of 10 years or more, almost all of the analysis that you will do will be on partially realized investments. Measuring private equity will make you get used to thinking in terms of long-term interim results. This requires a very different mind-set from the public markets, where today’s investments can be measured tonight.

Despite this long-term horizon, interim results can be used for decisions that matter. Investors can, for example, actively manage their private equity portfolios by selling (or buying) positions in partnerships. Measuring performance midstream is also critical for the ongoing investment process. Often the decisions about new investment opportunities and follow-on investments are made from the performance characteristics of funds that are only part way through their lives. Interim results also serve as a gauge of the health of a private equity fund or portfolio. Without them, your reports to investment boards and other stakeholders would seem bare.

The analytical techniques that we write about are useful at several levels of abstraction and scale. For example, you can calculate the IRR on a company, a fund, a group of funds that originated in the same year, or on a whole portfolio of funds. The result from each tells a different story, but the principles are precisely the same.

As you apply these techniques, you may be drawn to compare your performance results with industry norms. When you do, you should be aware that research in private equity is still in its infancy. Unlike research in the public markets, where practitioners and academics can mine rich veins of transactional data, the literature on private equity is sparse and is mainly based on selected sets of proprietary data.

In our collective work, we get to see a great deal of private data. From our point of view, the current state of commercially available information about private equity is a mess. We know that universe data about private equity is rightly hard to get, assemble, maintain, and audit. We also believe that the industry, with its emphasis on quartile returns, is currently poorly served. We are not alone in our criticism. In this text, we avoid the use of proprietary data.

Unfortunately, there are aspects of the private equity industry that are driven by hype, myth, and folklore. We have heard our share of nonsense, where achieving a high IRR is a goal unto itself. What usually gets lost amidst the hype are the true measures of wealth creation and risk. For example, we often see the average IRRs published in trade publications and journals. We think this kind of analysis is at best misleading and at worst plain silly. Investors should focus instead on the effects that this type of investing has on the investor. The return, as most prominently measured by the IRR, is at best a proxy for the overall wealth generated. As you will see, a high IRR does not necessarily mean that a great deal of wealth was generated.

We start this text with a brief introduction, lay out some perspectives, and describe a structured investment approach. We describe a simple data framework before introducing standard asset-class measures and analytical techniques. We address some of the challenges of quarterly reporting in the face of partial or incomplete data. We beat the IRR into submission, providing an exhaustive review of its calculation, anomalies, and variations. We delve deeply into the topic of peer universes and benchmarks. We introduce aspects of visualizing the performance of investments that we have found to be particularly helpful. We then introduce more advanced measures such as the Index Comparison Method, which allows you to compare your investments to the public markets. We move on to topics on risk, where we present techniques that help you uncover both how and where wealth was gained and lost. Finally, we broadly introduce two methodologies for cash flow modeling before wrapping up.

As practitioners, we know that private equity isn’t all that mysterious. But we run a risk here. Secret societies thrive in the dark. Mystique sells. Yet recent events have shown that the world has grown suspicious of private equity, its means, and its motives. There are episodic calls to take legislative actions to control it and to create accounting standards to constrain it. On balance, we think that the private equity industry could benefit from a little more light.

As a close friend of ours who runs a major pension fund reminds us: “Private equity is only 20 percent of my assets but takes 80 percent of my time.” We hope that this book helps you better manage these assets and your time. Finally, and pragmatically, we know that every measure needs a context, that experience counts, and that insight comes in ways that cannot be predicted. We hope that this book adds to your knowledge, stimulates thinking, and helps you invest wisely.

We welcome hearing from you.

James M. Kocis James C. Bachman IV Austin M. Long III Craig J. Nickels

Acknowledgments

This book was made possible with the help of Tim Moore, who knocked our heads together, and Tom Judge for providing an enormous opportunity. Special thanks to Andrew Conner, David A. Kaplan, and Chihtsung Lam.

Much of this work would not have been possible without the help of Kendra Alaishuski, Stephen Bruhns, Joseph Fung, Berlin Lai, Romit Mukherjee, Lorna Palmer, Ana Perez, James Rearden, and the rest of the team at the Burgiss Group. Nelson Lacey, thanks for the connections. And of course, for making it possible in hurry, Skyler Balbus, Bill Falloon, Meg Freeborn, Kevin Holm, and Laura Walsh at Wiley. This book would also not have been possible without the continuing support from Laureen Costa, Julian Shles, Larry Unrein, Sandy Zablocki, and the rest of the crew at J.P. Morgan Asset Management.

Then there are the host of others we must thank including Anthony Aronica, Susan Carter, Linda Costa, Paul Finlayson, Tom Gotsch, Leslie Halladay, Pat Haverland, Linda Hoffman, Guy Holappa, Mark McBride, Jesse Reyes, Stephen Roseme, Louis Sciarretta, and Cheng Wang.

For research above and beyond the call of duty, Joan Siminitus and Anita Matt for helping find a critical reference.

Special thanks to Alice Heatherington and Zoe Westhof for their careful editing and diplomatic delivery of constructive criticism. Finally a big thanks to the crew at La Isla, for the best coffee in Hoboken, NJ.

How to Use This Book

This book builds on itself. If you are new to private equity, we think that you should read it from front to back, for the concepts and terms we introduce early on are needed for understanding what we explain later. In lieu of reading it from cover to cover, please refer to our guidance below. If you plan on reading only one chapter, read Chapter 16, The Private Equity Professional.

We have broken this text into four parts.

Part One is largely background and sets the foundation for the technical discussions that follow. There are no equations in Part One.

• For those new to private equity, reading the first two chapters is a good start. These two chapters will give you a sense of private equity, its beginnings, what drove its growth, and where it is today. If all you want is a general understanding of the asset class, you can probably stop here.

• To get a general understanding of a structured approach to private equity portfolio management, and how it fits into a larger program of investment, read Chapter 3, Managing the Investment Process. This chapter draws heavily from the experience of Messrs. Long and Nickels.

• If you are responsible for tracking or monitoring a portfolio of private equity investments, you should read Chapter 4, Capturing a Portfolio. This chapter sets the stage for the discussions on measurements that follow by describing the basic data you will need to capture.

• To understand some of the challenges of tracking the underlying investments that a private equity fund makes, its portfolio holdings, read Chapter 5, Tracking Portfolio Holdings.

Part Two covers the fundamental techniques you can use to measure, compare, and present the performance of this asset class.

• For anyone wanting to understand the performance measurements, Chapters 6 and 7 are required reading. These chapters explore multiples and many variations on the theme of return, as most prominently measured by the IRR.

• For those trying to compare their portfolio with benchmarks or universes, read Chapter 8.

• We present a short critique on private equity research that we have encountered in Chapter 9. Read this chapter as a prelude to more advanced topics.

• If you are responsible for quantitative due diligence or for preparing summary presentations, read Chapter 10. It presents some charting techniques that we have found interesting and useful.

• To understand how to compare the performance of your investments to the public markets, read Chapter 11, which presents Long & Nickels’ Index Comparison Method (ICM).

Part Three wades into deeper water, helping you to extract more information from your portfolio.

• To understand what part luck and skill played in picking investments for a private equity portfolio, read Chapter 12, Performance Attribution.

• To better understand how wealth has been created, read Chapter 13, The Concentration of Wealth.

• To understand what effect the size of a portfolio has on performance expectations, read Chapter 14, The Diversification of Portfolios.

• To become acquainted with the general techniques of cash flow modeling, read Chapter 15, Cash Management Models.

Part Four is the wrap-up, outlining our view of the private equity professional and summarizing the contents.

About the Authors

James M. [email protected]

Jim is the founder and president of the Burgiss Group, one of the leading providers of software and services to the private equity limited partner community. Jim’s involvement with the private equity industry began in the late 1980s with a consulting engagement with Mitchell-Hutchins. He and his team designed Private i, the world’s most popular program for private equity portfolio management. Private i is used to manage in excess of $1 trillion of private equity investments. Jim’s previous book is The Paradox Programmer’s Guide: PAL By Example, coauthored with Alan Zenreich, published by Random House. Jim has a BS in Chemical Engineering from the New Jersey Institute of Technology.

James C. Bachman IV, [email protected]

James is the Head of Research at the Burgiss Group. In this role, he is principally responsible for research-related initiatives as well as expanding the technology platform’s portfolio management capabilities. Prior to the Burgiss Group, James worked at the Bridgeton Companies, an alternative investment boutique. As one of Bridgeton’s first employees, James played a significant role in the firm’s capital management, derivatives brokerage, and research and development divisions.

James obtained his BA in Economics and Business Administration as an Omicron Delta Epsilon graduate from Muhlenberg College and received his MBA from Texas A&M University at Commerce. Additionally, he holds the Chartered Alternative Investment Analyst designation. James is a member of the CFA Institute’s Global Investment Performance Standards (GIPS) Private Equity Working Group.

Austin M. Long III, JD, [email protected]

Austin is the head of Alignment Capital, a private equity consultancy. Austin has been active in the private markets since 1987, when he cofounded what was to become the University of Texas Investment Management Company’s (UTIMCO) private investment group. When he left in 2000, the UTIMCO private equity program had $2.2 billion in commitments. Austin is a former co-chair of the Institutional Limited Partners Association. He is a frequent speaker at industry gatherings. Austin co-founded Alignment Capital Group in 2001 with Craig Nickels.

Austin received his BA degree from Baylor in 1970, his Masters in Professional Accounting from The University of Texas at Austin in 1981 and his JD degree from DePaul University in 1987. He is a Certified Public Accountant and has been admitted to the bars of Illinois and Texas. Austin is a member of the CFA Institute’s Global Investment Performance Standards (GIPS) Private Equity Working Group.

Craig J. Nickels, [email protected]

Craig is the Director of Private Markets for Washington University in St. Louis where his responsibilities include the oversight and management of the University’s private market investments within the multi-billion dollar endowment. Included asset classes are private equity (venture, buyout, mezzanine, and so on), real estate, and real-assets.

Craig graduated from The University of Texas at Austin with a BBA in Finance in 1981. He was awarded the Chartered Financial Analyst Designation in 1986. Craig is a member of the Chartered Financial Analysts Institute and the CFA Society of St. Louis. Craig is also a member of the CFA Institute’s Global Investment Performance Standards (GIPS) Private Equity Working Group.

Austin Long and Craig Nickels are the inventors of U.S. patent #7,058,583, Method for Calculating Portfolio Scaled IRR and U.S. patent #7,421,407, Process and System for Determining Correlation of Public and Private Markets and Risk of Private Markets. For summaries, see Appendix H.

PART One

Setting the Foundation

CHAPTER 1

Background

“There is always a critical job to be done,” said Doriot. “There is a sales door to be opened, a credit line to be established, a new important employee to be found, or a business technique to be learned. The venture investor must always be on call to advise, to persuade, to dissuade, to encourage, but always to help build. Then venture capital becomes true creative capital—creating growth for the company and financial success for the investing organization.”

—Georges Doriot quoted in Ante, Creative Capital, p. 173

This chapter introduces private equity by tracing some of the history and evolution of one of its earliest forms, venture capital. We then explain some of the major forms of private equity investing. We present some unsolicited advice about how to start a program of private equity investing and then let you in on a big secret.

OWNING COMPANIES

On December 12, 1980, Apple Computer, owned by its employees and a few venture capital firms, went public (Apple n.d.). From that day forward, Apple was a public company and was required to comply with the regulations of the U.S. Securities and Exchange Commission. With that event, early investments in Apple by venture capitalists paid off. Since then, Apple has been required to have external audits, comply with government filings, and invite public scrutiny. Further, Apple’s officers had increased liability and were subject to rules that made public their compensation and personal transactions involving the company.

If you buy a single share of Apple today, you instantly own a piece of the company. As a shareholder, you receive financial reports, have voting and other rights, and are invited to the annual meeting. Most importantly, by owning that share of Apple, you have standing—you have equity. Yet you can leave this all behind with one electronic order—it’s as easy as selling that share.

Private companies are an entirely different matter. What do you own when you have put some of your hard-earned cash into a private company? As your transaction was private, it was largely unregulated. Need to cash out your private equity in that company? Good luck. Who will you sell it to? Will anyone buy it? And so, realistically, what is it worth? What rights do you have?

VENTURE CAPITAL’S BEGINNINGS

Investing in private companies, whether through sweat equity or with money, is as old as business. Venture capital is but one form of private equity investing and is generally understood to be the business of investing in new or young enterprises with innovative ideas.