Introducing the model portfolio

CEPRES created a model portfolio to allow us to analyse the performance of the asset class. In this first instalment Simon Tang introduces the portfolio and examines performance to date.

How to invest in today’s private equity market? To come up with a plan, it is important to understand where we are.

The construction of our model portfolio is based on a set of simple assumptions: an institutional LP has been investing in private equity since 2007 with a global strategy covering primary funds in the main private equity segments of buyout and growth, private debt and venture capital.

The portfolio consists of 78 funds invested across 10 years starting in 2007, which equates to approximately eight new fund commitments a year on average. The majority of GPs in our portfolio are based in the US (51 percent), followed by Europe (30 percent), with the remaining smaller proportion of GPs categorising themselves as global (10 percent) and Asia-based (8 percent).  The geographic focus of the funds raised by these GPs follow these same lines.

In terms of fund stage focus, most of our capital commitments went to buyout (including growth equity) strategies (73 percent) where the average fund size was $1.7 billion, indicating an emphasis on the mid-market. We also made peripheral investments in private debt (5 percent) and venture capital funds (6 percent).

Our portfolio’s pooled fund net IRR and TVPI returns are 13.9 percent and 1.5x, respectively, and, as you would expect, outperforming Public Market Equivalents of all major global indices listed, proving that our private equity portfolio does in fact add alpha. But keep in mind that we are currently only referring to “ordinary” returns, when in fact we should determine our portfolio’s “risk-adjusted” returns by using CEPRES PE.Analyzer 4.0 to quantify in our portfolio’s alpha outperformance and the corresponding beta market risk for each of the PMEs in specific terms.

If we now dissect the overall portfolio returns, we see that fund net IRR returns were weak for vintage year 2007 but incrementally increased in 2008 through 2010, tapering again from vintage years 2011 through 2013. Clearly the investments made at high, pre-crisis valuations dragged on returns, while those made in the depths of the crisis performed significantly better.

Between 2011 and 2013, market visibility was relatively better and investors could see indications that governments’ efforts to stimulate economies were beginning to work; and as investment activity picks up, so does competition for deals. By 2014 and 2015, fund net IRRs stabilised to what you would consider as “normal” private equity returns of mid- to high teens, while 2016 and 2017 vintage years are clearly still too early to assess. In terms of fund net IRR returns by vintage year, our model portfolio looks quite healthy.

In terms of consistency of returns, our model portfolio’s performance spread is healthy with 51 percent of the total number of funds within the 1.0-1.5x net multiple (TVPI) range, plus another 32 percent of the funds showing net multiple returns in excess of 1.5x; only 17 percent of the funds are defaulting or underwater with a net multiple of less than 1.0x. The portfolio’s overall positive returns are due to a strong spread of returns across the positive side of the spectrum.

Liquidity

Since our portfolio has been 10 years in the making, we have seen substantial liquidity coming back. Despite a weaker IRR in 2007, our fund commitments during that year have in aggregate distributed 1.09x or 109 percent of our paid-in capital to these 2007-vintage funds. We have almost completely recovered our risk exposure for 2008 (0.99x DPI), while our cash-on-cash returns for 2009 and 2010 are very strong. DPI begins to taper in 2011 at 0.95x and 0.51x for 2012, but that is to be expected as those funds are in their seventh and sixth years, respectively, and are in their harvesting periods.

The remaining funds in vintages 2013 onwards are still relatively young and are either still in their investment periods or just starting to exit from deals. On an overall basis, the portfolio has provided robust liquidity and we have recovered nearly 80 percent of our total paid-in capital.

Looking at liquidity from a cashflow perspective, the J-curve maps out our overall capital contributions and distributions to and from the funds in the portfolio by investment year (not vintage year). After indexing all of the individual funds’ net cashflows to the same starting point of year zero, the purple bars show our substantial contributions during the earlier years and tapering, while the green bars are the opposite and represent distributions coming back to us, which is increasing over time as the portfolio matures.

The black line shows the net cashflow position on an annual basis, while the light purple line is our J-curve showing our cumulative cash position, or in other words, our capital gain development over the years. The J-curve clearly shows our model portfolio has delivered consistent liquidity over time and our portfolio gain crossed into positive territory in year six, which is the timeframe to be expected from private equity.

In this article, we’ve performed a portfolio monitoring of a typical institutional LP portfolio, and in doing so, we now understand the return profile in terms of vintage year, fund stage focus and performance spread, as well as the portfolio’s liquidity and risk characteristics. The analyses presented here are merely a sample of the many other portfolio monitoring analysis that we can and should perform on our private equity portfolio.

By doing this, we can understand the current health and condition of our portfolio, which then forms a basis for the next goal: to understand the portfolio’s trajectory. Accomplishing these two goals will enable us to formulate a stronger investment thesis that leads to smarter investment decisions, which ultimately results in a defensible portfolio that can weather macro threats and reach our return and liquidity targets. 

Simon Tang is a Singapore-based partner at digital PE investment network CEPRES.