Beating probability

Investors add private equity to their portfolios in order to move towards the efficient frontier and a higher Sharpe Ratio. Investors in efficient markets can avoid the perils of manager selection by structuring portfolios that closely mimic the market. Private equity investors do not have that option as there is no investable benchmark available. Nor would investing in such a benchmark be an attractive proposition: as any historical review of private equity performance will reveal, median private equity returns tend to underperform public equity indexes.

It is therefore especially important to select top performing managers when investing in private equity. While the fact that active private equity managers exhibit greater variability in returns compared to active managers of listed equity is a headache for investors, it is also indicative of the inefficiencies that persist in the private equity markets. Inefficiencies allow skilled managers to earn superior returns while unskilled managers post poor results. The distribution of actively managed returns provides therefore a measure of the opportunity presenting itself to investors.

From 1869, fortune seekers from all over the world converged on Kimberley, South Africa, in the hope of digging up diamond riches. The cottage industry with its many high-profile individuals that created the “The Big Hole” in Kimberley underwent developments that were not dissimilar to the experience of today's private equity industry. In 1876, for instance, when all restrictions on the number of claims that an individual could own were dropped, the chaos of 3,600 individual claims was reduced to just 98 syndicated holdings. In addition, the performance variance exhibited by those diamond miners was at least a match to the dispersion of returns that characterises private equity. And investors can find surprising parallels between the techniques employed by the miners and their own methods of successful private equity manager selection.

Reconnaissance. In mining as in private equity, one essentially needs to do some exploration before one can start digging. Anybody who has been waiting for the surge in German Mittelstand transactions triggered by succession issues or the burst in buy-and-build transactions that one would have expected given the number of power point presentations that delved into this theme knows the importance of distinguishing between investment myth and reality when making private equity allocation decisions.

Success in private equity investing requires an understanding of the different market segments, the drivers of investment returns and the relative supply of capital that seeks to be invested in the opportunities prevailing in certain market segments. In order to identify interesting investments, some of the factors to consider are:

  • • Geographies: market sizes and returns tend to vary within regional/local economic zones and relative to each other
  • • Stages: demand for venture capital, expansion capital, buyout capital varies in line with macro-economic developments
  • • Styles: value creation strategies will change in accordance with growing maturity of markets.
  • Bulk sampling. How to identify top performing funds/managers? Investors are indeed spoiled for choice. While in 1983 the European Venture Capital Association had just 43 member firms, their membership increased to 330 firms in 1996 and 950 firms in 2001. If one adds to that number the private equity firms operating in the US and Asia it becomes clear that just the screening of new fund offerings is a daunting task. (We register between 150 and 200 new fund offerings each year globally.) But even this effort needs to be focused as important opportunities might otherwise be missed.

    Monitoring existing partnerships is equally critical. Access to general partners' performance data is important in determining which groups are encircled by problems resulting from troubled portfolios and underperforming funds, and which groups provide convincing investment returns over various fund generations.

    Core drilling. Having identified potential funds as investment candidates is, however, just the beginning. Next comes the due diligence that examines the managers' track record. Given how difficult it can be to raise capital from investors, it isn't surprising just how aggressive private equity groups can be in presenting their investment results during a fundraising. Among the behaviours encountered are:

  • • aggressively valuing unrealised portfolio companies above cost;
  • • neglecting to discount firms in the portfolio that have encountered difficulties;
  • • failing to incorporate an illiquidity discount for shares of publicly traded firms still held in the portfolio.
  • Institutional investors, who often are surprisingly willing to accept performance-related general partner claims at face value, may not always identify these problems. Differences in valuation methodology can give the appearance that certain groups have superior performance when interim returns are compared, while in actuality this is not the case. Given the importance of the manager selection decision it is obvious that a potential investor needs to be able to handle such pitfalls and to examine the robustness and relevance of a track record on a basis that makes it not only comparable to other funds but also helps to determine whether the track record has a likelihood of being sustainable.

    Crushing and processing. If past results support a manager's competence claims in relation to a proposed investment strategy, one must proceed to examine the organisation and its people, as they are the ones that will be executing the strategy and will look after investors' money for the next decade. Is the current core management team the one that can fully lay claim on past investment performance? Are there succession issues? What is the culture of the private equity firm in question? How do they retain and motivate mid-level talent and build subsequent generations of deal-makers? Is there a concentration of risk with regard to the founding principal(s)? Are investors viewed as partners or a nuisance best dealt with through placement agents and preferably only seen once a year at an annual meeting? Beyond a group's top bracket LPs who receive all that loving attention and who are usually featured in reference lists, it helps to talk to some mid-sized LPs in order to get a fair picture of the GP's relationship management skills.

    The last few years have highlighted the importance of focusing on manager or organisational risk and this is the most difficult part of a due diligence, because it addresses soft issues that defy “scientific” assessment and will invariably result in a judgmental conclusion. But in order to enter into a ten-year relationship an investor needs to be very comfortable with the organisation of the GP.

    Cutting and polishing. Assuming one is confident about the merits of a particular fund and its management team, there is just one final hurdle to cross: the investment agreement. Generally LP agreements are skewed in favour of the GP, and investors will invariably have to make some compromises when negotiating those agreements.

    While an individual item is rarely enough to qualify as a deal breaker on a stand-alone basis, it is the pattern that should concern a potential investor in a fund. With hindsight, it has not been such a bad idea to pass on opportunities where a GP has consistently tried to push for maximum advantage throughout the legal documentation. It is very useful to monitor terms and conditions in the market place and to have a clear understanding of market standards in order to determine the degree of deviation of an individual fund agreement from the market standard.

    However, the single-most important issue in a negotiation of terms and conditions is whether an investor is prepared to pass on a seemingly attractive investment opportunity if basic terms are not met. Lawyers keep track on what LPs did accept in the past, but a track record of walking away if basic demands are not met is as useful as it is rare in contract negotiations.

    Safety in numbers. The principal lesson that investors have recently learned is that even the most detailed due diligence offers no assurance to invest in top-performing managers. It does by no means provide a guarantee of realising top quartile investment performance. There is an element of unpredictability with regard to the outcome of any private equity investment that cannot be addressed by analytical methods. In order to increase the likelihood of a successful private equity investment programme, it is therefore of critical importance to observe the rules of diversification and some healthy skepticism towards whatever the latest hot area to invest in might be. Finally, one must believe in the persistence of the inefficiencies of the private equity market, as it is those inefficiencies that do not only make manager selection so difficult but also provide the basis for the continued potential of private equity to generate superior return. “So little time, so much to do” as Cecil Rhodes put it – now he was a real miner.