(www.PrivateEquityCentral.net) One hears the term “top quartile” quite a bit in the private equity industry, and with good reason – many institutional investors and their advisors are fond of saying that they only invest in such funds. What is not immediately apparent is what these investors mean by “top quartile.”
Whatever the definition, GPs on the road with a fund know they need to find something – anything – in their track record that says top quartile. Luckily, there are many ways to do this, some of them more legitimate than others. The arbitrary nature of short-term performance monitoring and the haze shrouding deal attribution can all be brought to bear in the presentation of a track record to make it seem, shall we say, more impressive than a totally objective reading would indicate.
According to placement agents, consultants and investment bankers, there are a number of ways to, if not outright fudge the numbers, massage them so as to accentuate the good and obfuscate the bad:
Trick One – Import a Track Record. It’s hard to put your group in the top quartile if you’ve only done a few deals together. Why not borrow deals from firms that you used to work at? It is up for debate whether a track record that combines deals across different deal teams is meaningful. This practice is slightly more legitimate when the whole team has invested together somewhere and then leaves en masse to form a new firm. It gets tricky when Bob combines a 55 per cent IRR track record from his former employer with Bill’s 45 per cent IRR from an entirely different firm. Not that new groups can’t be huge winners, it’s just difficult for them to show this pattern when they used to all play on separate teams.
Trick Two – Play Favorites With Funds. There are top quartile funds and then there are top-quartile groups. If you’re not one, you should try to be the other. Some groups have very good early funds but horrible recent performance. Other groups have only ever cracked the top quartile with a recent, and rather immature, fund. In either case, the phrase “top quartile” can be applied. In the first case, the group only mentions their early funds, arguing, with some justification, that the interim performance of their more recent fund or funds is not meaningful. Of course, don’t mention that Fund I was $300m but for Fund V you’re planning on putting $3bn to work. In the second case, the group trumpets the top-quartile returns of a recent fund (which may have mostly unrealised investments) and leaves out the fact that the previous four funds all show middling performance.
Trick Three – Be Gross. The performance information provided by Venture Economics is presented net of fees. If you can’t be top-quartile on this basis, present your strategy on a gross basis and hope that no one reads the footnotes.
Trick Four – Play With Valuations. Ah, the freedom that comes with unrealised returns. Private equity firms essentially have two broad options here – arbitrarily writing up an unrealised deal or leaving it at cost despite signs of weakness. The leave-at-cost play is the more widespread of the two strategies, but no less misleading. For example, a company that was purchased in 1998 at a multiple of 9 times earnings should perhaps not be held at cost now that its earnings are down, along with multiples at which comparable companies are being sold. Given the choice between dropping a fund out of the top quartile during fund raising and keeping a portfolio company a cost, some GPs find it hard to resist the second route.
Trick Five – Turbo-Charge Your PPM. This is a variation on Trick Four. Sometimes, a private placement memorandum can be used to present portfolio company valuations that are slightly rosier than has been reported in official financial statements. When it comes time to market a fund, a couple of little write-ups for the PPM can mean the difference between best quartile and just futile. “This used to be more prevalent when investors believe you could go from X to 2X in six months,” says a placement agent.
Trick Six – Pro Forma Fabulous. Kelly DePonte, a managing director at private equity consulting firm Probitas Partners, says: “Projected returns are especially helpful when you don’t have any realisations. It’s also known as the crystal ball strategy.” A PPM that presents pro-forma returns essentially tells a story that certain portfolio companies will be sold on certain dates at certain valuations. If you can get away with this, more power to you.
Trick Seven – Lose the Zeros, Get With the Heros. There are a number of ways to eliminate bad deals from your track record. Here’s a classic – change the strategy for the new fund and eliminate from your track record transactions that are not “relevant,” which also happen to have been disasters. And another classic – lay claim only to the good deals that you worked on at your prior firm. Success has many fathers but failure is an orphan.
Trick Eight – Identity Theft. Similar to Trick Seven. The guys who did the epic, early deals on which most of your top-quartile status is based have all retired or now spend more time on their yachts than on the factory floor. But you present their track record as yours.
Trick Nine – Play With the Peer Group. Not in the top quartile of 1996 venture capital funds? Throw buyout funds into the mix. Can’t beat the whole universe of private equity funds? Compare yourself against a sub-sector: “We’re in the top quartile” of Oklahoma-based mezzanine funds.
Trick Ten – Hate The Game. Bad-mouthing the internal rate of return has been trendy lately as investors and GPs alike struggle with the lack of valuation standards in the private equity industry. Venture Economics numbers are suspect, you say. The only thing that matters, you say, is cash-on-cash returns. You refuse to play the top-quartile game. You say, “Hey, we delivered a 2.5X return on cash.” You fail to mention that it took fifteen years to get there.