Detail from Ancient Greek black-figured dinos (wine-bowl) with the first chariot in the procession

Detail from Ancient Greek black-figured dinos (wine-bowl) with the first chariot in the procession
“Sophilos Dinos” (wine-bowl) showing guests arriving at the wedding of Thetis and Peleus. In the first car -Zeus and Hera, 2nd-Poseidon and Amphitrite. Source: British Museum (Wikicommons)

Thursday, September 15, 2016

Private Equity Funds Returns: The Basics

PE use borrowed funds to buy companies, so typically these investments are riskier than the public markets and are mostly illiquid.

Private equity cash flows are typically described by the “J-Curve ”, with investments generally being made in years 1-5 (negative returns) and realizations generally occurring in years 4-11 (positive). The years when a partnership is closing to new investors are called vintage years.

But what about returns from PE investments? The returns are the excess IRRs or alphas.

Alpha is the increment to market rate that equates the out-of-pocket cost of the investment to the Present Value of its gross return. Studies have shown that PE excess IRRs are between 5-8%, even (and more particularly so) in a down economy.

Excess returns are calculated after correction for the leverage effect.

0=Sum CFi (1+r)^-i,

The IRR is the return (discount rate) that will equalize the present value of all invested capital with the present value of all returns, or where the net present value of all cash flows (positive and negative) is zero; CFi is the cash flow for period i (negative for takedowns, positive for distributions).

The targeted IRRs may hover around 25%, which can be a decent investment.

Benchmarks:
• Cumulative IRR
• Cumulative Realization Multiples (DPI and RVPI, and their Sum)
• Time Weighted Return
• Investment Horizon Return
• Public Market Comparables – Index method
• DPI = Distributions / Paid-In Ratio, a.k.a. realized multiple
• RVPI = Residual Value / Paid-In Ratio, a.k.a. unrealized multiple

More on Alphas at Morgan Stanley, PE K@Wharton

What makes for an attractive investment (in general)?



1. Strong Brand Name: ("attractive portfolio of content and leading brands") - This corporate attribute is key from an exit opportunity perspective as well as an overall risk perspective. The lower the risk a company presents the more stable cash flows are likely to be and the more likely a beneficial exit is likely to be. Both components are critical for private equity deals and thus brands make a target that much stronger should these brands be highly recognizable and powerful.

2. Growth Profile (CAGR)

3. Opportunities for Multiple Expansion: ("highly scalable business ") Multiple expansion occurs when a company is worth 7.0 times EBITDA when first purchased (i.e. 7x TEV/EBITDA) but then 10.0x upon exit. The increase in multiples is driven by either increased growth, strengthening brand positioning, a decreasing risk profile, or all three in some combination.

4. Strong Management Team

5. Strong CFs

Recent trend: An increase in PE secondaries activity











This year we have seen an uptick in PE secondary market activity (PE-to-PE sales). Typically, private equity firms hold onto companies for three to seven years. Sometimes, however, a PE firm will sell a portfolio company to another PE firm rather than hold on to it. According to Mergermarket this year so far there have been 38 of these so-called secondary transactions disclosed, with values totaling $28.9 billion.


1 comment :

  1. IPEV Guidelines http://www.privateequityvaluation.com/download/i/mark_dl/u/4012990401/4625734325/151222%20IPEV%20Valuation%20Guidelines%20December%202015%20Final.pdf

    "Fair Value for a Fund interest is, at its most basic level, equivalent to the summation of the
    estimated value of underlying Investments as if realised on the Measurement Date. The
    proceeds from such hypothetical Realisations would flow through to the investor in an
    amount equal to NAV. "

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