What is Private Equity? Understanding Private Equity

What is a private equity

Private Equity (PE) is another source of investment capital that invests in the equity capital of privately held companies, I.e. companies that are not publically traded.  Private Equity actually derives from high net worth individuals and institutional investors that acquire equity shares of privately held companies or acquire a controlling stake in publically traded companies to make them private, eventually becoming delisted from public stock exchanges. These companies are not listed or traded on any stock exchanges. The PE capital can be used to develop new products and technologies, expand working capital, make acquisitions, or strengthen a company’s balance sheet. Now private equity has gained a great amount of influence in today’s financial marketplace.

Private equity investors generally work towards funding new technology, making new acquisitions, expanding working capital and bolstering the balance sheets of companies. Private Equity firms also work in the same manner as Venture Capitalists — invest in the long term in startups to help them grow and then reap benefits after the companies go public or merge with other firms. Unlike mutual funds or hedge funds, however, private equity firms often focus on long-term investment opportunities in assets that take time to sell with an investment time horizon typically of 10 or more years.

Assessing Performance

Two metrics are typically used to assess the performance of private equity investments: the internal rate of return (“IRR”) and the cash on cash return multiple. Strictly defined, the IRR is the discount rate that sets the net present value of a series of cash flows equal to zero. It is perhaps the most widely used performance measurement tool for private equity. By contrast, the return multiple looks at the ratio of the money returned to money invested. For example, $1 invested in a private equity fund that generates $2.50 in distributions implies a 2.5 times return multiple. There are pros and cons associated with using each metric.

1. Internal Rate of Return (IRR)

Using an IRR allows investors to measure the performance of a series of periodic uneven positive and negative cash flows. This feature is especially relevant in the context of private equity investing because capital is drawn down and invested over time (negative cash flows) with distributions paid out over time (positive cash flows). This contrasts with many traditional investments that consist of one lump-sum investment and one cash-out, which tends to make performance calculations much simpler. Despite its advantages, the IRR does have several drawbacks.

It places too much weight on investments that return capital after short investment periods, even if the absolute dollar returns lag behind those of their peers. This tendency was most evident in the fevered VC market of the late 1990s, when companies progressed from start-up to IPO in record time, generating high initial IRRs for many venture funds. Another drawback is the lack of an industry standard in computing IRRs. Different private equity firms may use slightly different methodologies in computing their investments’ IRRs. Even a small change in the methodology can have a dramatic impact on the results.

2. Return Multiple

As an alternative to the IRR, the return multiple corrects one of the main IRR drawbacks: placing too much weight on early distributions. Return multiples are simply a calculation of the monies invested versus the monies returned, which is not sensitive to the timing of distributions. In addition, by using the return multiple, investors do not need to concern themselves with the various subtleties and differences in IRR computations among different firms or investments. However, the return multiple also has a drawback: it fails to take into account a basic premise of investing—the time value of money, or the fact that a dollar today is worth more than a dollar tomorrow due to inflation and the opportunity cost of tying up capital in investments.

Interpreting Private Equity Performance

We think it is prudent for investors to use both the IRR and return multiple together in evaluating performance. A high IRR generated by “quick hits” is not typically a sustainable investment strategy that produces long-term wealth. Similarly, a high return multiple is not attractive if it takes an undue amount of time to generate. Striking a balance between the two metrics may be a sensible way to think about performance measurement.

Understanding Quarterly Performance

When investors analyze interim valuations and performance, they need to consider factors other than the nuances of valuation metrics. Given that private equity is by nature a long-term, illiquid asset class, interim valuations may not be that meaningful, especially in forecasting long-term performance. Additionally, many private equity firms have different valuation methodologies that can affect interim performance reporting.

When reading quarterly reports, especially early on in the life of a fund, investors should focus on understanding qualitative items such as the investment pace and industry or sector focus of the fund. For example, if capital is being deployed rapidly, it could mean that the fund is too aggressively chasing deals and could be susceptible to valuation trends over a narrow period of time. Alternatively, rapid capital deployment could be prudent given the nature of a fund, its strategy and the quality of its investments.

Key Drivers

Therefore, it is important to try to understand what is driving the investment pace. Paying close attention to the sectors in which capital is being invested will help an investor understand industry trends and which sectors will drive performance for a fund. It is also important to note that during the early years of a fund’s existence, it will show a decrease in value (i.e., a value less than 100% of contributed capital). Part of this decline can be attributed to how management fees are computed. Management fees are calculated on committed capital rather than the invested capital.

This magnifies the fee drag on performance early on in the life of a fund, with typically few offsetting investment valuation increases or positive realizations early in the investment cycle. Furthermore, write-downs and write-offs may occur early on in the life of a fund, as losing investments are identified, while many of the remaining investments are held at cost, even if performing ahead of schedule. The combination of fee drag and potential write-downs early on in the life of a fund is commonly referred to as the “J-Curve” of performance since early on, the performance pattern of a typical private equity fund resembles the letter “J”.

In the middle years of a fund’s life (typically years three to four), when realizations are beginning to occur or certain unrealized investments are potentially written up, the fund’s value may begin to rise (i.e., to a value greater than 100% of contributed capital). As previously stated, private equity is not an asset class that typically generates meaningful interim performance, especially early on in the fund’s existence, but rather a long-term asset class that is best evaluated over the entire period of the life of a fund. As a fund matures and investments are realized, a closer examination of the fund’s net asset value, distribution information and performance metrics will become more meaningful.

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