Private Equity As an Asset Class Guy Fraser-Sampson
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Private Equity as an Asset Class Guy Fraser-Sampson Praise for Multi Asset Class Investment Strategy: “. pension fund trustees right around the globe should read the book . it is certain to stir up some much needed debate . has received rave reviews from within the UK pension industry” (Global Pensions) “. time and money well spent . the tectonic plates are shifting under the UK investment establishment” (Daily Telegraph) “. an indispensable roadmap for anyone looking to create a successful investment programme . .” (The Securities Investment Review) “It’s some time since I read anything as clear and punchy . if you are involved in setting investment strategy for a pension fund, this book cannot help but clarify your thinking.” (Benefi ts & Compensation International) “This book stakes Fraser-Sampson’s claim to be recognised as one of the great thinkers on portfolio theory, ranking alongside Markowitz and Swensen.” (Rebecca Meijlink, AlphaBet Capital) “I somehow expected another version of Swensen’s “Pioneering Port- folio Management”. However, this is in my eyes a huge improvement and a surprisingly entertaining and satisfying read.” (Thomas Meyer, EIF, author: Beyond the J-Curve) Private Equity as an Asset Class For other titles in the Wiley Finance Series please see www.wiley.com/fi nance Private Equity as an Asset Class Guy Fraser-Sampson Copyright © 2007 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England Telephone (+44) 1243 779777 Email (for orders and customer service enquiries): [email protected] Visit our Home Page on www.wiley.com All Rights Reserved. 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Contents Introduction xiii Acknowledgements xxiii 1 What is Private Equity? 1 Fund investing versus direct investing 2 Terminology 4 Primary versus secondary fund investing 6 A broad delineation: buyout and venture 7 Capital: allocated, committed, drawn down and invested 9 How do private equity funds work? 11 Structure 11 Cashfl ow 13 Investment 15 Fundraising 16 Summary 20 2 Private Equity Returns – The Basics 23 Understanding the J-curve and compound returns 23 Upper quartile fi gures 29 Median returns 30 Average returns 31 Pooled returns 34 viii Contents Multiples 34 Distributed over Paid In (DPI) 37 Paid In to Committed Capital (PICC) 38 Residual Value to Paid In (RVPI) 38 Total Value to Paid In (TVPI) 38 Valuation 39 Fees 40 Time-weighted returns 41 Summary 42 3 Buyout 45 Types of buyout transactions 45 MBO 45 MBI 46 BIMBO 46 LBO 47 Take private 47 Roll-up 48 Other “buyout” activity 48 Established businesses 50 Debt 52 Earnings 54 Size 55 Control 58 Barriers to entry 61 Summary 64 4 How to Analyse Buyouts 67 Earnings 68 EBIT 70 EBITDA 71 Earnings growth 72 Multiple 74 Multiple increase in an imperfect market 74 Multiple increase in a perfect market 77 Leverage 78 Recapitalisation 79 Timing 80 Contents ix Modelling and analysing buyout funds 82 Summary 87 5 Buyout Returns 89 US versus European buyout 89 Buyout skill bases 91 Imperfect markets 92 Earnings multiples 94 Earnings growth 97 Leverage 100 Fund size 101 What can we expect from buyout returns in future? 107 Recent fundraising levels 109 Some conclusions and predictions 111 Summary 113 6 Venture Capital 115 What is venture capital? 115 Backing new applications, not new technology 116 Classifi cation by sector 118 IT 118 Telecoms 121 Life Science 124 Classifi cation by stage 128 Seed 129 The US model 131 Seed stage focus 131 Home run mentality 133 “Value add” 133 The US model comes to Europe 134 Why European venture capital fi rms have avoided the seed stage 134 Classifi cation by stage, continued 135 Early stage investing 135 Mid- and late stage investing 135 Summary 135 7 How to Analyse Venture 137 The fundamentals 137 Money multiples 137 x Contents Valuation 140 Cost and value 147 IRRs and multiples 149 Going In Equity (GI%) 150 Percentage of the holding within the fund 151 The impact of home runs 151 Summary 155 8 Venture Returns 157 US out-performance versus Europe 157 Money multiples drive IRRs 159 Home runs and the golden circle 160 Market conditions 163 European venture – is it as bad as it seems? 165 Returns and fund size 170 Venture returns by stage 175 What of the future? 177 Summary 180 9 Due Diligence 183 Buyout funds 186 Venture funds 188 Co-investors 191 Cross-fund investing 192 Buyout companies 192 Venture companies 194 Fund of Funds 196 Monitoring private equity funds 198 Summary 201 10 Planning your Investment Programme 203 Cashfl ow planning 203 Allocated, committed and invested capital 205 Diversifi cation by time 206 Proper commitment levels 208 Diversifi cation by sector and geography 209 Total Return 213 How to deal with uninvested capital 214 Secondaries 216 Mezzanine 219 Contents xi Private equity proxies 219 Towards a new world of private equity programmes 220 Summary 222 Glossary 225 Index 253 Introduction There are a number of books already in print on the subject of private equity, and (I believe) a couple more in the course of preparation, so it may be felt that a book such as this requires some justifi cation. If so, it can very simply be provided. I have always felt the lack of a single comprehensive guide to private equity; something that does not seek to examine the relationship between GPs and LPs, or to indulge in esoteric analysis of private equity returns, but which sets out simply to answer the key questions, such as “what is private equity?” and “how does it work?”. Surprisingly for an asset class whose roots go back to before the second world war, there is no such book available and it is precisely this gap that this work is designed to fi ll. There is, for example, no one standard text book which can be used for the private equity elective in business schools, and I have designed the overall structure of the book in consultation with academics who teach such courses in an attempt to achieve as close a fi t as possible with the course outline (not as easy as it sounds since there seems to be no one universally accepted list of course content!). Nor is there one that can be recommended to entry level professionals in private equity fi rms, nor for institutional investors who may be looking to enter the asset class for the fi rst time, nor for pension consultants and their trustee clients. However, please do not assume that just because you might have many years of private equity experience you will come across nothing new in this book. Concepts such as Total Return investing, and treasury and portfolio secondaries, have been in my thinking for several years but have been articulated for the fi rst time in this book. These are novel ideas and may seem controversial to some, but I trust you will at least xiv Introduction fi nd them thought-provoking. Similarly, my analysis of historic private equity returns, both buyout and venture, has been performed spe- cifi cally for this book, using the most up-to-date fi gures available at the time of writing (Autumn 2006), and my conclusions and suggestions in this regard are original and newly formed. My previous book Multi Asset Class Investment Strategy, also pub- lished by John Wiley & Sons, answered the questions “why should I invest in private equity?”, “how much should I allocate to it?”, “how should private equity returns be compared and analysed against those of other asset classes?” and “how does private equity fi t within an overall portfolio?”.