the overhang: over-hyped? - privcap · a violin fund is one of measurability—there simply...

This publication is exclusively for Privcap subscribers © 2013 Privcap LLC

private equity performanceA Privcap Publication

Volume 2 | Q3 2013

In this issue Bios of expert participants / 3 About the ILPA Benchmark / 4 Benchmarking ‘Niche’ Funds / 5 How Does Growth Equity Perform? / 6

The Overhang: Over-Hyped?Performance experts talk capital imbalances and perverse GP incentives / 10

Private Equity Performance Q3 / Vol. II 2013 / 2This publication is exclusively for Privcap subscribers © 2013 Privcap LLC

Editor’s Note

private equity performance

Privcap LLC

David Snow Co-founder and CEO Gil Torren Co-founder and President

Content

Matthew Malone Editorial Director

Production Artist

Vasheena Doughty Designer

Contributors

Tom Stein Tim Devaney

Contacts

Editorial David Snow / [email protected] / 646.233.4558

Matthew Malone / [email protected] / 646.801.2337

Sponsorships & Sales Gill Torren / [email protected] / 646.233.4559

The Measurement MandateYou shouldn’t invest in something that can’t be measured —this axiom stands as a hurdle to

some alternative investment strategies finding broader institutional acceptance. In this issue of

Private Equity Performance we take a look at two strategies that fall into very different places on

the “measurability” spectrum.

On the one end of the spectrum is growth equity—the collection of private equity funds that

invest in the space between late-stage venture and buyouts. As we learn from Andrea Auer-

bach, Michael Elio and Stefanie Langer, the performance history of growth equity funds is long

enough, and the funds similar enough to each other by way of target investment, that investors

have access to illuminating data that shows how individual firms have performed relative to

each other, to other private equity sub-strategies, and do other asset classes.

On the other end of the spectrum are “niche” strategies. The trouble with niche strategies, of

course, is that they are many and wildly different from each other, ranging from trailer parks

to debt instruments to violins. The challenge faced by an investor given the chance to invest in

a violin fund is one of measurability—there simply haven’t been enough violin funds to build a

credible benchmark. You might show me your track record of generating 50% growth per year

in a Stradivari collection, but how do I know whether that makes you an expert or incompetent

violin collector?

Enjoy Volume 2 of the Private Equity Performance report, David Snow CEO & Co-Founder, Privcap [email protected]


/ Andrea Auerbach Managing Director and Head of U.S. Private Equity Research • Cambridge Associates

Andrea Auerbach is a managing director at Cambridge Associates LLC in the Boston office. She heads the U.S. private equity research team, which performs due diligence on investment opportunities in private equity, mezzanine and distressed markets. Her responsibilities include visiting investment firms and their portfolio companies and tracking the industry. Auerbach and her team also advise the firm’s investment consultants on new and existing firms raising and managing funds.

Prior to joining Cambridge Associates in 2001, Andrea was a senior director at Prudential Private Equity. Over the course of her eight years with Prudential in New Jersey, New York and London, Auerbach invested and managed over $1 billion of capital in U.S. buyouts, venture capital, real estate, and European mezzanine and private equity. She also led early efforts to benchmark Prudential’s $5 billion buyout portfolio, and domestic and European fund investment portfolios. Auerbach was also an equity research associate focused on technology at Harris Nesbitt Gerard.

/ Michael Elio Managing Director, Industry Affairs • ILPA

Michael Elio recently joined the ILPA as its managing director for industry affairs. Prior to joining the ILPA, he was a managing director at LP Capital Advisors and led the firm’s Boston office ,where he served as the lead consultant to East Coast and European institutional investors. Mike served as the primary consultant for many of the firm’s largest clients, including public and pri-vate pension plans. He was also a vice president at State Street Corporation and vice president at Credit Suisse First Boston Private Equity, where he oversaw the Funds Management group.

/ Stefanie Langer Head of Investor Relations • Independence Capital Partners

Stephanie Langer is Head of Investor Relations for the Independence Capital Partners affili-ated funds and oversees fundraising, transfers, investor data management, performance report dissemination, compliance and new business development. Stefanie was a Managing Director at Hamilton Lane Advisors where she was responsible for key client portfolio management, manager selection related to all non-buyout or venture private equity funds in the U.S. and abroad. She previously worked for Ernst & Young as a Principal in the Corporate Finance division overseas. Stefanie is a graduate of Franklin and Marshall College and completed the Ernst & Young Executive Program.

Participants


Benchmarking

The ILPA Private Markets Benchmark

Performance is paramount in private equity, but important as it is, LPs struggle to measure it. To help them in one sector, Cambridge Associates and the Institutional Limited Partners Associa-tion (ILPA) recently released the ILPA Private Markets Benchmark, which includes over 1,800 institutional funds and is distributed to ILPA members.

The benchmark is a subset of the overall Cambridge benchmark. ILPA asks its members for their portfolios, aggregates the list and passes all the information to Cambridge, which then runs its benchmark on the institutional fund set.

“The results are interesting,” said ILPA’s Michael Elio. “Our medians tend to be slightly higher than the Cambridge medians but our top quartiles tend to be slightly lower. So if you think of the band that institutional investors are investing in, it’s a little tighter, which is a testament to the skill of the institutional investor.”

Managers are clamoring to contribute. “We’ve been getting calls from GPs, saying, ‘We know we’re contributing to the Cambridge benchmark, but we’d also like to hop over and be part of the ILPA benchmark,’” said Andrea Auerbach of Cambridge Associates.

The ILPA Private Markets Benchmark shows the private equity asset class has done better by way of median performance than other benchmarks might suggest. GPs might see this as a higher

performance hurdle to clear, but Elio pointed out the upside.

“The reality is we target top quartile funds when investing, not median,” he said. “And our top quartile is slightly lower, so there’s a little more room in there for general partners.”

Components of the ILPA Private Markets Benchmark

• U.S. Private Equity (buyout, growth, private equity energy and mezzanine)

• U.S. Venture

• Global Distressed

• Global Natural Resources

• Global Private Equity and Venture

• Global Fund of Funds/Secondary Funds

Recent ResultsAs of September 30, 2012, the most recent quarter available, the ILPA Private Markets Benchmark for U.S. Private Equity reported a 13.55% ten-year return. Performance for international funds, excluding U.S. private equity and venture capital funds, was 13.95% over the same ten-year period.

Click to watch this video at privcap.com

http://ilpa.org/ilpa-private-markets-benchmark/


Performance is a GP’s best marketing tool. But demonstrating performance isn’t always easy, especially for managers with niche strategies that don’t fit into neat categories for benchmarking against peers.

STEP ONE in successfully marketing a niche strategy is to figure out who your audience is and how receptive they’ll be. “If you’re in front of a person who’s interested in private equity strategies with private equity returns, it’s probably not a good idea to talk about a niche debt strategy which has a private equity structure,” said Stefanie Langer of Independence Capital Partners.

STEP TWO is to determine what other selections the investor will evaluate when vetting your strategy. “If the selection will put you against a group executing a strategy that’s wildly different from a risk-return profile—an industrial focus, something like that—it will make it difficult to win the business,” Langer said.

Niche strategies come in all shapes and sizes. “There’s capital-end niche like consumer-focused, private equity, credit-oriented, financial services-only focused or tech-focused,” said Andrea Auerbach of Cambridge Associates. And then there are very specific niches, like pharma royalties, shipping or litigation claims.

She has even looked into wineries and violins. “…There’s always another one out there,” she says. “It just requires you to find it.”

The good news for niche managers is that investors are more open to novel approaches. “They have a hurdle for the whole portfolio and they have hurdles for subsectors of the portfolio,” said Michael Elio of the Institutional Limited Partners Association. “And they may have that opportunistic bucket where they say, ‘This may be an opportunity over the next five years and it’s something we’re willing to go into.

12

How to Market a Niche Strategy

Strategies

This may be an opportunity

over the next five years and it’s something

we’re willing to go into.”

Michael Elio

Stefanie Langer


http://www.privcap.com/trouble-with-niche-strategies/


Feature

The Growth-Equity ChallengeHow does it differ from venture and buyouts? Should LPs think of it as a distinct category?Growth equity overlaps both late-stage venture capital and buyouts, and its long-term perfor-mance is indeed different from both sub-strategies of private equity. According to Cambridge Associates growth equity funds have significantly out-performed venture capital funds on a 10-year basis and also on a shorter term basis (see chart next page). However buyout funds have outperformed growth equity over the past three years and 10 years (but not over a five-year window, interestingly).

Over the past 10 years, leveraged buyout funds performed the best, with a cumulative 12.8 percent return. Growth equity funds returned an average of 11.4 percent; venture capital re-turned a relatively meager 5.3 percent. In a shorter time frame—the five years since the financial crisis hit, growth equity reined supreme: it returned 7.9 percent, versus 5.4 percent for buyouts and an even lower number for venture capital.

A growth-equity company “has no technology risk—it’s more execution risk at that point,” notes Andrea Auerbach of Cambridge Associates. “It has an established product, existing customers and a business model, so it’s not in any experimental stage.”

What’s more, she says, “growth equity investors are coming in later in the life cycle of a compa-ny, so that moment from investment to exit isn’t perhaps as long as it might be for a seed-stage venture capital manager.”

It’s not surprising, then, that growth equity funds have become the darling of the limited part-ner community. As venture returns have sunk, a growing number of LP allocations have shifted to growth. More important, they’ve stayed there.

“It’s the characteristics of growth that have kept the LPs coming back,” observes Michael Elio of the Institutional Limited Partners Association. “The lower volatility, slightly less risk, and returns that are almost as good as the buyouts space is something that will keep people going back.”

But while LPs flock to growth equity, they may not always get what they’re hoping for. That’s because the lines have blurred between later-stage venture funds, expansion-stage buyout funds and growth-equity funds. That’s evidenced by the number of large buyout funds that

By Tom Stein and Tim Devany

“It’s the characteristics of growth that

have kept the LPs

coming back.” Michael Elio continues on next page

Growth Equity Defined:Source: Cambridge Associates LLC

• Investor takes a minority position (less than 50% ownership).

• Company typically has no prior institutional investors; company is often founder-owned.

• Additional rounds of financing are not expected until exit.

• No (or minimal) leverage is used at initial investment.

• Company is typically EBITDA positive or expects to be within 12 to 18 months.

• Invest at growth inflection point where capital can drive organic revenue growth in excess of 10%.

• Company has an established product or services, existing customers, and business model. Investment theses underwritten on defined plan to achieve profitability.


became growth managers, and the venture funds that suddenly started doing growth deals.But growth equity is a challenging strategy to get right. Success often requires a very different skill set. Unlike venture, in which hungry startups are beating down the door for capital, growth equity often requires GPs to source deals on their own and then convince entrepreneurs that they really need the money.

“In certain moments, there are definitely folks who do a little bit of growth investing but when their regular market returns they recede back to their main line of business,” says Auerbach. “Tigers can’t change their stripes, so part of the institutional investor’s job is to figure out what kind of tiger you are and then pay attention.”

So should there be a clear line, a sort of DMZ, between the different fund types? “I think we need to draw the line,” Elio says. “I think it’s important. One, for benchmarking, and two, GPs need to do what the LPs ask them to do or what they told the LPs that they’re going to do.”

Elio believes that if the industry has very strict definitions, it will be easier for LPs to know ex-actly what they’re investing in and how they’re going to benchmark those investments going forward.

Feature

Growth Equity vs. Venture vs. Buyouts

(L to R) Stefanie Langer of Independence Capital Partners; Michael Elio of the Institutional Limited Partners Association; Andrea Auerbach of Cambridge Associates and David Snow of Privcap.

Growth Equity: End-to-End Return ComparisonEnd-to-end asset class returns

are pooled returns for each asset class, net to LPs.

End-to-End Asset Class Return3-Yr 5-Yr 10-Yr

Venture Capital 12.7% 4.9% 5.3%

Growth Equity 16.8% 7.9% 11.4%

Leveraged Buyouts 17.2% 5.4% 12.8%Source: Cambridge Associates LLC Private Investments Database as of June 30, 2012.

“In certain moments, there are

definitely folks who do a little bit of growth investing but

when their regular market

returns they recede back to their main line

of business.” Audrea Auerbach

continues on next page


http://www.privcap.com/defining-measuring-growth-equity/

http://www.privcap.com/defining-measuring-growth-equity/


Feature

Given the superior performance of growth equity over the last five to 10 years, can we expect to see the formation or rebranding of more growth-equity firms?

“I think growth equity will expand just by virtue of rebranding,” says Stephanie Langer of In-dependence Capital Partners. “The groups that heretofore might have been doing venture or buyouts but found that more competitive may want to do growth because it’s allowing them to deploy more capital.”

So as long as LPs stay hungry for growth deals, expect to see more funds go hunting there. ■

“I think growth equity will

expand just by virtue of rebranding”

Stephanie Langer

Notes: Data shows the percentage of invested capital in deals based on a total value gross multiple of invested capital (MOIC). Analysis included 260 growth equity invest-ments, 22,507 venture capital investments, and 5,188 leveraged buyout investments made between 1992 and 2008. Loss ratio is defined as the percentage of capital in deals realized below cost, net of any recovered proceeds, over total invested capital.

Venture Capital

% o

f Inv

este

d Ca

pita

l (T

otal

Val

ue =

Rea

lized

+ U

nrea

lized

)

Realized Loss R

atio

<1.0x100% 40%

90%35%

80%30%

70%

25%60%

20%50%

40% 15%

30%10%

20%

5%10%

<1.0x - 1.99x <2.0x - 4.99x <5.0x Loss Ratio

Growth Equity Leveraged Buyouts

Growth Equity: Risk-Reward ComparisonTotal Value Gross Multiple of Invested Capital Dispersion:

Source: Cambridge Associates LLC


Strategies

Growth capital is growing fast in popularity. Both venture outfits and private equity firms are now scouring the landscape for growth-stage businesses and the returns they promise. Which raises an important question: What constitutes a growth-capital deal, and whom should you trust to make those investments? Three leading PE professionals—Stephanie Langer of Independence Capital Partners, Michael Elio of the Institutional Limited Partners Association and Andrea Auerbach of Cambridge Associates—discuss the inner workings of growth capital and why it’s not for everyone.

Defining Growth Equity

How do you define growth equity versus buyouts and venture capital?

Auerbach: As folks who have been monitoring the growth-equity space for some time, we’ve been working on a definition that we feel stands the test of

time. First, the investor is taking a minority position defined as typically less than a 50 percent ownership. The company typically has no prior institutional investors and has not taken in any additional venture capital dollars prior to being ap-proached by a growth-equity manager. The other expectation is that these compa-nies will not need additional rounds of capital and therefore this is the first and last investment in the company. Another defining characteristic: little-to-no leverage is used at the time of investment. And at the time they're receiving this investment, the company is generally growing at something greater than 10 percent.

Is there anything to add to that definition?

Langer: The idea of growth capital is to really have that capital serve as a launching pad for the next stage of development, which might actually

include the development of a new technology, a new business line, an acquisition, something that really is going to catapult the company to the next stage, poten-tially changing some part of its paradigm.

It seems LPs are increasingly interested in defining growth equity. It also seems there’s a renaissance among growth-equity firms, which are raising their flag and saying, “We are growth equity, we are unique.” Why do you think it is that the growth-equity firms are so eager to say, “We’re not buy-outs, we’re not venture, we’re growth equity”?

Elio: Elio: A rose by any other name, right? I think coming up with a firm defi-nition will be helpful to the asset class, in the way other substrategies have

spun out of private equity, such as infrastructure. In the past, growth has always fallen under most of the venture allocations of a lot of members. Still, it’s all about their strategy and execution. So they can call themselves what they want but LPs go in there and they do their diligence. If it fits into the category of growth, then it’s growth. I think there are some aspects to growth in any particular investment, but is it a true growth-equity type of investment, where you’re not the majority inves-tor and you’re not levering the company? I think LPs know better.

“The idea of growth capital is to really have that capital

serve as a launching pad for the next stage

of development…” Stephanie Langer


http://www.privcap.com/defining-growth-equity/


Fundraising & Performance

Is t he ‘Overhang’ Overblown?

The private equity overhang—the amount of capital raised by private equity funds that remains uncalled and available for investment—is down considerably from its peak. It dropped from a high of $445 billion at the end of 2009 to $325 billion at the close of 2012, according to invest-ment adviser Cambridge Associates.

A number of factors including improved market conditions have contributed to the decline. But beware: today’s active fundraising environment could cause the overhang to grow once again.

Privcap gathered three PE experts to examine the growing hazard of the overhang. Joining the discussion were Michael Elio of the Institutional Limited Partners Association, Andrea Auerbach of Cambridge Associates and Stefanie Langer of Independence Capital Partners.

Privcap: We hear about the overhang a lot but is the problem overhyped?

Andrea Auerbach: I feel like the overhang is looming larger. It had waned over the last couple of years, as the bulk of capital that was raised in the ‘07-’08 timeframe got worked down. The overhang hit its peak in 2009, at $445 billion dollars, and right now the total dollars in the overhang is down a fair chunk. And the reason why I would characterize it as looming larger is because the fundraising environment is getting healthier. More capital has been raised year over year and every time you raise a fund, it adds to the overhang. So I feel like the overhang is coming up off of its own nadir and is starting to crest again.

Privcap: Should LPs take into account the overhang when they think about whether or not to invest in the current environment?

Stefanie Langer: It’s something that LPs should consider whenever they’re investing in any private equity fund. I’m a big believer in cycles existing throughout life and throughout the world—and the private equity industry is no different. So as a consequence of capital inflows and outflows never being fully correlated or aligned, there will always be some inefficiency. And I think we want inefficiency in the market. So, generally speaking, I’m a believer that this is no different than the last time there was a cycle like this and it will probably work itself out.

Auerbach: What’s interesting about the overhang, to Stefanie’s point, is that there’s some amount of capital that should overhang the market, otherwise managers would invest all their money and then constantly be fundraising—and we don’t want that. Normally you would want to see a four-to-five-year supply of capital overhanging the market. Right now we’ve already come into that range of a five-year overhang. But with the fundraising environment building, I’m a little nervous about what that might mean in certain pockets of the market.

Privcap: When the overhang was at its peak, in 2009, was there evidence that GPs were acting on perverse incentives to put capital to work?

Michael Elio: Limited partners were definitely on edge that that was going to be the case. So that raised flags for them to pay a lot more attention to the deals that were happening. To the

The overhang is down, but new risks are on the horizon

$325BDown from 2009 overhang high of

$445B

“What’s interest-ing about the

overhang, is that there’s some

amount of capital that should over-hang the market,

otherwise managers would

invest all their money and then

constantly be fundraising—and

we don’t want that.”

Andrea Auerbach



http://www.privcap.com/private-equity-overhang/


Overhang

GPs’ credit, that pressure didn’t turn out to be true, though, and a lot of extensions came in for investment periods. So that was a way to alleviate the pressure.

Privcap: The cynical way of looking at that is, “Oh these guys are just trying to collect fees on a limp fund.” But in fact it’s also a way of not disgorging everything from the fund in a shorter amount of time, when perhaps the investment environment isn’t optimal.

Elio: Correct. But if you’re a limited partner, extending the investment period is a way to effectively make a new commitment to that GP. And given the funds that were in the market at that time and the alternatives that you had, sometimes extending the investment period was a better option.

Privcap: Has there ever been a case in the recorded history of private equity of a fund simply getting to the end of its life and maybe they didn’t spend all the money and they just gave it back? Or is that just not an option for many GPs?

Elio: It’s almost an urban legend.

Langer: The anecdote I would offer is the ’07-’08 period. At least some of the groups that formed my organization were slow off the mark to do deals. They were very mindful and thoughtful about how they were deploying the capital. But because, in the case of smaller funds, they had less pressure, they were able to execute their strategy in a judicious way over a four-to-five-year period. So I haven’t seen it my organization but I think it certainly exists in other parts of the market. And particularly if you have a much larger fund, that’s probably the case.

Privcap: Andrea, are there other interesting ways of looking at overhang? For example, by size of fund? Do we see any interesting trends when we look at the overhang that way?

Auerbach: Yes. Generally speaking, in looking at the overhang, it kind of sorts itself out in a 40-40-20 proportion. Funds of $5 billion and up usually take 40 percent of the overhang. Funds between $1 billion and $5 billion take up the other 40 percent. And then 20 percent is generally left for funds of $1 billion and under.

And what’s interesting is that a lot of love has been shining on the middle market over the last couple of years. And so their overhang has climbed up by $17 billion in two years. The trans-action volume in the middle market has generally stayed business as usual, so it’s kind of regu-lated itself very well. But with institutional investors continually looking and committing capital to funds in the lower middle market, it may have a shade more capital than it normally has to dole out in a regulated manner. So we’re watching for signs of multiple expansion in that space.

Privcap: Stefanie, have you seen any signs that an abundance of unspent capital is af-fecting deal flow or deal valuations in the middle market?

Langer: Because we have groups that are both real estate private equity and private debt, it’s been interesting to watch what’s happening on the private debt side. I’ve been at several conferences over the last couple of weeks where, anecdotally, people were suggesting that multiples are going up, that deals are getting priced more competitively and how that is impacting financiers for middle market deals. And I think, above a certain size level, that certainly is the case. I would say in the real middle market to the upper middle market, that is most certainly the case. In the lower-middle market, not so much. I think it’s still a little bit more inefficient.

Privcap: Has there ever been

a case in the recorded history of private equity of a fund simply

getting to the end of its life

and maybe they didn’t spend all the money and

they just gave it back? Or is that

just not an option for many GPs?

Elio: It’s almost an urban legend.




Overhang

Privcap: If we take the current trends and put them on a trajectory forward, what does that say for the overhang and what does that therefore say for the dynamics in the deal market?

Elio: I do think that the overhang will continue to grow but I think the components of the over-hang will change. I think LPs in general are not enamored with the megafund model, so if those investment-period extensions come through and they’re not approved, they’re not likely to turn around and put that money right back into the megaspace. So that brings us to the middle market. If too much money is pouring in there, how much of it gets earmarked for coinvest-ments going forward? We’ll see.

300.0

250.0

200.0

150.0

100.0

50.0

2003

32.6 29.9

72.166.6

121.7108.7

207.2

175.1

261.2

177.9

210.6

123.5

61.1

22.8

61.2

19.3

86.7

12.1

94.8

13.4

2004

■ Total Capital Raised■ Total Capital Paid

US$

(bill

ions

)

2005 2006 2007 2008 2009 2010 2011 2012

Capital Commitments (US$) 32.6 72.1 121.7 207.2 261.2 210.6 61. 61.2 86.7 94.8 982.8

% Paid In 92% 92% 89% 85% 68% 59% 37% 31% 14% 14%

Estimated Paid-In Capital (US$)1 29.9 66.6 108.7 175.1 177.9 123.5 22.8 19.3 12.1 13.4 544.0

Capital Uncalled (US$) 2.7 5.5 13.0 32.1 83.3 87.1 38.3 41.9 74.6 81.4 438.8

Remaining Fees (US$)2 0.0 1.1 3.7 9.3 15.7 15.8 5.5 6.4 10.4 12.8 75.9Total Uninvested (2006–12) 362.8

2006–12 Cumulative

U.S. Private Equity Estimated Capital Overhang


Source: Cambridge Associates LLC

the overhang: over-hyped? - privcap · a violin fund is one of measurability—there simply...

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