Private Equity as an Asset Class(Book).pdf

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PrivateEquityasanAssetClassGuyFraser-Sampson PraiseforMultiAssetClassInvestmentStrategy:...pensionfundtrusteesrightaroundtheglobeshouldreadthebook...itiscertaintostirupsomemuchneededdebate...hasreceivedravereviewsfromwithintheUKpensionindustry(GlobalPensions)...timeandmoneywellspent...thetectonicplatesareshiftingundertheUKinvestmentestablishment(DailyTelegraph)...anindispensableroadmapforanyonelookingtocreateasuccessfulinvestmentprogramme...(TheSecuritiesInvestmentReview)ItssometimesinceIreadanythingasclearandpunchy...ifyouareinvolvedinsettinginvestmentstrategyforapensionfund,thisbookcannothelpbutclarifyyourthinking.(Beneﬁts&CompensationInternational)ThisbookstakesFraser-Sampsonsclaimtoberecognisedasoneofthegreatthinkersonportfoliotheory,rankingalongsideMarkowitzandSwensen.(RebeccaMeijlink,AlphaBetCapital)IsomehowexpectedanotherversionofSwensensPioneeringPort-folioManagement.However,thisisinmyeyesahugeimprovementandasurprisinglyentertainingandsatisfyingread.(ThomasMeyer,EIF,author:BeyondtheJ-Curve) PrivateEquityasanAssetClass ForothertitlesintheWileyFinanceSeriespleaseseewww.wiley.com/ﬁnance PrivateEquityasanAssetClassGuyFraser-Sampson Copyright©2007JohnWiley&SonsLtd,TheAtrium,SouthernGate,Chichester,WestSussexPO198SQ,EnglandTelephone(+44)1243779777Email(forordersandcustomerserviceenquiries):cs-books@wiley.co.ukVisitourHomePageonwww.wiley.comAllRightsReserved.Nopartofthispublicationmaybereproduced,storedinaretrievalsystemortransmittedinanyformorbyanymeans,electronic,mechanical,photocopying,recording,scanningorotherwise,exceptunderthetermsoftheCopyright,DesignsandPatentsAct1988orunderthetermsofalicenceissuedbytheCopyrightLicensingAgencyLtd,90TottenhamCourtRoad,LondonW1T4LP,UK,withoutthepermissioninwritingofthePublisher.RequeststothePublishershouldbeaddressedtothePermissionsDepartment,JohnWiley&SonsLtd,TheAtrium,SouthernGate,Chichester,WestSussexPO198SQ,England,oremailedtopermreq@wiley.co.uk,orfaxedto(+44)1243770620.Designationsusedbycompaniestodistinguishtheirproductsareoftenclaimedastrademarks.Allbrandnamesandproductnamesusedinthisbookaretradenames,servicemarks,trademarksorregisteredtrademarksoftheirrespectiveowners.ThePublisherisnotassociatedwithanyproductorvendormentionedinthisbook.Thispublicationisdesignedtoprovideaccurateandauthoritativeinformationinregardtothesubjectmattercovered.ItissoldontheunderstandingthatthePublisherisnotengagedinrenderingprofessionalservices.Ifprofessionaladviceorotherexpertassistanceisrequired,theservicesofacompetentprofessionalshouldbesought.OtherWileyEditorialOfﬁcesJohnWiley&SonsInc.,111RiverStreet,Hoboken,NJ07030,USAJossey-Bass,989MarketStreet,SanFrancisco,CA94103-1741,USAWiley-VCHVerlagGmbH,Boschstr.12,D-69469Weinheim,GermanyJohnWiley&SonsAustraliaLtd,42McDougallStreet,Milton,Queensland4064,AustraliaJohnWiley&Sons(Asia)PteLtd,2ClementiLoop#02-01,JinXingDistripark,Singapore129809JohnWiley&SonsCanadaLtd,6045FreemontBlvd,Mississauga,ONT,L5R4J3,CanadaWileyalsopublishesitsbooksinavarietyofelectronicformats.Somecontentthatappearsinprintmaynotbeavailableinelectronicbooks.BritishLibraryCataloguinginPublicationDataAcataloguerecordforthisbookisavailablefromtheBritishLibraryISBN978-0-470-06645-4(HB)Typesetin11/13ptTimesbySNPBest-setTypesetterLtd.,HongKongPrintedandboundinGreatBritainbyTJInternationalLtd,Padstow,Cornwall,UKThisbookisprintedonacid-freepaperresponsiblymanufacturedfromsustainableforestryinwhichatleasttwotreesareplantedforeachoneusedforpaperproduction. ContentsIntroductionxiiiAcknowledgementsxxiii1WhatisPrivateEquity?1Fundinvestingversusdirectinvesting2Terminology4Primaryversussecondaryfundinvesting6Abroaddelineation:buyoutandventure7Capital:allocated,committed,drawndownandinvested9Howdoprivateequityfundswork?11Structure11Cashﬂow13Investment15Fundraising16Summary202PrivateEquityReturns–TheBasics23UnderstandingtheJ-curveandcompoundreturns23Upperquartileﬁgures29Medianreturns30Averagereturns31Pooledreturns34 viiiContentsMultiples34DistributedoverPaidIn(DPI)37PaidIntoCommittedCapital(PICC)38ResidualValuetoPaidIn(RVPI)38TotalValuetoPaidIn(TVPI)38Valuation39Fees40Time-weightedreturns41Summary423Buyout45Typesofbuyouttransactions45MBO45MBI46BIMBO46LBO47Takeprivate47Roll-up48Other“buyout”activity48Establishedbusinesses50Debt52Earnings54Size55Control58Barrierstoentry61Summary644HowtoAnalyseBuyouts67Earnings68EBIT70EBITDA71Earningsgrowth72Multiple74Multipleincreaseinanimperfectmarket74Multipleincreaseinaperfectmarket77Leverage78Recapitalisation79Timing80 ContentsixModellingandanalysingbuyoutfunds82Summary875BuyoutReturns89USversusEuropeanbuyout89Buyoutskillbases91Imperfectmarkets92Earningsmultiples94Earningsgrowth97Leverage100Fundsize101Whatcanweexpectfrombuyoutreturnsinfuture?107Recentfundraisinglevels109Someconclusionsandpredictions111Summary1136VentureCapital115Whatisventurecapital?115Backingnewapplications,notnewtechnology116Classiﬁcationbysector118IT118Telecoms121LifeScience124Classiﬁcationbystage128Seed129TheUSmodel131Seedstagefocus131Homerunmentality133“Valueadd”133TheUSmodelcomestoEurope134WhyEuropeanventurecapitalﬁrmshaveavoidedtheseedstage134Classiﬁcationbystage,continued135Earlystageinvesting135Mid-andlatestageinvesting135Summary1357HowtoAnalyseVenture137Thefundamentals137Moneymultiples137 xContentsValuation140Costandvalue147IRRsandmultiples149GoingInEquity(GI%)150Percentageoftheholdingwithinthefund151Theimpactofhomeruns151Summary1558VentureReturns157USout-performanceversusEurope157MoneymultiplesdriveIRRs159Homerunsandthegoldencircle160Marketconditions163Europeanventure–isitasbadasitseems?165Returnsandfundsize170Venturereturnsbystage175Whatofthefuture?177Summary1809DueDiligence183Buyoutfunds186Venturefunds188Co-investors191Cross-fundinvesting192Buyoutcompanies192Venturecompanies194FundofFunds196Monitoringprivateequityfunds198Summary20110PlanningyourInvestmentProgramme203Cashﬂowplanning203Allocated,committedandinvestedcapital205Diversiﬁcationbytime206Propercommitmentlevels208Diversiﬁcationbysectorandgeography209TotalReturn213Howtodealwithuninvestedcapital214Secondaries216Mezzanine219 ContentsxiPrivateequityproxies219Towardsanewworldofprivateequityprogrammes220Summary222Glossary225Index253 IntroductionThereareanumberofbooksalreadyinprintonthesubjectofprivateequity,and(Ibelieve)acouplemoreinthecourseofpreparation,soitmaybefeltthatabooksuchasthisrequiressomejustiﬁcation.Ifso,itcanverysimplybeprovided.Ihavealwaysfeltthelackofasinglecomprehensiveguidetoprivateequity;somethingthatdoesnotseektoexaminetherelationshipbetweenGPsandLPs,ortoindulgeinesotericanalysisofprivateequityreturns,butwhichsetsoutsimplytoanswerthekeyquestions,suchas“whatisprivateequity?”and“howdoesitwork?”.Surprisinglyforanassetclasswhoserootsgobacktobeforethesecondworldwar,thereisnosuchbookavailableanditispreciselythisgapthatthisworkisdesignedtoﬁll.Thereis,forexample,noonestandardtextbookwhichcanbeusedfortheprivateequityelectiveinbusinessschools,andIhavedesignedtheoverallstructureofthebookinconsultationwithacademicswhoteachsuchcoursesinanattempttoachieveascloseaﬁtaspossiblewiththecourseoutline(notaseasyasitsoundssincethereseemstobenooneuniversallyacceptedlistofcoursecontent!).Noristhereonethatcanberecommendedtoentrylevelprofessionalsinprivateequityﬁrms,norforinstitutionalinvestorswhomaybelookingtoentertheassetclassfortheﬁrsttime,norforpensionconsultantsandtheirtrusteeclients.However,pleasedonotassumethatjustbecauseyoumighthavemanyyearsofprivateequityexperienceyouwillcomeacrossnothingnewinthisbook.ConceptssuchasTotalReturninvesting,andtreasuryandportfoliosecondaries,havebeeninmythinkingforseveralyearsbuthavebeenarticulatedfortheﬁrsttimeinthisbook.Thesearenovelideasandmayseemcontroversialtosome,butItrustyouwillatleast xivIntroductionﬁndthemthought-provoking.Similarly,myanalysisofhistoricprivateequityreturns,bothbuyoutandventure,hasbeenperformedspe-ciﬁcallyforthisbook,usingthemostup-to-dateﬁguresavailableatthetimeofwriting(Autumn2006),andmyconclusionsandsuggestionsinthisregardareoriginalandnewlyformed.MypreviousbookMultiAssetClassInvestmentStrategy,alsopub-lishedbyJohnWiley&Sons,answeredthequestions“whyshouldIinvestinprivateequity?”,“howmuchshouldIallocatetoit?”,“howshouldprivateequityreturnsbecomparedandanalysedagainstthoseofotherassetclasses?”and“howdoesprivateequityﬁtwithinanoverallportfolio?”.Thesetwobooksaredesignedtobereadinconjunc-tionandthereforeIdonotproposetorepeatanyofthatcontenthere.Inanyevent,itwouldseemtoﬁtmuchmorenaturallywithinabookonoverallassetallocationthanwithinaspecialistworkofthisnature.Iwould,therefore,stronglyrecommendthatyoureadtheotherbookﬁrstifyouhavenotalreadydoneso.Beforewegetintothemainbodyofthebook,thereareanumberofpointswhichIwouldliketomakebywayofgeneralintroductioninthehopethatitwillenhanceyourunderstandingofwhatistofollow.Imustalsoconfessthatthishopeissomewhatself-serving,sincetherewereanumberofgeneralissuesrunningasathreadthrougheverychapterbutwhichweredifﬁculttoclassifysufﬁcientlytoidentifyexactlywheretheymightproperlybediscussedindetail.NUMBERS,THEIRUSESANDLIMITATIONSTheﬁrstisthatwhilenumbersareallwehavetoworkwith,weshouldconstantlyremindourselvesthattheydonotpaintaperfectpicture.Thisistrueofallinvestment,butprobablymoresowithprivateequitythanwithanyotherassetclass.Privateequityisdifferentinsomanyways,butmostimportantlyitistheonlyassetclasswhere(1)annualreturnsaremeaningless,invalidandirrelevantand(2)truereturnscanonlybemeasuredmanyyearsinarrears.Thus,whileweshouldmakefulluseoftheavailabledataweshouldalwaysbereadytotempertheresultswithperceivedtrendsandpersonalexperience,particularlywherewemaybeinthemidstofstructuralchange.Similarly,weshouldalwaysthinkaboutwhatliesbehindtheﬁgures.Asanindustryweseempronetolookingatﬁgures,particularlyper-formanceﬁgures,anddrawingquickandseeminglyobviousconclu-sionsfromthem.Yetinmanycases,ifwestoppedandaskedourselves Introductionxvsomeintelligentquestionsastohowtheﬁgureshavebeenpreparedandpresented,orastowhattheyactuallyrepresent,orastowhatfactorsmighthaveinﬂuencedthem,wewouldalmostcertainlyarriveatatotallydifferent,andcertainlyamoreinsightful,result.WewillseethattheﬁgurespurportingtorepresentEuropeanventureperformanceareaparticularlyclearexampleofthis,butthereishardlyasingleaspectofprivateequitydatawherethesamepointdoesnotholdtruetosomelesserdegree.Understandingwhatliesbehindtheﬁguresisinﬁnitelymorevaluablethanasimplepresentationoftheirsurfacevalues.Indeed,oneofmymainobjectivesinagreeingtowritethisbookwasthehopethatthisoneimportanttruthcouldbeconveyedandunderstood.THENEEDFORTRANSPARENCYANDFULLDISCLOSUREThisleadsusontothesecondpoint,whichisapleaforfulltrans-parencywithintheindustry.Timeandagaininthebookweﬁndour-selveswishingtoanalyseaparticularpointonlytoﬁndthatthedataweneedisnotavailable,andthushavingtomakesomehopefullyintel-ligentdeductionsandassumptionsinstead.Theprivateequityindustryisnowlarge,matureandwelldeveloped.Surelywehavereachedastagewherefulldetailsofeveryindividualtransactioncanhappilyandsafelybereleased,classiﬁedaccordingtoacommonlyagreedanalyticalmodel,andthedatamadepubliclyavailable,ifnecessaryforafee?Itisquiteridiculousthatanindustrywhichraiseshundredsofbillionsofdollarseveryyearshouldbeunabletotell,forexample,whetherlever-ageratioshaverisenorfalleninEuropeanbuyoutwithinaparticularperiod,ortowhatextentcertaininvestorsarebeingdilutedorotherwisebythetermsofUSventurefundingrounds.Iwouldarguethattransparencyandfulldisclosurewouldactuallyhelpratherthanharmtheindustry.Wearesubjectedtoanenormousamountofill-informedcriticism,rangingfromblogsintheUnitedStatesthatmayhavegotholdofasmallpartoftheportfoliodataofapublicpensionplan,orevenanindividualfund,andpublishitwithoutunderstandingthatsomethingliketheJ-curvecouldcompletelyalteritsapparentmeaning,to(regrettably)articlesintheEuropeannationalpresswhichfailtounderstandevenfundamentalconceptssuchasthedifferencebetweenventureandbuyoutfunds,orbetweenallocated,committedandinvestedcapital.Weretheinformationpubliclyavailable xviIntroductiontorebutthesestoriesthensurelylifewouldbemadeeasier,notmoredifﬁcult?JustwhatisitthatGPsareafraidof,thattheyfeeltheneedtoshelterbehindsuchmassiverampartsofconﬁdentiality?ALLOCATED,COMMITTEDANDINVESTEDCAPITALAssignalledintheprevioussection,thethirdpointIwishtomakeisthattimeandagainovertheyearsIhavebeenstruckbyhowfewpeoplereallyunderstandthedifferencebetweenallocated,committedandinvestedcapital(veryfewLPs,forexample,actuallyover-commitastheyshould).Asyouwillsee,Iarguethatoncethedistinctionisfullyappreciated,thenitcallsforaradicalnewapproach,whichIhavechosentocallTotalReturninvesting,tohowweshouldlookataprivateequityfundprogrammeasawhole,andthatthisinturnhasseriousimplicationsasto,forexample,howwelookatthesecondariesspace.Itisdifﬁculttoexaggeratetheimportanceofthiskeydistinction,whichdoesnotjustimpactthequestionofprogrammemanagementbutinfactrunsthroughdiscussionofeveryaspectofprivateequity.Isitbetter,forexample,toearna60%IRRfor6monthsora25%IRRfor6years?Theansweris,ofcourse,thatitalldepends.Itdependsonwhetheryouaregoingtobeabletoreinvestthatmoneystraightawayataprivateequityrateofreturn.Inonlyaboutonecaseoutofamillionistheanswertothisquestiongoingtobe“yes”,sotheanswertotheoriginalquerywouldclearlybethelatterratherthantheformer.YetinthatcasewhydoweuseIRRasameasureoffundperformance(ratherthan,say,moneymultiples),whichmightincentivisetheGPintheabovecasetogiveyoutheformercourseofactionratherthanthelatter?AndwhydowebasetheGP’smanagementfeeoncommittedratherthaninvestedcapital,butthecarriedinterest(inmanycases)oninvestedratherthancommittedcapital?Illogical,captain.CANTHEINDUSTRYABSORBMORECAPITAL?Thereisalsothequestionoftheamountofcapitalbeingraisedbytheindustry,andtheresultingriseinaveragefundsizes.Thisisatopicofparticularrelevancesincemyearlierbookarguesthatmostinvestorsworldwideshouldbemakinganallocationof25%totheassetclass.Wereanythinglikethistooccuritwouldofcourseresultinmassive Introductionxviiinﬂuxofnewcapitalandfearshavebeenraisedofthecapacityoftheindustrytohandlethismuchmoney.Theﬁrstpointtomakeisthatthisnewcapitalwouldnotofcoursebecomingintotheindustryallatoncebutratheroveraboutan8-yearperiodinthecaseofeachnewinvestor,andsomeofthesemaytakesomeyearseventomakethedecisionintheﬁrstplace,whichmeansthatwecouldbelookingatanythingbetween10and15years.Thus,wewouldbelookingatasteadyandfairlyslow(thoughadmittedlysizeable)expansionratherthanasuddenexplosion.Thesecondpointisthatthecapacityof,say,thebuyoutindustrytoabsorbnewmoneyappearstobealmostinﬁnite.IhavewrittenmanyarticlesinrecentyearsaboutthisphenomenonsoIthinkmyviewsarewellknown,butletmesayagainthatthereseemstomenologicalreasonwhythesizeofmegabuyoutfundscouldnotriseveryconsider-ablybeyondtheirpresentlevels.Clearlyifanyonefundhastheabilitybyitselftoabsorb,say,anextra$10billionofnewcapitalinanyonevintageyearthenthisshouldconsiderablylowerpeople’sanxietylevels.Thisclearlyhasimplicationsforpatternsofequityownership,andwecanexpectmanymorecompaniestobetransferred,atleasttem-porarily,fromthequotedmarketsintothehandsofprivateequityplayers.Italsosuggeststhatevenverylargecompaniesmaynolongerbebeyondtheirgrasp,particularlyifthecurrenttrendforhuntinginpacksandlayingoffequitytopotentialcompetitorscontinues.Ithasimplications,too,forreturns.YouwillhavetoreadtherelevantchapterstoseewhatIhavetosayaboutthis,butonegeneralpointbearsmakingattheoutset.Thereisaclearcommonsenserelationship,whichisingeneralborneoutbytheavailabledata,betweentheamountofmoneypouredintoanyparticularclassofprivateequityinvestmentandthereturnwhichthatclassislikelytoproduce.Perhapsfortunatelyforthosefewofuswhodounderstandthis,itisatruthwhichthevastmajorityofLPsandtheiradvisershaveapparentlyfailedtograsp.ACCESS,ANDWHATTHISMEANSFORINVESTMENTMODELSAnotherpointwhichisnotatallunderstoodbymostLPsisaccess,andthisproblemisofcourseparticularlyacuteinthecaseofUSventureandwhatlittleisleftoftheEuropeanmid-market.HowmanyLPsrealise,forexample,thatUSventurereturnsaredrivenbyasmall xviiiIntroductionnumberofnomorethanabout20ﬁrms,andthatthereiseffectivelynochanceofcommittingnewcapitaltoanyfundwhichtheymanage,sincethisislikelytobeover-subscribedatleastonehundredandpossiblyonethousandtimes?Clearlyvirtuallynone,butthisisperhapsbothunderstandableandexcusable.Withoutwishingtoascribeanycynicalmotivetothem,thesituationishardlyhelpedbyinvestmentmanagersandadviserswhoclaimtobeabletodeploylargeamountsofcapitalherewhenclearlyonanyviewtheycannot.Thetruthisstark:ifyouseektocommitanythingotherthanaminisculeamountofmoneytoUSventurethenthebestpossibleoutcomeisthatyouwillendupintheupperquartilebutoutsidethatall-importanttopdecile.Amorelikelyoutcome(giventheamountofmoneyseekingahomeandthenumberofavailablefunds)isthatyouwillﬁndyourselfwithsecond,thirdorevenbottomquartileper-formance.Iamnotbyanymeanssuggestingthatinvestorsshouldnotattempttodoso,sinceIamabigsupporterofUSventure,buttheyshouldgointoitwiththeireyesopenandrealisticexpectations,andthiswillnothappensolongassomepeoplewithinthefundoffundsandadvisorycommunitiescontinuetomakeself-servingextravagantclaimsthatcannotbereconciledwiththefacts.THEGP/LPRELATIONSHIPThisisatopicwhichIdonotproposetodiscusswithinthebodyofthebook.Thismaycausesomesurprise,sinceitisasubjecttowhichwholechaptershavebeendevotedinbooksbothactualandplannedbyotherwriters,andIthereforeowethereaderanexplanationofwhythisis.Ratherlikeaccess,thisisanareawherewholebattleﬂeetsoftheoryanddiscussionfounderupononemassiverockofreality.ExceptperhapsforthecaseofLPswhoinvestonatrulymassivescale(someoftheUSpublicpensionplans,forexample),andeventhenonlywheretheyareinvestingwithGPswhoaredeterminedtoraiseasmuchmoneyaspossibleinordertomaximisetheirmanagementfeeincome,thisissimplynolongeranissue.TheGPhasalmostsupremebargainingpower,andanyindividualLPeffectivelyhasnobargainingpoweratall.Considerthesituation:theLP’sonlysanctionwhenfacedwithwhatmaybedeemedanunacceptablesituationisnottoinvest,buttoinvestelsewhere.Thefund,ifitisaqualityfund,willbepotentiallyover-subscribedalmostimmediately.Itthereforemattersnotonejottothe IntroductionxixGPwhethertheLPinvestsornot;ifthatparticularLPdoesnotproceed,thereareotherswhowill.Conversely,iftheLPgoeselsewhereandﬁndsthatherviewsarenowlistenedto,thisshouldraisequestionsaboutthelevelofinvestorinterestinthisnewfundgenerally,andthusofitsquality(thereareobviousexceptionshere,whereanassetclassfallsoutoffavourforreasonswhichmayhavelittletodowithinvest-mentlogic,suchasEuropeanventure,butforthemostpartitwillbetrue).Letmequalifythisstatementofgeneraltruth,however.ThereareobviouslysomethingswhichevenwithsuchsupremepoweraGPsimplycouldnotgetawaywith,butIamnotsurethatwehavereallytestedthelimitsyetofwhatthatmightbe,particularlyinthecaseofgoldencircleUSventureﬁrms.Therewasinitiallyresistancetotheideaofa30%carry,forexample,butthiswentontobecomealmostcommonplace(IknowofoneLP,aUSendowment,whoasamatterofprinciplestoppedinvestingwithagoldencircleﬁrmonthisissue,andhaspresumablylivedtoruethelostinvestmentreturnseversince).Similarly,therewasresistancetothedramaticfundsizeincreaseswhichoccurredjustbeforethecollapseofthebubble,butthesestillwentahead.Indeed,oneortwoﬁrmssuccessfullyresistedallinvestorattemptstoreducethemagain,evenwhentheneedforthishadbecomestarklyobvious,andmanyoftheirpeershadalreadydoneso.Thisgeneralprinciplemustlogicallyholdtrue:aslongastherearenewinvestorswaitingtocrowdintoafundifexistingonesfailtotakeuptheirofferedentitlement,thenGPswillbeabletocalltheshots.PleaseunderstandthatIamnotcondoningtheposition.Personally,IﬁnditextremelyregrettablethattheeconomicinterestsofGPsandLPsareforthemostpartsobadlymisaligned,andthatfriendlyandconstructiveprofessionaldiscussionoffundtermsnowseemstobelongtoavanishedgoldenage.Iamsimplyrecordingandrecognisingreality.Thisbookisdesignedtobeapracticalguidetoprivateequity,andIhavethereforedecidedthatthereisnoplaceinitforsterileacademicdiscussionofwhatshouldideallybethecaseifonlythingsweredif-ferent.Itisratherlikealotofﬁnancetheory,whichisﬁneintheorywhenyoulearnitatbusinessschoolbutcollapsesassoonasyoutrytoputitintopracticeintherealworld.Forthosewhomaydisagree,letmesaythis:notonlyisthesituationnotgoingtoimprove,butifany-thingitisgoingtogetevenworsegiventhelargeamountsofextracapitalwhichwillbeseekingahomeintheassetclassinfuture.So, xxIntroductionasanAmericanmightsay(butI,beingacourteousandwell-brought-upEuropean,couldn’tpossibly):“getreal!”.Fortheforeseeablefuture,fundtermswillbemoreorlesswhateverGPswantthemtobe.Anobviousquestion,onewhichIamoftenaskedbuttowhichIdonothaveananswer,iswhyLPsdonotbandtogethertocombinetheirbargainingpower,perhapsevendrawingupstandardapprovedsetsoflegalterms,suchashashappenedinotherindustries,forexampleship-ping,internationalsaleofgoods,etc.Idoknowthatsomeattemptshavebeenmadetodothis,particularlyintheUSA,andyoudooccasionallyﬁndithappeningonanadhocbasiswithintheinvestorbaseofapar-ticularfund,e.g.onthefundsizereductionissue,butIhavecertainlynevercomeacrossanyreallyeffectivelargeandlong-termgrouping.Perhapsthereisapointerhereforthefuture.ManyLPscomeacrosseachotheronaregularbasisanyway,andtherereallyisnologicalreasonwhytheyshouldnotformalisetheseencountersintosomesortofindustrystandardsboard.Perhapsonedaywewillcomeacrossfundsbeingraised“onInternationalLPcommitteestandardterms(2100)”,butsomehowIdoubtit.OneﬁnalpointbeforeIleavethisrathercontroversialsubject.TherearemanyLPswhosaythattheyviewtermsandfundeconomicsasthemostimportantsinglefactorindecidingwhethertocommittoafundornot.Withgreatrespect,Iﬁndthisviewcompletelyillogical.Aglanceatsomeoftheﬁgurespresentedlaterinthisbookwillshowthatthepotentialforout-performancebytheverybestfundsinalmostanyprivateequitydiscipline,andmostobviouslyinventurecapital,ishuge.Eveninthecaseofbuyout,itishugecomparedwithsomeotherassetclasses,suchasquotedequities.Ihavenotrunthecalculations,butitseemsinconceivablethattheimpactofanyfundterm(forexample,thedifferencebetweena20%carryanda30%carry)couldmakesuchadifferencetotheoverallperformancethatitwouldinvalidatetheinvestmentdecision.Thatfundisstillgoingtobeadramaticallyout-performingfund.Doyoureallycarethatitwillonlyreturn9×toyouratherthan10×?Andcanyoureallybesosureofyourownjudgementthatifyouturnitdownyouwillchooseanotheronethatwillachieve10×(theoddsagainstwhichareimmense)ratherthan,say,2×?IfyouarethesortofpersonwhoisgoingtoturndownachancetoinvestwiththelikesofKleinerPerkinsorSequoiaonthebasisofanydisagreeablefundterm(unlessitissomethingwhichmakesitlegallyimpossibleforyoutoinvestbecauseofyourownregulatoryorconstitutionalsituation)thenIwouldrespectfullysuggestthatyouhavenotgraspedtheway Introductionxxiprivateequityreturnswork,andwouldbebetteremployedinadifferentareaofinvestment.Itisformuchthesamereasonsthat,aftermuchreﬂection,Ihavedecidednottocommentspeciﬁcallyonfundterms.First,thisdiscus-sionmoreproperlybelongsinabookaimedatanaudienceoflawyers,andwouldinvolvealotofdetailedissueswhichanon-legally-qualiﬁedreadermayﬁndverychallenging.Second,itwouldbeverydifﬁculttodowithintheconﬁnesofasinglechapter,and,ifdoneproperly,wouldprobablyrequireawholebooktoitself.Third,therearespecialistlawyerswhowillguideyouthroughtheprocessshouldyouencounteritinpractice,sothisisknowledgewhichyouasaninvestordonotreallynecessarilyneed.Fourth,itwouldunbalancethebook,sinceIwantedtodiscussdirectinvestment(i.e.,incompanies)aswellasindirectinvestment(i.e.,infunds).Finally,andmostimportantly,evenifyoudounderstandeverythingthereistoknowaboutfundterms,thisknowl-edgewillforthemostpartbelargelyirrelevantsincethetermswillbemoreorlesswhattheGPsdecidetheywillbe,andthescopeforany1meaningfulnegotiationwillbestrictlylimited.So,justtorecapitulate,thisbookisintendedasapracticalguidetohowtogoaboutthebusinessofmakingprivateequityinvestments,whetheratthecompanyor(probablymoreusually)atthefundlevel.ItattemptstodescriberealityasI,asapractitioner,haveexperienceditovertheyears,andtosticktothehighwaysofthepossible,nottoexplorethebacklanesofintellectualperfection.Privateequityinvest-ingisquitedifﬁcultenoughalreadywithoutgettingdistractedbylargelyirrelevantissues.1Sinceabout1998Icanonlyrememberoneinstancewhereamajorchangewasmadetothefundtermsduringthelegaldocumentationreview,andthiswaswheresomethingwasinconsist-entwithanassurancewhichhadbeengivenverballyduringthefundraisingprocess.Inallothercases,thechangesthatoccurredweresimplytocorrectdraftingerrorswhichwereclearlynon-sensical,thoughinthecaseofonewell-knownbuyoutﬁrm,thelawyersoncesaidtome“tobehonest,wedon’tunderstandwhatitmeanseither,butwe’renotgoingtochangeit”. AcknowledgementsOnceagainThomsonFinancialhavekindlymadeavailabletheirVentureXpertdatabasetome,andsoonceagainImustexpressmysinceregratitudeandappreciation,particularlytoBobKeiserwhoagainpatientlyanduncomplaininglydealtwithalltheminutiaeofcopyrightreleasesandsoforth.Withoutaccesstotheirﬁguresthisbookcouldnothavebeenwritten.TheteamatWileyhaveagaindoneasuperbjob.IwouldliketoexpressthankstingedwithsadnesstoRachaelWilkieandJennyMcCall,bothofwhoseeffortshavebeenrewardedwithwelldeservedpromotiontootherareasofresponsibilitywithinWiley.Iwillmissworkingwiththemboth,particularlyRachaelwhowasmyoriginaleditorandtakesthecredit(blame?)forﬁrstenticingmeintoprintinbookform.ThecontinuingmembersoftheteamareChrisSwain,JuliaBezzant,CarolineBainesandSamanthaHartleyandIwouldliketoexpressmythankstoallofthem,plusCaitlinCornish,whoprovedanablesubstituteforRachaelonatemporarybasis.TotheminparticularmustgothecreditforpublishingthebookoutsidetheirnormalproductionscheduleinordertohaveitavailableforlaunchatSuperReturn.Anumberofpeoplekindlyreadthebook,orindividualchapters,indraftandprovidedtheircomments,whichIhavestriventoincorporatewhereverpossible.IwouldliketosingleoutinparticularDaviddeWeeseofPaulCapitalPartnersandJoannaJordanofGreenparkCapital,whobothtooktimeoutoftheirbusyschedulestoprovideveryhelpfulinformationonthesecondariesmarket.MyfriendandformercolleagueJoeSchorge,nowwithPAConsultingGroup,againrenderedvaluableassistancewiththegraphicsaswellasearlymorningbrainstormingsessionsattheBelsizeCafé. 1WhatisPrivateEquity?Itusedtobequiteeasytodeﬁnewhatwasandwasnotaprivateequityinvestment:“anyequityinvestmentinacompanywhichisnotquotedonastockexchange”.Intruth,however,thisrathersimplisticdescrip-tionhasbeenintroubleforalongtime.Whataboutinvestmentsthatarestructuredasconvertibledebt?Whataboutcompanieswhicharepubliclylistedbutaretakenprivate?Orwherethecompanyremainslistedbuttheparticularinstrumentintowhichthenewinvestmentoccursisnot?Whataboutasituationwhereaninterestinacompanyisacquirednotforitselfbutwiththeintentionofgainingownershipofunderlyingassets,particularlyproperty(realestate)relatedassets?Evenafewyearsagomanywouldhavedrawnbackfromclassifyingthisasapukkahprivateequitytransaction,yettodayfundsarebeingraisedspeciﬁcallytotargetsuchopportunities.Thereagain,thereisthewholesecondariesscene,whereexistinginterestsinprivateequityaretradedbetweeninvestors.Justtocompli-catemattersstillfurther,secondaryplayersaretodayequallyhappytobuydirectlytheunderlyinginvestmentsofthefund,andfrequentlytomakeprimaryinvestmentsinnewfundsaswell.Clearlythequestion“whatisprivateequity?”isnolongercapableofaquickandsimpleanswer,evenifiteverwas.Withoutwishingtoconfuseyoustillfurther,thereisanincreasingconvergencebetweentheactivitiesofprivateequityfunds,hedgefundsandpropertyfunds,andbythetimethisbookispublishedwemaywellhaveseentheﬁrstrecordedexampleofallthreeco-operatingtogetheronthesametrans-action;itcanonlybeamatteroftime.However,therewasawell-knownlawcaseinEnglandmanyyearsagowhenajudgefamouslysaidthatalthoughyoucannotdeﬁneanelephantyoustillrecogniseonewhenyouseeit(thoughsomebelievehemayhavepinchedthisideafromDoctorJohnsonwithoutacknowledgement).Ithinkallofuswillhaveaninstinctforwhataprivateequitytransactionisorisnot,butitisgrowingincreasinglydifﬁculttobecertainaboutthisastheparametersoftheassetclassarebeingstretchedallthetime. 2PrivateEquityasanAssetClassInthischapterIamgoingtosetoutsomebasicconceptsofhowprivateequityfunctionsasanassetclass,manyofwhichwillthenbedevelopedinmoredetailinthefollowingchapters.Thisopeningchapterwillthusbeofmostusetothosewithnopriorexperienceofprivateequity,butIwouldurgetherestofyoutostaywithusratherthanturningstraighttothenextchapter,asIwillbereferringlaterinthebooktotheseconceptsintendingthemtohavepreciselythemeaningandcontexttowhichIamjustabouttoascribethem.FUNDINVESTINGVERSUSDIRECTINVESTINGTheﬁrstandmostfundamentaldistinctionintheprivateequityworldisbetweenthosewhoinvestinfundsandthosewhothenmanagethecapitalinvestedinthosefundsbymakinginvestmentsintocompanies.Thisdistinctionissometimesdeﬁnedbytheterms“fundinvesting”and“directinvesting”,andconfusinglysomeinvestorsdoboth.WealsohavetodealwithwhatOscarWildedescribedas“asinglepeopledividedbyacommonlanguage”,althoughtobefairUSprivateequityterminologyhasbecomeincreasinglycommoninEuropeandIshallusuallybeadoptingitasindustrystandard,exceptwhereitisabsolutelyessentialtodrawsomeparticulardistinctionofmeaning.InAmerica,thosewhoinvestinfundsarecalled“LPs”,sincethemostcommonformofprivateequityfundisalimitedpartnership,thepassiveinvestorsinwhicharecalledLimitedPartners.InEurope,suchfolkhavehistoricallybeencalledsimply“investors”.TherearevariousdifferenttypesofLPanditisworthspendingsometimeexaminingtheseheresincetheywillallhavedifferentinvestmentcriteriaand,mostimportantlyofall,differentlevelsofknowledgeoftheassetclass(typicallyreferredtoratherarrogantlyas“sophistication”).AtthetopendofthescalearetheFundofFundsmanagers.Thesewilltypicallydonothingexceptinvestinprivateequity,andthebestofthemwillhavestaffwithperhaps20years’specialistexperience.Some(HorsleyBridgewouldbeagoodexample)mightspecialiseinoneparticulararea(traditionallyearlystageUSventureintheircase)whereasothers(Harborvest,togiveanexampleofsimilarvintage)aregeneralistbothastothetypeofinvestmentswhichtheymakeandthegeographicalareaswhichtheycover.Aswewillsee,however,thebulkofprivateequityactivityoccursintheUSAandinEurope,anditisthesetwoareasintowhichtheprivateequityworldhastraditionallybeensubdivided. WhatisPrivateEquity?3Perhapsperversely,manyoftheFundofFundsalsomakedirectinvestmentsalongsidetheirfundinvestments(thisisknownas“co-investment”becauseitusuallytakestheformofpersuadingthemanagerofafundintowhichyouhaveputmoneytoallowyoutoinvestalongsidethefundinoneormoreofitsportfoliocompanies).Isay“perversely”becausethereisanargumentthatbyindulginginco-investmentoneactuallyharmsexactlythatdiversiﬁcationwhichisoneoftheadvantagesusuallycitedbyFundofFundsmanagersofinvestingintheirpro-grammes.Theywouldargue,onthecontrary,thattheamountsinvolvedarerelativelysmall,thattheoverallimpactofmanagementfeesislessened,albeitveryslightly,andthatitenablesinvestorstoputmoremoneytoworkintheassetclassthanwouldotherwisebethecase.Notwithstandingthesecogentarguments,thereisnonethelessavocifer-ousminoritywhoregardthisapproachasstarkstaringsophisticated.Formostinvestorsseekingtoentertheassetclass,thefundoffundsapproachwillbepreferred.Fewwillhavetherelevantlevelsofspecial-istexpertiseavailablein-housetobeableconsistentlytoselectthebestpartnershipsand,evenifonecould,manyofthebestare“invitationonly”sothatgainingaccesstothemmaywellproveimpossibleanyway;thisisaparticularissuewithUSventurefunds.OutsidetheUSAthereisafurtherissuewhichisthatallocationstoprivateequityareusuallyunrealisticallylow(solow,infact,thatmostinvestorswoulddobetternottobemakinganyallocationatall),sothatnotonlycanthecostofacquiringsuchexpertiseneverbecontemplated,butthereisnowayinwhichevenunskilledtimecanbemadeavailabletostudyandanalysethecoupleofhundredfundofferingswhicharelikelytobereceivedinanyoneyear.TheFundofFundsapproachprovidesskilledfundselectionexper-tise.Italsoensuresthatcapitalwillbecommittedonascientiﬁcbasiseveryyear(veryimportanttoobtaindiversiﬁcationbytime,aswewillsee),andthatallreportingandaccountingatthepartnershiplevelwillbetakencareof.Infact,theFundofFundsrouteintotheassetclasscanbethoughtofasthe“ﬁreandforget”option.ProvidedonecommitstoeachsuccessiveFundofFundsvehiclefromthatmanager(typicallyevery3years)thenonecansimplysitbackandmanagethecashinﬂowsandoutﬂows.ThenextstepupmightbetousesomeaspectsoftheFundofFundsapproachbutperhapssupplementedbyone’sownefforts.Forexample,aEuropeaninvestorwhohastakenthetroubletosetaproperallocationlevelandtoacquirerelevantinternalexpertise,mayfeelconﬁdent 4PrivateEquityasanAssetClassenoughtostartmaking,say,EuropeanbuyoutselectionsthemselvesbutwishtousespecialistFundofFundsproductsaimedat,forexample,USbuyoutandventure.Alternatively,suchspecialistfundscanbeusedsimplytoadda“tilt”toaprivateequityprogrammebygoingunder-weightoroverweightinaparticulararea.Directinvestmentistheﬁnallayerintheprivateequityenvironment,wheremoneyactuallygetschannelledintoinvesteecompanies,andthisistheroleoftheprivateequitymanager(“GP”).Theinvestmentprocessmaythereforebeseenasconsistingbroadlyoftwolevels,thefundlevelandthecompanylevel,anditisthisdistinctionwhichIlabelasthedifferencebetween“fundinvestment”and“directinvestment”.Eachrequiresitsownparticularmodellingandanalysis,andwewillbelookingatthisinmoredetailinlaterchapters.Importantly,eachalsorequiresitsownskills.Thisisoftenoverlookedbyinvestorswho,notcontentwithfundinvesting,decidetheywouldalsoliketoshareinsomeofthe“fun”ofdirectinvesting.Aswehavealreadynoted,wherethistakestheformofco-investmentitwillusuallyhaveanadverseimpactondiversiﬁcation.Whereittakesplacedirectly,withouteventhecomfortingumbrellaofafundco-investor,thenitisfrequentlyarecipefordisastersincefewinvestorshavetheskillsofaspecialistGP.Thiswasaparticularproblemduringthedot.combubbleasvariousfamilyofﬁces,banksandlargecorporatesscrambledtotakestakesintechnologyandinternetcompanieswithouttherelevantcompanybuild-ingskillstoensuretheirsuccessandalsowithoutthedisciplineandmentaltoughnesstorideoutthebadtimeswhentheyinevitablyarrived.Manyofthesecompanieswouldhavebeendoomedinanyevent,withhopelesslyill-conceivedbusinessplansandpoormanagement,butnotall.Whoknowshowmanystrugglingbutworthwhilecompaniesmighthavesurvivedthemaelstromifthebusinessofdirectinvestinghadbeenlefttotheprofessionals?TERMINOLOGYIhavereferredtotheOscarWildefactoraboveandwhileIproposetodealwiththislargelybyignoringit,therearesomeimportantpointstomakerightattheoutset,sincetherearesomedifferencesinterminol-ogywhichgototheveryheartofunderstandingtheassetclass,andwhichareaconstantsourceofconfusionfortheuninitiated.InEurope,theassetclassasawholeiscalled“privateequity”,anditisbroadlysubdividedinto“buyout”and“venturecapital”(orjust WhatisPrivateEquity?5“venture”),aswewillseebelow.WhilethisbroadclassiﬁcationalsoholdsgoodintheUSA,differenttermsarefrequentlyused.There,theassetclassasawholeisusuallycalled“venturecapital”andbuyouts(particularlylargeones)areoftenreferredtoas“privateequity”.Ithinkyouwillseeatoncethehugescopeforconfusionwhichthiscreates.Iamfrequentlyconsultedbyjournalistsworkingfornationalnewspaperswhoareabouttowriteanarticleonthesector,andﬁndmyselfhavingtomakethispointagainandagain;itseemsthatIhavebeenonlypartiallysuccessful,sinceIhavelostcountofthenumberoftimesIhaveseenlargeEuropeanbuyoutﬁrmsreferredtoas“venturecapitalists”.Infairnesstothejournalistsinvolved,noneofwhompretendtobeexpertsonthesector,thisconfusionistoacertainextentperpetuatedandencouragedwithinEuropefortherathercynicalpurposesofthoseconcerned.Intherighthands,venturecapitalisapowerfultoolforeconomicgrowth.Researchsuggeststhatevenbytheendof2000,venturecapitalhaddirectlycreatedabout8millionnewjobsintheUSA(roughlyequivalenttoonejobforevery$36000ofinvestment),andthatifoneaddedintothemixthejobscreatedindirectlyinsup-portingandrelatedbusinessesthenthetotalrosetoastaggering271million.NocomparablestudieshavebeenmadeinEurope;thedeliber-ateconfusionbetweenventureandbuyoutmakesanyreferenceto“venture-backed”companiesmeaninglessinthiscontext.However,itislogicallyimpossiblethatventurehashadnoeffectwhatever.ItmustthereforebeacceptedthatventurecapitalissociallyandeconomicallydesirablesinceithasacleartendencytoboostbothGDPandemploy-ment.Venturecapitaltypicallyrepresentslessthan1%oftotalcapitalinvestmentinanyoneyearintheUSA,yetventure-backedcompanies2aresaidtocreateabout13%ofGDP.Buyout,bycontrast,canbeseenbythoseEuropeangovernmentswhopractisewhatmightbetermeda“socialeconomic”model(mostofthecontinentalcountries,andincreasinglytheUK)asundesirable.Aswediscusshowbuyoutoperatesitwillbecomeclearthatbuyouttransactionsgenerallyhavetheeffectofreducingemploymentthroughrestructuringandrationalisation,andcertainlyofdecreasingtaxyieldsinceﬁnancialstructuringwilluseloaninteresttoreducetaxableearn-ings.Smallwonder,then,thatindustrybodiesinEuropehavesought1PublicSectorReview:Finance,Summer2004,pp.62and63.2PublicSectorReview,asbefore. 6PrivateEquityasanAssetClasstowrapthemselvesintheﬂagofventurecapital.TheBritishVentureCapitalAssociation,forexample,speaks(despiteitsname),not,asonemightexpect,fortheventurecommunityintheUKbutoverwhelminglybymemberfundsizeforthebuyoutcommunitytransactingdealsacrossEurope.Thisisunfortunateforallsortsofreasons,notleastthattheventurecommunityinEuropeisleftwithoutanybodytolobbyonitsbehalf.FortunatelyfortheBVCAandtheEuropeanbuyoutcommunity,Euro-peanpoliticiansaresufﬁciently“unsophisticated”thatthisdeceptiongoesunmasked.UnfortunatelyfortheEuropeanventurecommunitytheyareforcedunjustlytoendurethebrickbatswhichareregularlyaimedat“venturecapitalists”(meaningbuyoutﬁrms)byleft-wingpoliticians.ItwillbeapparentfromthetitleofthisbookthatIhavechosentoadopt“privateequity”asthenameoftheassetclassasawhole,and“buyout”and“venture”asitstwomainconstituents.IbelievethatthisistheleastconfusingapproachavailableanditreﬂectsthewayinwhichIhavealwaysviewedtheassetclass.IwillgenerallybeadoptingtheUSexpressions“LP”(LimitedPartner)and“GP”(GeneralPartner)for“investor”and“ﬁrm”or“manager”,respectively,buttherewillbeocca-sionswhenthecontextsuggeststhattheEuropeantermsshouldbepreferred.Incidentally,itmaycomeasasurpriseforAmericanreaderstolearnthattheterms“LP”and“GP”werelargelyunknowninEuropeuntilaveryfewyearsago.PRIMARYVERSUSSECONDARYFUNDINVESTINGWhenIwrotemybookMultiAssetClassInvestmentStrategyIwasabletodevoteonlyonechaptertoprivateequityandtheseconstraintsmeantthatIwasabletogiveonlyapassingreferencetosecondarytransactions.Thiswasunfortunate,assecondaryinvestinghasbecomeaverysigniﬁcantpartoftheprivateequitylandscape,andalsohasanimportantparttoplayintheplanningofprivateequityfundpro-grammes,particularlyintheearlystages.Wewillexamineboththeseareasinmoredetaillater,butforthemomentIamhappytobeabletodevotesometimetoexplainingwhatsecondarytransactionsareandhowtheywork.Itiswidelyassumedbyinvestorsthatprivateequityfundsareilliquidinvestments.Whilethisisstrictlytrueasamatteroflaw(inthesensethattheyarenotquotedonanexchange)itisnottrueasamatterofpractice,becauseoftheveryactivesecondarymarketwhichexists. WhatisPrivateEquity?7Brieﬂy,ifyouholdaninterestinaprivateequityfundandwishforwhateverreasontosellit(thusalsobringingtoanendyourobligationtocontinuetofundcapitalcalls)thenthereareasigniﬁcantnumberofspecialistsecondarypurchaserswhowillbehappytoquoteyouapriceforit.VariousinvestorsandFundsofFundsalsoplayinthisspace,thoughitdoesnotformthemainthrustoftheiractivities.Thespecialistsecondaryplayershavegrownrapidlyinrecentyears,bothinnumberandinsize,totheextentthatthereisnowusuallyanexcessofdemandoversupplyforsecondaryproduct,reﬂectedinveryﬁrmpricing,atleastforbuyoutfunds(venturefundsarestillaffectedbytheuncertaintycreatedbythetechnologybubble,particularlythosethatarenotwellknownand/ormaybeseenashavingkeptsomecom-paniesaliveunnecessarily).Thusthemyththatprivateequityasanassetclassisilliquidisjustthat–amyth.Itshouldbeperfectlypossibletodisposeofanentireprivateequityfundprogrammeinthespaceof3monthsorsoshouldoneforsomereasonwishtodoso.Ihavepersonallyconductedasecondarytransactioninlessthanamonthfromstarttoﬁnish.Ofcourseonewillnotusuallyrealisethefullpotentialvalueoftheinterest,butthenthatisthenatureofsellinganyfuturecashﬂowforapresentvalue.Itshouldalsobeborneinmindthathavingtosellalargeholdingofquotedequi-tiesonaﬁresalebasisisunlikelytobringintheirfullbookvalue.Secondarytransactionsalsotakeplaceatthecompanylevel,typ-icallytakingtheformofaGPseekingtoselltheremainingportfolioofafundinordertobeabletowinditupinatimelyfashion.VeryrarelyonemayseeaGPwhohasbeenunabletoraiseanewfundsellingtheactiveportfoliooftheirexistingfundorfundsattheurgingoftheirLPs;thesesituationsaremuchmorelikelytoinvolveoneofthecor-porateorbankinginvestorstowhomwereferredearlierpanickingandcompoundingtheiroriginalerrorbyseekingtoselltheirinvestmentsattheworstpossibletime.TheskillsofasecondaryinvestoraredifferentagaintothoseofaGPoraconventionalLP,butareprobablytheclosestofalltostandardﬁnancetheoryandthustheeasiesttolearn.Certainlytheyareatthemostobjectiveandquantitativeendsoftherelevantcontinuum.ABROADDELINEATION:BUYOUTANDVENTUREBuyoutcanbedistinguishedfromventurecapitalinanumberofways.Chiefamongthesearethefactthatitgenerallyfocusesonestablished 8PrivateEquityasanAssetClasscompaniesratherthanyoungbusinesses,andthefactthatitusesdebtaswellasequityﬁnancing(andfrequentlyhybridsofthetwo).Itisalsogenerallytruethatittendstoconcernitselfwith“traditional”businessactivitiesratherthantechnology,althoughthisdistinctionisbecomingsomewhatblurredasformer“dot.com”andtechnologybusinessesmature.Wehavealreadyseenanumberofbuyoutsinthetelecomsspace(someofthemverylarge)andthereisnologicalreasonwhyacompanywhichhasoriginallybeenventurebackedshouldnotinthefullcourseoftimebethesubjectofabuyouttransaction.Sizeisalsooftenadvancedasadifferentiatingfactorandnowthattheexcessivevaluationsofthedot.combubblehavesubsidedthiscanalsoprobablybeadoptedwithsomeconﬁdenceasageneraltruth.However,thistooshouldbetreatedwithsomecaution.Whileitiscer-tainlytruethattheaveragesizeofbuyoutfundsisgettinglargerandlarger,enablingtheminturntotransactlargerandlargerdeals,therearestillafewbuyoutﬁrmswhoarehappytooperateatthesmallerendofthemarket.Anotherapparentdistinctionisthatbetween“control”and“non-control”investing,theformerbeingwheretheprivateequitymanagereitherownsamajorityofthesharesinthecompanyoratleasthascontroloverthemajorityofthevotingrights.Treadcarefully,here,though.Whileitisextremelyunusualtoﬁndaventurecapitalisthavingcontroloveracompany,exceptwherethismayhaveoccurredthroughthefailureofthecompanytoachieveitstargetsandthetriggeringofdefaultand/orpreferencerights,thisisbynomeansthesamethingassayingthatcontrolwillalwaysbepresentinabuyouttransaction.Indeed,non-controlinvestingusedtobeextremelyprevalent,andevenatthetimetriggeredargumentsaboutwhetheritcouldproperlybecalled“buyout”investing.Thereisnowgeneralagreementthatsuchtransactionsprobablyconstituteaseparateclassaltogether,calledeither“expansioncapital”or“developmentcapital”.Theimportanceofsuchdealsshouldnotbeunderestimated,sincewhiletheyhavelargelyfadedfromviewintheUKandtheUSAtherearestillsomeﬁrmswhospe-cialiseinthemeveninthesecountriesandmanymanagersinsuchcountriesasFrance,ItalyandSpainundertakedevelopmentcapitaldealsalongsidebuyoutsinthesamefund.Notetoothatthehistoricbuyoutreturnﬁgureswillcontainlargeelementsofdevelopmentcapital,particularlytheEuropeanﬁguresfortheearlyandmid-1990s.Thesefactorsareadvancedassuggestedguidelinesandwhiletheywillprovehelpful,andperhapsevendeﬁnitiveinmostcases,Ithinkit WhatisPrivateEquity?9Table1.1GuidelinesforclassifyingprivateequitytransactionsVentureBuyoutSmallenterprisevalue(particularlyLargeenterprisevalue,sometimesinEurope)verylarge(multi-billion)BankdebtalmostneverusedBankdebtalmostalwaysusedYoungcompanies,evenstart-upGenerallymature,establishedcompaniesInvesteecompaniesrarelyProﬁtlevelsofinvesteecompaniesproﬁt-makingcrucial(althoughturnaroundsituationsareconsidered)InvesteecompanywillalwaysTechnologyconsiderationslargelybedevelopingorapplyingirrelevantnewtechnologyAminoritystakewillalwaysbetaken.ControlalwayspresentintrueControlwillusuallyonlyarisethroughbuyouts,thoughsomeﬁrmsdefaultand/orreﬁnancingpracticedevelopmentcapitalValuationlargelyamatterofFirmrulesofﬁnancialtheoryinstinctandexperienceavailablewithwhichtocalculatevaluation(e.g.,earningsmultiple)VenturemanagerswilloftenhavebeenBuyoutmanagerstypicallycomesuccessfulstart-upentrepreneursfromanaccountancy,investmentand/orwillhavespecialistbankingormanagementtechnologyexpertiseconsultancybackgroundwillbeobviousevenfromthebriefoutlineabovethattherewillalwaysbesomethatdefyprecisedeﬁnition.Howwouldyouclassify,forexample,aﬁrmthattookmajoritystakesinfairlymaturetechnologycompaniesusingonlyequity,oraﬁrmthatuseddebtﬁnancingtotakeamajoritystakeinatroubledearlystagecompany?Happily,commonsensewillusuallyprevailbutTable1.1mayprovehelpful.CAPITAL:ALLOCATED,COMMITTED,DRAWNDOWNANDINVESTEDWewillbeexamininginsomedetailhowprivateequityfundsandtransactionswork,butthismaybegreatlyfacilitatedbyanexplanationrightattheoutsetofthedifferentcategoriesofcapitalwhichoneencounters.Thispointisabsolutelykeyas,forexample,afailuretounderstandthedifferencebetweencommittedandinvestedcapitalliesattheheartoftheveryfundamentalmistakeswhichoneseesbeingmadehabituallybyinvestorswhohaveeitherrecentlyenteredtheassetclassfortheﬁrsttime,orwhoseeitasatiresomedistractionfromthe 10PrivateEquityasanAssetClassmainbusinessofinvestinginbondsandquotedequitiesandthusneverbothertoacquiretherequiredlevelofknowledge.Withoutwishingtobeundulyparanoidorcynical,coulditbethatitisperhapsintheinter-estsofsuchpeople,whomayneverhavereallybelievedintheassetclassanyway,toseeitsreturnsartiﬁciallydepressedintheirhands?Attheveryleast,theyareunlikelytobeunhappyshouldsuchaneventu-alityoccur.Itmaybehelpfulﬁrsttoseeabasicgraphic(Figure1.1)showingthewayinwhichprivateequityfundswork.Allocatedcapitalisthatamountoftheircapitalwhichaninvestornotionallysetsasideintheirmindtobedevotedtoprivateequity.Forexample,ifa$500Mpensionfunddecidestomakea15%allocationtoprivateequity,thenitsallocatedcapitalwillbe$75M.Allocatedcapitalcanbethoughtofasroughlyrepresentingthetotalamountofcapitalwhichaninvestorwouldideallyliketohaveactuallyinvestedinprivateequityinvestments(i.e.,com-panies)atanyonetime.CommittedcapitalisthatamountofcapitalwhichaninvestorhasactuallylegallypromisedtoprovidetoprivateequityfundsbysigningLimitedPartnershipAgreements.Twopointsneedtobemadehere.First,intheearlyyearsofaprivateequityfundprogrammethisﬁgurewillnecessarilybequitesmall.Second,becauseofthewayinwhichprivateequityfundswork,whichwewillbeexaminingindetailbelow,itisnecessarytoover-commit.Inotherwords,yourtargetcommittedcapitalshouldnotbethesameasyourprivateequityallocation,butconsiderablymore(usuallyatleast160%ofallocatedcapital).Thisistheonesinglepointwhichismostfrequentlymisunderstoodaboutprivateequityandleadstodramaticunder-investment.CommitmentsDrawdownsDistributionsYear123456789101112Figure1.1Howaprivateequityfundworks WhatisPrivateEquity?11Drawndowncapitalisthatamountofyourcommittedcapitalwhichhasactuallybeendrawndown(i.e.,requestedbyaprivateequityfundandpaidtothem).Thiswillincludebothcapitaltobeinvestedincom-paniesandalsomoneyrequiredforfeesandexpenses.Investedcapital,asthenamesuggests,isthatpartofdrawn-downcapitalwhichhasactuallybeeninvestedincompanies.Ithinkitwillbeapparentalreadythattherecanbeadramaticdifferencebetweenallocatedcapitalandinvestedcapital.Acommonmisconcep-tionamongstthosewhohavebeenusedtoinvestinginquotedsharesandbondsisthatonecansomehowpickupthephoneandorderacertainamountofprivateequity,thusfullyinvestingyourallocationallatonce,ratherthanrealisingthatitneedsatleast8yearsofcarefulplanningandexecution(includingsigniﬁcantover-committing)togetanywherenearyourobjective.HOWDOPRIVATEEQUITYFUNDSWORK?StructureWehavealreadyseenthatprivateequityfundsareinvariablystructuredaslimitedpartnerships,thusleadingtothesteadyadoptionoftheAmericanterminology“LP”(forLimitedPartner)foraninvestorinsuchfundsand“GP”(forGeneralPartner)foramanager.Yethereagainweﬁndourselveshavingtoqualifythisdeﬁnitionalmostimmediately.Itisprobablymorecorrecttosaythatinstitutionalprivateequityfundsarecustomarilystructuredaslimitedpartnerships.Manyfundswhichareintendedforretailusearestructuredasquotedvehicles,andtheseareoftenalsousedbyinvestorslookingto“park”uninvested3allocatedcapital.Aswewillseeinalaterchapter,thesevehiclesarefrequentlycashrichandrarelyapproachthelevelofreturnsachievedbyinstitutionalpartnerships,atleastmeasuredinIRRterms.Thereareotherfundsaimedpredominantlyatretailinvestorsanddrivenbytaxbreaks:exampleswouldbeaVCT(VentureCapitalTrust)4intheUKoranFCPR(FondsCommundePlacementàRisques)in3Thisisnotagoodpracticeastherearemuchbetterwaysofdoingthis.Seemyearlierbook“MultiAssetClassInvestmentStrategy”,JohnWiley&Sons,London,2006,particularlypages177to180.4Thisdoesnotevenneedtoinvestexclusivelyinprivateequity.AnFCPRwillenjoyspecialﬁscaladvantagesifeven50%ofitscapitalisinvestedinEuropeanunlistedsecurities. 12PrivateEquityasanAssetClassFrance.Inthesecases,again,highqualityinstitutionalreturnsareunlikelytobeachieved,butinvestorswillhopethatthebeneﬁtoftheassociatedtaxbreakswillmakeupforthis.Incertaincountries,notablycontinentalEurope,legalandregulatoryreformhasbeenslowtocatchupwithrealitywiththeresultthateventodayotherlegalformsaresometimesforceduponaninstitutionalfund,buttherewillusuallyalwaysbealimitedpartnershipavailableasaparallelstructureforthosewhoseownjurisdictionpermitsthemtoinvestinone.Somejurisdictionsgofurtherandalmostforcealimitedpartnershipstructureonaninvestor.InAmerica,forexample,pensionfundsare5subjecttoERISAregulations.Whilethesedonotimposeanystrictrequirementtorestrictprivateequityinvestmenttolimitedpartnerships(referenceistoVentureCapitalOperatingCompanies(VCOCs)andthereisaparticularissuewithregardtothemakingofcapitalcontribu-6tionsbeforethedateofthefund’sﬁrstinvestment),inpracticeUSlawyershavebecomeadeptatdraftingLPAs(LimitedPartnershipAgreements)insuchawayastoaccommodatetheseandsoasamatterofpracticefewAmericanpensionfundswillcontemplateanyotherstructure.Alimitedpartnershipisknownasaclosed-endfundsinceithasaﬁnitelifetime(typicallyeither10or12years,dependingonwhetheritisabuyoutorventurefund,respectively,butineachcasewiththeoptionoftwoannualextensions).ThishasalwaysbeenthemodelintheUSAandtheUK(atleastforinstitutionalfunds),wherethelimitedpartnershiphaslongbeenacceptedasawayofdoingbusiness,butlesssoinotherregions.IncontinentalEurope,forexample,muchprivateequityinvestingtookplacethroughopen-endedstructures.These“ever-green”vehicleswerethesubjectofmuchcriticismfromAnglo-Saxonobservers,whoclaimedthattheyprovidedlittleincentivetomanagerstoforceexitsfromtheirinvestments,andthattheirreturnscouldnotvalidlybecomparedwithlimitedpartnershipsbecausetypicallytherewasnomechanismforthemtoreturncapitaltoinvestors.5EmployeeRetirementIncomeSecurityAct.6Broadly,toqualifyasaVCOC,atleast50%ofcapitalmustbeinvestedinventurecapitalinvestmentsandtheentitymustexerciseactualmanagementrightsinrespectofatleastoneoftheunderlyingcompanies. WhatisPrivateEquity?13CashﬂowPrivateequityfundsareunlikeanyotherformofinvestmentinthattheyrepresentastreamofunpredictablecashﬂowsoverthelifeofthefund,bothinwardandoutward.Thesecashﬂowsareunpredictablenotonlyastotheiramount,butalsoastotheirtiming.Forexample,whilefundswilltypicallyselecttheirinvestmentsovera3-yearperiod,theperiodduringwhichtheyarelegallyabletodoso(the“investmentperiod”)isusuallysetat5yearstoprovideﬂexibilityandeventhensomefunds(particularlyventurefunds)willmakefollow-oninvest-mentsintotheirportfoliocompaniesforsomeyearsthereafter.Wewillbeconsideringlaterwhatthismeansforthewayinwhichweshouldmodelprivateequityfunds,andanalysereturns,butletusforthemomentexaminehowthisallhappensinpractice.Whenafundneedscash,eitherforthepaymentoffeesorthemakingofinvestments,theGPwillissueaDrawdownNotice(sometimescalledaCapitalCall,thoughstrictlyspeakingtheCapitalCallistheprocesstowhichtheDrawdownNoticegiveseffect).Thiswillaskforacertainamountofmoneytobepaidintoaspeciﬁedbankaccountbyacertaindateandwillgivebriefdetailsofwhatthemoneyisrequiredfor.TheLPwillcheckthatthepurposesforwhichthemoneyisrequiredarevalidaccordingtothetermsoftheLPA(istheinvestmentwithinthestatedscopeofthefund?,istherearestrictionontheamountofmoneythatmaybecalledinanyoneyear,orforanyoneinvestment?,etc.)andthattheamounthasbeencorrectlycalculated.ItwillthentakestepstohonourtheDrawdownNoticebymakingtherequiredbanktransfer.Animportantpointtonotehereisthatfundsaregenerallynotallowedtodrawdownmoneytoholdonaccount,althoughtheyareallowedtodosoinanticipationofaspeciﬁctransactionwhichtheyhopetocloseshortly,andfrequentlytoreturnitanddrawitdownagainifthetransactiondoesnotcomplete,althoughthiscangivecertaintypesofinvestors,particularlyFundsofFunds,proceduralheadachesoftheirown.Distributionsaretheothersideofthecashﬂowcoin.Wheneverafundexitsaninvestmentbysaleorﬂotation(American:IPO)thentheywillhavecashavailabletoreturntoinvestors.Thisisusuallyeffectedbyadistributionnotice,whichisjusttheoppositeofaDrawdownNotice,andwillnotifyeachindividualinvestorofhowmuchmoneytheymayexpecttohavetransferredintotheirbankaccount,andwhen. 14PrivateEquityasanAssetClassSincethetimingofexitsisunpredictablethensonecessarilyisthetimingofdistributions.Toinjectyetfurtheruncertaintyintothesitua-tion,afundmayactuallysellitsholdinginaparticularcompanyintranchesovertime,particularlywheretheexitisbyﬂotation.Oneimportantpointwhichisoftenoverlookedisthetendencyofsomeprivateequityfunds,particularlyUSventurefunds,tomakedis-tributionsinspecie.Allthismeansisthatinsteadofsellingsharesinanunderlyingcompanyandthendistributingcash,theydistributethesharesthemselves,leavingtheindividualinvestorstodecidewhenandhowtosellthem.Indeed,withUSventurefunds,distributionsinspecieareprobablymorenumerousthancashdistributions.Afurthercompli-cationisthatsuchsharesarefrequentlyrestrictedstock,i.e.,theycannotbetraded(sold)foracertainlengthoftime(usually6months).Thisimposesarequirementforaspecialist“endgame”teamwithinanyinvestorinsuchfunds,ﬁrstlybecausethatinvestormaynotalreadyhaveamechanisminplacefortradingquotedstocks(itmay,forexample,beaspecialistprivateequityFundofFunds),secondlybecausethemanagementofrestrictedstocksrequirescomplexcomplianceandregulatorysystems,andﬁnallybecauseeveniftheinvestordoesalreadydealinquotedstockstheyareunlikelytohaveananalystcoveringthecompanyinquestion.Thismeansthatmostinvestorssimplyselltheirsharesontheﬁrstavailableday,whichcanobviouslyleadtothemhavingtoacceptadisappointingpriceasmanysharesarethrownintothemarkettogether.ThereweresomeEuropeanfundswhousedthispracticeinthemid-1990s,buttheproblemsdescribedaboveledtosuchadverseinvestorreactionthatalmostwithoutexceptionEuropeanfundsdecidedtoeschewsuchmeasures,anditwillnowbefoundonlyintheveryunusualandhighlytheoreticalcircumstanceofafundbeingwoundupwhilestillholdingactiveinvestments.However,intheUSAitiscommonplaceandthosewhorushintoinvestingdirectlyinUSfunds,particularlyoftheventurecapitalvariety,withoutputtinginplacemechanismsfordealingwithit(therearevariousthird-partyquoteddistributionmanagementservicesthatarepreparedtoprovidetheserviceforafee)maybeinforanunpleasantsurprise.Infairness,thewidespreadadoptionofelectronicregistrationanddealingservicesinrecentyearshavemadethislessonerousthanonceitwas,butitstillimposesaprodigiousregulatoryburden,andinanyeventonlyaspe-cialistprofessionalinvestorislikelytohaveaccesstotheseexpensivefacilities. WhatisPrivateEquity?15InvestmentThemostimportantthingtounderstandaboutthewayinwhichaprivateequityfundinvestsisthatinvestmentpowerisconﬁnedtothemanager(GP).TheLPshavenovoiceatallintheinvestmentprocessand,indeed,shouldnotwanttohavesincethereisasigniﬁcantriskofthemlosingtheirlimitedliabilityiftheycanbeshowntohaveplayedanactivepartinthemanagementofthepartnership.Thecombinationofpassiveinvestingandlongfundlifetimeshasmadeprivateequityanunpalatabledishforsome,andemphasisestheneedforextremecareandspecialistskillsintheselectionofmanagersintheﬁrstplace.Anyprivateequityfundislikelytolastlongerthantheaveragemarriageandwhileanactivesecondarymarketdoesexist,aprivateequityfundcommitmentshouldbethoughtofasessentiallylongterm.Therearesomeinvestorswhochafeatthebitandﬁndwaysofinﬂu-encingtheinvestmentprocess,eitherfrombehindthescenes,orthroughsittingontheinvestmentcommitteeorevenquiteblatantlywithapowerofveto.Thiswillbedramaticallyunpopularwithmostinvestors,how-ever,eventotheextentofputtingthemoffcommittingtothefundatall.Agoldenruleofprivateequityfundselectionisthatthoserespon-siblefortheinvestmentprocessshouldbemembersofthefull-timeexecutiveteam,butnobodyelse.Historicallytherewasaninterestingjuxtapositionherebetweenprac-ticeandattitudesincontinentalEuropeandelsewhere.Ontheconti-nent,itwascommonplaceforprivateequityfundstobeafﬁliatedto,orevenownedby,entitiessuchasbanksandinsurancecompanies.Evenwherethiswasnotopenlythecase,GPswouldseektopositionthem-selveswithinthesemi-formalnetworksthatpermeatedalllocalbusi-nessdealingsbybringingseniorpeoplefromsuchorganisationsintotheinvestmentdecisionprocess.Thejuxtapositionarosebecausethiswasfoundtobeveryattractivetolocalinvestors(wholikedboththeideaofenhanceddealﬂowandsomecheckorbalanceontheinvestmentteam)butdeeplyunpopularwithAnglo-Saxoninvestors,whodeploredthelackofindependenceandpossibleinterferencewiththeinvestmentprocessforreasonswhichmightnotbepurelyﬁnancial.TherewasaperiodinFrance,forexample,whenbankswereinclinedsimplytoparktroublesomedebtorsintheircaptiveprivateequityportfolio.Tobefair,therewereinstancesofthisintheUKandtheUSAaswell,buttheseweremostlyresolvedsomeyearsagobytheexecutiveteambuyingthemselvesoutfromtheirparentorganisation(CVC 16PrivateEquityasanAssetClasssplittingawayfromCitibankwouldbeanobviousexample).Thistookmuchlongeronthecontinent,wheremanyGPswerecuriouslyreluctanttogoitontheirown,andindeedtherearestillmanycaptiveandsemi-captiveﬁrmsinoperation.Interestingly,however,theteamsareatleastatgreatpainsnowadaystostresstheirindependence.ThisisadelicatematterandIdonotwishtoprovokecontro-versy.However,itdoesseemtomethatevenwheretheremaybenoout-sidersinvolvedontheinvestmentcommitteeitisprobablyillusorytotalkaboutindependencewithinanylargegroup.DeutscheBank,forexample,simplycloseddowntheirsupposedlyindependentprivateequityoperationinLondononeday,regardlessoftheinterestsoftheoutsideinvestorswhichtheteamhadmanagedtoattractintotheirfund,andtherehaverecentlybeenpersistentrumoursofasimilarnaturesurroundinganotherbank.Allinall,Iwouldagreewhole-heartedlywithanaphorismwhichiscreditedtoPhilHorsley,averyseniorandrespectedprivateequityfundinvestor(andaformerpartnerofmine)totheeffectthatyoushouldneverinvestwithaprivateequityteamifyouhavetogotosomebodyelse’sofﬁcetomeetthem.FundraisingInasenseweshouldhavediscussedfundraisingﬁrst,sinceitischrono-logicallyatthebeginningofthefundcycleandformsanobviouspre-requisitetoanyformofinvestmentactivity.Youcannotinvestmoneyunlessyouhaveitintheﬁrstplace.Letusexplorebrieﬂyhowthefundraisingprocessplaysitselfoutinpractice.Mostfunds(includingFundsofFunds)tendtoworktoa3-yearfundcyclewhichmeansthatinthethirdyearofFundItheywillbeoutfundraisingforFundII,andsoon.Thisisanimportantfactorwhichisoftenoverlookedbythoseseekingtoenterthesectorfortheﬁrsttime.Forexample,Europeanpensionfundswillfrequentlyputadesiredprivateequityallocationouttotender,ignoringthefactthat(1)someofthebestprivateequitymanagersdonotparticipateinsuchprocesses,(2)onaverageonlyathirdofthemwillbefundraisingatanyonetime,and(3)thetenderingprocessdoesnotapplytoinvestmentfundsanyway!Therearemanyotherobjectionstothetenderingprocess7whichprobablyliebeyondthescopeofthisbook,butletussimply7“Gottimetokill?”,GuyFraser-Sampson,PensionsWorld,January2006. WhatisPrivateEquity?17notethatthisisadeeplysub-optimalwayofchoosingprivateequitymanagers;indeed,asyouwillseewhenwecometolookatmanagerselection,thisisreallyjustacompleteabrogationofresponsibilitywhencomparedwithbestpractice.Theﬁrststepinthefundraisingprocessshouldbefortheteamtositdownandplantheirinvestmentmodelfortheirnextfund.Thisshouldconsistofmappingoutwherethemostlucrativereturnsarelikelytobemade,assessinghowmanyoftheseinvestmentstheycansecure(thisislikelytobeastrictlylimitednumberinmostcircumstances),andthushowmanyarelikelytobemadeina3-yearperiodandhowmuchmoneyisrequiredforthem.Theywillthenresolvetoraiseexactlythatamountofmoney(plusasmallcontingency)andnomore,sincetodosowouldpullthemawayfromthesweetspotwhichtheyhaveidentiﬁed.YouwillnoticethatIsay“should”.Sadly,whatIhavejustdescribedisbestpracticebutisincreasinglynowhonouredinthebreachratherthantheobservance.Particularlyinthecaseofthelargebuyoutfunds,thereisanincreasingfeelingthattheywillsimplyadjusttheirtargetfundsizetomeetinvestordemand.Thisisnotnecessarilydamaging,orevenreprehensible(seemycommentsonfundsizeinthebuyoutchapter),butitiscertainlynotbestpractice,anddoesraiseworryingissuesaboutwhatexactlymotivatesbuyoutmanagers.Infairness,Ishouldpointoutthatifoneglossesovertheunfortunateexcessesofthedot.combubblethenthisbestpracticeisstilllargelyobservedinotherquarters,mostnotablybythebestUSventureﬁrms.ThenextstageintheprocessistoprepareanOfferingMemorandum(sometimescalledaPrivatePlacementMemorandum)whichisthelegaldocumentonthebasisofwhichinvestmentwilltakeplace,althoughtheactualcontractualdocumentisofcoursetheLimitedPartnershipAgreement,whichwillbesignedseparatelybyeachin-vestor,ormadethesubjectofasubscriptionagreement,whichwillbesignedseparatelybyeachinvestor.WhiletheprecisestatusofanOMinrelationtoaprivateequityfundhasneverbeendeﬁnitivelyestab-lished(andwouldinanyeventdifferfromonejurisdictiontoanother),itdoesseemthatitsrepresentationswillbeincorporatedintotheresult-8ingcontract,whetherexpresslyorimpliedly,andthatknowingly8ItisprobablymorecorrecttosaythatthecontractwillbedeemedtohavebeenenteredintobythepartiesonthebasisoftherepresentationsmadeintheOM. 18PrivateEquityasanAssetClassmakingafalseormisleadingstatementwithinanOMcouldwellleaveoneopentocriminalcharges.Inpractice,marketingoftentakesplacewithoutanOM,atleastinﬁnalform,andIhaveknowntheOMtobeproducedrightattheend,anddeliveredtoinvestorswithalltheothercontractualdocumentation,i.e.,aftertheyhaveactuallytakentheirdecisiontoinvest,whichwoulddoubtlessraiseanumberofnicelegalpoints.Formarketingpurposes,themostimportantdocumentationisthepresentation,whichisexactlywhatitsoundslike:asetofPowerpointslideswhichareusedasthefocusforaface-to-facefundraisingmeeting.Therearesomeinvestorswhoasktoseethepresentationinadvance.Personally,Iwoulddis-couragethispractice.Awell-craftedpresentationwillactmerelyasacounterpointorbackdroptowhattheteamwanttosayandshouldnotbeconsideredasastand-alonedocument.Iftheinvestorwantstoknowspeciﬁcinformationtohelpdecidewhetherornottotakethemeeting,thenwhynotsimplyaskforit?GPscouldbebetterpreparedhere.Itshouldbepossible,forexample,tohavereadytohandastandardformfundperformanceslide(preferablyonasinglesheetofpaper)whichcanbeupdatedquarterly.Oncethemeetinghastakenplace,thepresen-tationwillactasausefulaidememoireinconjunctionwiththemeetingnotewhichwillbepreparedbyamemberoftheinvestor’steam.PracticeisdividedamongstLPsastowhathappensnext.Thisisacomplexareaandmostinvestmentdecisionprocessespassthroughseveralstages.However,inbroadtermsthedecisionprocesswillbeeitherprecededorfollowedbyaperiodofduediligence,duringwhichtheLP’steamwillendeavourtocarryoutasmuchanalysisandasmanybackgroundchecksaspossibleontheGPs.Inpractice,itisprobablymoreaccuratetosaythatinmostcasesthedecisionprocesswillbeaccompaniedbytheduediligenceprocess,sincesomeanalysismaywellbedoneataveryearlystage(onthehistoricﬁnancialperformance,forexample)whiletheﬁnaldecisionmaywellbeexpresslysubjecttoduediligencewhichhasyettobecarriedout.Myviewsonduediligencemaybeslightlyeccentric,butImustsaythatinmyopinionmuchoftheduediligencewhichisperformedbyLPsisexcessive,andinmanycasesineffectiveorevenirrelevant.DuediligenceshouldbeanintelligentexerciseduringwhichtheLPteammembersdiscusswhataretheissuesthattheyseewiththeoffering,andsetoutspeciﬁcstepstoanswertheseparticularquestions.Unfor-tunatelyinpracticeoneismorelikelytomeetthescattergunapproach, WhatisPrivateEquity?19whichIoncehearddescribedas“askingformygrandmother’sbirthcertiﬁcate”,andwhichisaptlyknownas“paperingtheﬁle”intheUSA.Thereallyironicthingisthattheintelligentapproachismuchmorelikelytodiscloseusefulinformationthanthescattergunapproach.ApproachingtherefereesproposedbytheGPs,forexample,particu-larlywithastandardformsetofquestions,isunlikelytoyieldanysurprises;theGPwouldhardlyhavesuggestedthemintheﬁrstplaceunlesstheyknewinadvanceroughlywhattheyweregoingtosay.Oneortwoofthesecallsshouldbemadeasamatterofform,butfarmoreinterestingwillbeapproachingpeople“offthelist”asitwere.Particu-larattentionshouldbepaidtotrackingdownanyonewhohasrecentlylefttheﬁrm,theCEOofanyportfoliocompanywhichhasgotintodifﬁculties,andanyotherprivateequityprofessionalswithwhomtheGPhabituallyco-invests.Investmentbankersandhead-hunterscanalsoproveproductivesourcesofintelligence.Onceaninvestorisreadytoindicatethattheyaremindedtoinvestacertainamount,theybecomea“softcircle”andoncetheyhaveactu-allytakenaﬁrmdecisiontoinvestsubjectonlytoduediligenceandagreementonthelegaltermstheybecomea“hardcircle”.ThisiswhatGPsandtheirplacingagentsarereferringtowhentheytalkofhavingacertainamount“hardcircled”or“softcircled”.Withsuccessful,establishedgroupsitisnotunusualtoﬁndthatexistinginvestorsfrompriorfundsarealreadyhardcirclesbeforetheofferinggoesouttopotentialnewinvestors;indeed,itwouldbesurprisingifitwereotherwise,sincetheexistingLPswillwanttomakesureoftheirallocations.TheﬁnalstageintheprocessseesthelawyersbeingunleashedasthetermsoftheLPAaredebatedandnegotiated.Intruth,suchisthebargainingstrengthoftheGPsindesirablefundsthatlittleofanysub-stanceisusuallyconcededtoLPs,andtheirchoiceiseffectivelybetweensigningtheLPAorwalkingaway.Perhapssurprisingly,thereislittleattemptmadebyLPstogettogetherandnegotiatetermscollectively,nortoagree“industrystandard”termsamongstthemselvesandthensaythattheywillinvestonlyonthisbasis,thoughcommonsensewouldappeartocommendboththesecoursesofaction.Acynicwoulddoubt-lessventurethat,humannaturebeingwhatitis,LPsmightneverbeabletotrusteachothersufﬁcientlynottobreakranks,thusleavingtheremainderhorriblyexposed. 20PrivateEquityasanAssetClassSUMMARY•Privateequityinvestingcanbedividedgenerallyintotwostreams,fundinvestingandcompanyinvesting.Fundinvestingisessen-tiallyonelevelremovedfromcompanyinvesting,asthefundwillinturninvestinunderlyingportfoliocompanies.Forthisreason,companyinvestingisoftencalled“direct”investing.•Fundinvestmentsareinturndividedintoprimaryandsecondary.Aprimaryinvestmentisacommitmenttoinvestinanewfundwhichisasyetunformed.Asecondaryinvestmentisthepurchaseandtransferofaninterestinanexistingfundfromanotherinvestor.•Directprivateequityinvesting,i.e.,atthecompanyratherthanthefundlevel,canbedescribedastypicallybeinganinvestmentofanequitynatureinacompanywhichisnotlistedonanypublicequitymarket.Whilethereareanumberofpossibleexceptions,thisdeﬁnitionremainsbroadlytrue.•Allprivateequityinvesting,whetheratthefundorcompanylevel,canbesubdividedintobuyoutandventure.Buyouttransactionstypicallyincludedebtandinvolveestablishedandusuallyproﬁt-ablecompanies.Venturetransactionstypicallydonotincludedebtandinvolveyoung,evenstart-upcompaniesandsomeelementoftechnologicalinnovation.•Fundamentaltoaproperappreciationofhowprivateequityfundsworkisanunderstandingofthedifferencebetweenallocated,committed,drawndownandinvestedcapital.Allocatedcapitalrepresentsthatpartoftheoverallassetmixwhichhasbeensetasideforinvestmentinprivateequity.Committedcapitalisthatamountofallocatedcapitalwhichhasbeencommitted(i.e.,becomethesubjectofalegallybindingagreementtobepaidondemand)toaprivateequityfund.Drawndowncapitalisthatpartofcom-mittedcapitalwhichhasbeenpaidondemand.Investedcapitalisthatpartofdrawndowncapitalwhichhasactuallybeeninvestedinportfoliocompanies(theothermainuseofdrawndowncapitalbeingthepaymentoffeesandexpenses).•Thebulkofprivateequityfundsarethesedaystypicallystructuredasinstitutionallimitedpartnerships,thoughotherlegalformsexist,includingsomewhicharequotedand/oraimedatleastinpartatretailinvestors. WhatisPrivateEquity?21•Aprivateequityfundmaybethoughtofasastreamofcashﬂows(bothintoandoutofthefund)whichareessentiallyunpredictablebothastotheirtimingandamount.•SoleinvestmentpowersrestwiththeGP(manager)ofthefund.Thusallprivateequityfundinvestorsarewhollypassiveinthestrictlegalsense.•Fundraisingtypicallytakesplaceat3-yearintervals,althoughsomefunds,suchassecondaryfunds,haveinrecentyearsbeeninvestingmorerapidly,andthusfundraisingatshorterintervals.Thisphenomenonalsooccurredwithventurefundsduringthebubbleperiod. 2PrivateEquityReturnsTheBasicsWearegoingtodivestraightintoanexplanationofprivateequityreturnsatthispoint,ﬁrstlybecauseIthinkitfollowsonlogicallyfromwhatwewerediscussinginthelastchapter,andsecondlybecauselearningprivateequitywithoutﬁrstunderstandinghowthereturnsworkisratherlikelearningtoplaybridgewithoutunderstandinghowtoscore.Inprivateequity,thereareinterconnectionswhichmeanthatthenatureandcircumstancesofadeal,andoftheﬁrmwhichtransactsit,willtendtooperateinacertainwayonitslikelyreturn,bothastoamountandastotiming.Ideallyonecoulddiscussbothoftheseaspectsatonce,butofcoursethatisimpossibleinpracticeandsoIthinkitisbestifweﬁrstfamiliariseourselveswiththegeneralcharac-teristicsofprivateequityreturns.Howarethesemeasured,andwhy?Howwilltheytendtoreactindifferentcircumstances?Howmaywecomparethemwiththereturnsofotherassetclasses?Whatindustrybenchmarksareavailabletoassistus,andhowshouldweseektousethese?UNDERSTANDINGTHEJ-CURVEANDCOMPOUNDRETURNSIfpeoplewithnopriorexperienceofprivateequityhaveeverheardonethingaboutitinpassingittendstobetheJ-curve.Sadly,sincethisliesattheheartofcomprehendinghowprivateequityreturnswork,itiswidelymisunderstood,sometimesevenafterseveralattemptsatexplan-ation.Thisisnotbecauseitisanundulydifﬁcultorcomplexconcept,orthatthepeoplestrugglingwithitareunintelligent.Itisbecausethebackgroundtoitis(tothosebroughtupinaconventionalinvestmentenvironment)somewhatrevolutionaryandunlessanduntilonecangraspandacceptthisbackground,thentheconceptoftheJ-curvemakeslittlesenseor,evenworse,canbeseenassomesortofattemptedconﬁdencetrickonbehalfoftheprivateequityindustry. 24PrivateEquityasanAssetClassThiswillprobablybetheﬁrstofmanytimesinthisbookthatIsaythatprivateequityisdifferentfromjustaboutanyotherassetclass.Forourpresentpurposes,oneofthemaindifferencesisthatannualreturnscannotbeusedasaguidetoprivateequityperformance,whereasformostpeoplethisistheonlyreturnthatmattersforeveryotherassetclass.Thereasonthatannualreturnsarenotavalidmeasureofprivateequityperformancerestsononeoftheotherdifferenceswithotherassetclasses.Unlikeotherassetclasses,aninvestmentinaprivateequityfundrepresentsaninvestmentinastreamofcashﬂows.Ofcoursethereareotherassetswhichwouldappeartosatisfythisdeﬁnition,mostnotablybonds,butinfactthereisahugedifferencebetweenthetwo.Whenyoubuyabondyoutypicallyhavejustonecashoutﬂow(ondayone,whenyoubuythebond)andthenaseriesofcashinﬂows(thecouponpaymentsandthenthefacevalueofthebondattheendofitslife),thedatesandamountsofwhichcanbepreciselypredicted.Thatiswhy,forexample,youcancalculatetheredemptionyieldofabondatanytime.Withaprivateequityfund,youwillhaveawholeseriesofcashout-ﬂowsasmoneyisdrawndownbytheGP,butboththetimingandtheamountoftheseoutﬂowsistotallyuncertain(theonlythingyoudoknowisthattheirtotalvaluecannotexceedtheamountofyourcom-mittedcapital).SimilarlytherewillbeanumberofcashinﬂowsastheGPdistributestheproceedsofinvestmentsastheyarerealised,butagainitiscompletelyimpossibletopredictinadvancehowmucheachoneofthesewillamountto,orwhenitwilloccur.YoumightliketolookbackatFigure1.1torefreshyourselfonthis.So,yes,thewayofcalculatingthetotalreturnofbothabondandaprivateequityfundcanbebycalculatingacompoundreturnovertime,buttherethesimilarityends.Thecalculationinrespectofabondcanbedoneonthedayofpurchase;indeed,itisthisverycertaintywhichisamajorsellingpointforthingssuchasso-calledLiabilityDrivenInvestment.Thecalculationinrespectofaprivateequityfundcanonlybemadeoncetheverylastcashﬂowhasoccurred;inotherwords,thetruereturnwillonlybeknownretrospectively.Ihopeitwillbeobviousthough,thatthelaterinthelifetimeoftheprivateequityfundyouﬁndyourselfthenthemoreaccurateyourguesstimateoftheﬁnalresultislikelytobe,sincetheoutcomewillbecomesteadilylessuncertainwitheverypassingyearandeveryrecordedcashﬂow.Ofcoursethereissomeelementofthisinthecaseofthebondalso,butitisreallynothingmorethanthenormaloperationofthetimevalue PrivateEquityReturnsTheBasics25ofmoney.Asyouapproachtheredemptiondatethentheredemptionamountwillplayabiggerandbiggerpartinthetotalreturncalculation,butthisisonlybecauseitisbecomingcloserintimeterms.Thuslookingonlyattheannualreturnintermsofthecouponreceivedcouldactuallygiveaverymisleadingresult,especiallyinthecaseofashortbondthathasonlyafewyearslefttorun.However,thebondmarketsareasnearperfectasmakesnodifference,andthisdifferencewouldofcoursebereﬂectedinthemarketpriceofthebond,whichisafterallonlyasimplearithmeticcalculation.Thus,providedthatyoutakeintoaccountboththecoupon(therunningyield)andtheredemptioneffect,thenaperfectlyvalidannualreturncanbecalculatedforanybond.Notsowithaprivateequityfund.Thecashﬂowsareunpredictable,aswehaveseen,andtocomplicatemattersstillfurtherthebestiskeptuntillastfromaninvestorspointofview,asthebiggestinﬂowstendtooccurtowardstheendofthefundsliferatherthantowardsthebeginning(thisisparticularlythecasewithventurefunds,whoseaverageinvestmentholdingperiodwillbelongerthanthatofabuyoutfund).Thusanyattempttocalculateanannualreturnwillbehostagetofortune;thefortuneofhowmanycashﬂowsmightbereceivedthatyear.Increaseincapitalvaluesdoesnotworkhere,either,asmostprivateequityﬁrmsareveryconservativeonvaluation,particularlyinEuropewherestringentvaluationguidelinesareenforced.Acompanymaybesoldformuchmorethanitslatestvaluationinthefundsaccounts.Itisclear,then,thatweneedtolookatthecompoundreturnovertime(theIRR)ofaprivateequityfundinordervalidlytoassessitsperformance.Whathappens,though,ifweattempttodosoatanearlystageofitslife?ItisherethatwemeettheJ-curvephenomenon.IhopethatifyouhaveunderstoodwhatIhavebeensayingaboutthenatureofprivateequityreturnsthenthispartwillnowseemveryobvious.Brieﬂy,theJ-curveisproducedbylookingatthecumulativereturnofafundtoeachyearofitslife.Inotherwords,theﬁrstentrywillrepresenttheIRRofthefundfortheﬁrstyearofitslife.ThesecondentrywillrepresenttheIRRofthefundfortheﬁrsttwoyearsofitslife,thethirdtheIRRfortheﬁrstthreeyears,andsoon.Anyprivateequityfundwillexhibitstronglynegativereturnsintheearlyyearsasmoneyisdrawndown,ifonlythroughtheeffectofman-agementfees.However,asdistributionsstarttoﬂowbacktotheinvestorthenthedownwardmarchoftheIRRwillbereversedandtherewill 26PrivateEquityasanAssetClasscomeadaywhentheamountofinﬂowspreciselymatchestheamountofoutﬂows,thuscreatingacumulativeIRRofzero.ThisisthepointwheretheJ-curvecrossesbackoverthehorizontalaxisandsubsequentIRRsstarttobecomepositive(seeFigure2.1).Aparticularproblemwhichariseswiththisdiagramisthatpeoplearesousedtolookingatannualreturnsthat,tryastheywill,theyﬁnditverydifﬁculttograspwhatthechartisdepicting.Itisnotsayingthatthefundreturnedminus25%inyear3.Itissayingthatifyoumapallthecashﬂowsfromthebeginningofthefundtotheendofyear3youmaycalculateanIRRofminus25%.Similarly,ifyoulookatyear6itisnotsayingthatthefundsperformanceforthatyearwasﬂat.Itissayingthatfromthebeginningofthefundtotheendofyear6thepositivecashﬂowsexactlymatchthenegativecashﬂows,sothattheIRRoftheﬁrst6yearsiszero.Itisthisdifﬁcultyinbeingabletoabandontheblinkersofannualreturnsandviewtheworldafreshfromtheperspectiveofcompoundreturnsthatgetsinthewayofpeopleunderstandingprivateequityreturns.Oncethishasbeengrasped,theneverythingelsefallsveryeasilyintoplace.Privateequityreturnsarecalculatedandstatednotastheannualreturnsofanyparticularyear,butascompoundreturnsfromacertainyear(theyearofformationofthefund)toaspeciﬁedyear.Whenlookingatbenchmarkﬁguresfortheindustryasawhole,orindeedanypartofit,thenallthefundswhichformpartofthesamplethatwereformedinthesameyeararegroupedtogetherandtheirreturnsbecomethevintageyearreturn.25.0%20.0%15.0%10.0%5.0%0.0%0123456789101112-5.0%-10.0%-15.0%-20.0%InternalRateofReturn(IRR)-25.0%-30.0%YearFigure2.1J-curveillustration PrivateEquityReturnsTheBasics27Again,thisconceptseemstocauseevenintelligent,well-educatedpeoplealotofproblems,soletmeexpandonitalittletomakequitesurethattheconceptisfullyunderstood.Thisisimportantsincefromnowonwewillbemakingfrequentreferencestovintageyearreturns.Takethefollowingexample,whichshowsasimplesequenceofreturns.IhavechosenafewyearsofupperquartileEuropeanbuyoutreturnsandpresentedthemasatable(Table2.1).The1996ﬁgureshowsnottheannualreturnforallconstituentfundsduring1996,butthecompoundreturn(theIRR)forallconstituentfundswhichwereformedduring1996,from1996totheendof2005.Similarly,the1997ﬁgureshowsnottheannualreturnforallconstituentfundsduring1997,butthecompoundreturnforallconstituentfundsformedduring1997,from1997todate.Rule:thevintageyearreturnwillalwaysshow(inrespectofanyonevintageyear)thecompoundreturnofallconstituentfundsformedduringthevintageyear,fromthevintageyeartothedatespeciﬁed.(Inpractice,becauseofthewayinwhichtheﬁguresarecompiledandreleased,thespeciﬁeddatewillusuallybetheendofthelastcom-pleteyearforwhichtheﬁguresareavailable,withtheswitchtypicallytakingplaceinaboutMayofeachyear.)Forthosewhoarefamiliarwithsuchterms,itmayhelptothinkofthemasfrominceptionreturns.NowifyoulookattheJ-curveyouwillrealisesomethingelse.Atanyonetime,thevintageyearreturnsforthelastfewyears(i.e.,mostrecent)shouldbeverylowevennegative.Thatisbecausetheyrepre-senttheequivalentoftheﬁrstfewyearsoftheJ-curve,atimewheneventhebestprivateequityfundintheworldwillshownegativereturns.Sadly,Icannotdemonstratethistoyouwithactualﬁguresatthistimebecausethelastyearandahalfhasbeenabumperexitmarketandclearlysomefundshavehadanopportunitytoturnsomeinvest-mentsveryquickly,thusresultinginsomeveryhighIRRswhichhaveTable2.1UpperquartileEuropeanbuyout;vintageyearreturnstoDecember2005,cumulativeIRRtodate(%)1996199719981999200020012002200326.525.111.410.610.519.74.348.8*Source:ThomsonFinancial.*Seetext. 28PrivateEquityasanAssetClassbadlyskewedtheﬁgures.Thereisone2003vintageEuropeanbuyoutﬁrm,forexample,whichasatDecember2005boastedanIRRofover1200%!Thisisclearlybothunrealisticandunsustainable.Thisdoeshoweverillustrateanotherimportantprinciplewhenitcomestolookingatvintageyearreturns,namelythatﬁgureswhichareveryyoungareinherentlyunreliable.Indeed,innormalcircum-stancesasaguidelinetowhattheﬁnalperformanceofthefundislikelytobe,theyareallbutmeaningless.Youcanbecertainonlyofonething:theywillmostcertainlynotbethesameastheﬁnalresult.Theeffectofthetimevalueofmoney,however,meansthatthemoreyearsarollingcompoundreturngetsunderitsbelt,thecloseritwillbetotheﬁnalresult.Bytheendofafundslifeitbecomesincreasinglydifﬁculttoinﬂuencetheoutcomeoftheﬁnalﬁgureifafundhasachieved15%IRRfortheﬁrst11yearsofitslifethenevena50%1-yearreturninyear12willonlyliftittoabout16.6%overall.ItisforthisreasonthatIhaveinthepastdiscussedweightingvintageyearreturnsinordertorecognisethatayoungreturngainedoverjustacoupleofyearsislargelymeaningless,whileanoldreturngainedover10ormoreyearsisveryrobust;butthisideahasyettogaintheacceptanceofthein-1dustrybenchmarkproviders.Rule:thegreaterthenumberofyearsoverwhichavintageyearcompoundreturniscalculated,themorerobustitbecomes,i.e.,thelessdeviationthereislikelytobebetweenitandtheﬁnalfundreturn.Giventhecurrentanomaliesintheﬁgures,ImuststressthattheJ-curveheredoesnotrepresenttheJ-curveofanyparticularfundinreallife,butitisabroadgeneralisationofwhatyoucanexpecttoﬁndineverycase.Theonlydifferencewillbetheshapeofthecurve;abuyoutfund,forexample,willtendtopaybackitscapitalmorequicklythanaventurefund.Yeteventhisgeneralisationisenoughtoshowusthatitismeaninglesstolookattheperformanceofaprivateequityfundinitsearlyyears.Opinionmayvaryastowhatthatperiodmightbe(anditwillcertainlybelongerinthecaseofaventurefundthaninthecaseofabuyoutfund),butthereisnodisputethatitexists.Itendtypicallytoignorethelast5yearsorsovintageyearreturnswhenlookingatindustryﬁguresandIwouldurgeyoutodothesame.Havingnowexplainedhowprivateequityreturnsaremeasuredandpresented,weareabletounderstandabasicsetofvintageyearreturn1Forsomeworkedexamples,seemyearlierbookMultiAssetClassInvestmentStrategy,alreadyreferenced. PrivateEquityReturnsTheBasics29ﬁguresandalsohowtheJ-curveoperates.Wenowneedtolookatthebasicsofhowtheseﬁguresareslicedanddiced,andtheﬁrstconceptweneedtograspisthatoftheupperquartile.UPPERQUARTILEFIGURESTheupperquartileisthatdatapointinasamplepopulationthatstandsexactlyonequarterdownfromthetopinorderofranking.Thismayseemarathersimplisticpoint,butImakenoapologyforit,sinceitiswidelyandsurprisinglymisunderstoodwhenitcomestoprivateequity.TherearetwoaspectsinparticularwhichIwishtostressbecausetheyseemtocausethemostconfusion.Theﬁrstisthattheupperquartileisonequarterbelowthetopintermsofrankings,notamount.Letustakearandomlistofvalues:31261918Upperquartile17131212Median*11Median*10953Lowerquartile20−31*Strictlyspeaking,themedianisthemiddleobservationandisfoundbytheformula2(n+1)wherenisthenumberofobservationsinthesamplepopulations.However,asamatterofprac-tice,whereasamplecontainsanequalnumberofobservationsthenthetwomiddleobservationsareaddedanddividedbytwo(inotherwordsaveraged).Thusinthiscasethemedianwouldbecalculatedas11.5.Intheabovelistofvalues,18willbetheupperquartile,sinceitisthefourthoftheobservationsbyranking.Ithasnoreferenceatalltothevaluesoftheotherobservationssaveinthissense.Iamlabouringthispointbecausetherearethosewhoseemtobelievethatitisanumberwhichlieshalfwaybetweentheaverage(about11.56)andthevalueofthetopobservation(31),i.e.,19.44.Thisisnotthecase. 30PrivateEquityasanAssetClassNeitherisitthereturnofallthefundswithintheupperquartilegroupedtogether.Itisquitesimplythereturnoftheindividualfundwhichsitsatthebottomoftheupperquartile,i.e.,onequarterofthewaydowntherankedlistofobservations.Thisleadsusontothesecondimportantpoint.Theupperquartilecanbeaveryusefulstatisticaldevicebut,asallstatisticiansknowbutmanyinvestorsoverlook,ittakesnoaccountofthespreadoftheobser-vations.Inparticular,ittakesnoaccountofthespreadoftheindividualvalueswithintheupperquartile.Itmarksthebottomoftheupperquartile,butgivesnoclueastowherethetopmightlie.Perhapssur-prisingly,sincetheupperquartileﬁguresarebandiedaroundsoreadily,thereturnofthetopfundinanyvintageyearisnot.ThesigniﬁcanceofthiswillbeapparentfromTable2.2,whichsetsouttheupperquartileandtopfundvintageyearperformanceforUSventurefundsfrom1991to2000.Whiletheyearsarechosenmoreorlessatrandom,thepicturetheypaintisroughlytypicalofallvintageyears.Ihopeitwillbeobviousthatthisisapointofcrucialimportanceandis,sadly,yetanotherexampleofpeoplelookingatprivateequityreturnswithoutreallyunderstandingwhattheyarelookingat,oratleastbeingwillingtoengagetheirbrainandthinkaboutwhatliesbehindthem.WewillseelaterthatthisisaparticularproblemwithEuropeanventurereturns.Table2.2USventurefundcumulativeIRRs(%),vintageyears1991to20001991199219931994199519961997199819992000U/Q25.738.139.541.565.1114.561.211.8−1.5−1.7Top61.4102.3116.4112.9247.8415.9296.0721.0140.648.1Source:ThomsonFinancial.Figurespreparedto31.3.2006.MEDIANRETURNSYouwillseefromtherandomlistofvaluesabovethatthemedianissimplythehalfwaypoint,equivalenttotheupperquartile.Itisthatindividualfundwhichsitsatthehalfwaypointofthesamplepopulation.Again,thisisanimportantpointsincemanyconfuseitwiththeaverage(ormean,asitisproperlycalled).Therearethosewhosuggestthatthemedianisagoodexpressionofprivateequityreturnstoadoptonthe PrivateEquityReturnsTheBasics31basisthatifoneischoosingfromasetnumberoffundseachyear(thesamplepopulation)thenthemedianrepresentswhatoneismostlikelytoendupwith.Personally,Idonotagreewiththisproposition.Firstly,itassumesthatwewillbemakingjustoneselection,whereasinrealityonewouldbemakingseveral.Wewillbediscussinglaterjusthowmanyfundsoneneedsforaproperlybalancedportfolio,butitiscertainlymorethanone(evenfromeachcategory)inanyonevintageyear.Secondly,justastheupperquartilemeasureignoresthespreadwithintheupperquartileitself,sothemedianwillunderplaytheeffectofanyparticularlylow(butalso,andmoretothepoint,high)values.Aswewillseelater,particularlywithregardtoventurefunds,itisthesefewveryhighvaluesthatweareseekingtocaptureandthemediansimplydoesnotreﬂectthis.Thirdly,anygoodprofessionalfundinvestorwillbelookingtoinvestconsistentlyfromamongsttheupperquartile.Ofcoursethiscannotbeguaranteed,butwithexperiencecomesjudgementandahighqualityFundofFunds,forexample,wouldbelookingtohaveatleasttwo-thirdsofitsfundpicksendupintheupperquartile(Iusedtobeapartnerinaﬁrmwhichhadapproximatelya70%successrecordovera20-yearperiod).Takingthemedianasanysortofguidelineinthesecircumstancesisplainlymisleading.Finally,therearesomesamplepopulations,Europeanventurebeingthemostobviousexample,whichcontainalotofverysmallfunds,sosmallinfactthattheysimplywouldnotbeconsideredforinvestmentpurposesbyanyinstitution.Themedianwilltakealloftheseverysmallfundsintoaccountandtreattheminexactlythesamewayasalarge,institutionalgradefund,whichisagainclearlymisleading.AVERAGERETURNSIamaﬁrmbelieverintakingupperquartilereturnsastheappropriatemeasurebecauseIbelievetheymostcloselyapproximatetowhatanindividualinvestormayexpectinpracticeprovidedthatareasonabledegreeofprofessionalskillisexercised.Thetwomainreasonsforthisare:1.Thatacompetentinvestorwillbeabletoselectprettyconsistentlyagoodtwo-thirdsofitsfundsfromwithinthepotentialupperquartile. 32PrivateEquityasanAssetClass2.Thatsincetheupperquartilemeasuremarksonlythebottomoftheupperquartilebutgivesnoindicationofthetop(whichmaybeﬁve,orevententimeshigher)thenitislikelytobeaconservativeesti-mateofwhatmaybeachieved.However,thereareunfortunatelymanyintheinvestmentworldwhoviewprivateequityasanassetclasswithgravesuspicion,andpointtoanyattempttouseupperquartilereturnsassomesortofmarketingconﬁdencetrick.Thisisnotentirelytheirfaultinthatiftheyhavebeenbroughtuponadietofquotedinvestmentsthenthiswouldofcourseseemcorrect.Itis,however,theirfaultinthattheyshouldbewillingtodiveintotheprivateequityperformanceﬁguresindetailandgetagripofwhatliesbehindthemratherthanturningautomaticallytothemedianoraverageﬁgures.Itisthereforeamatterofnecessityalsotolookattheﬁguresonanaverageperformancebasis,ifonlytohavetheanswerstothesesortsofobjectionsreadilytohand.However,oneencountersanimmediatestat-isticalproblemherewhichIhopewillbeobviousinthelightofwhatwehavealreadybeendiscussing.Anaverage,ormean,iscalculatedbyaddinguptheindividualreturnsandthendividingthembythenumberofindi-vidualobservations(i.e.,thetotalnumberoffundsinthesample),thus:Σrµ=nwherem(theGreeklettermu)isthearithmeticmean(theaverage),risthereturnofanyindividualfund,andnisthenumberoffundswithinthesamplepopulation.Forthosewhomaynothavemetitbefore,Σ(theGreeklettersigma)simplymeansthesumof;inotherwords,itdenotesaddingupalltheindividualreturns.Canyouseethepotentialproblemhere?Whereoursampleincludesalargenumberofverysmallfunds,wearegivingthemthesameweightingthatwewouldaccordtoaverylargeone,regardlessofthefactthattheywouldnotbedeemedtobeofinstitutionalinvestmentgrade,andthattheywillgenerally(theverysmallonesanyway)create2verylowreturns.Theverylargefunds,conversely,arelikelytohave2Suchadiscussionliesbeyondthescopeofthisbook,oratleastofthischapter,butmanysuchfundsaregovernmentinspired/related(eitheratnationalorlocallevel)orattachedtouni-versitiesorresearchinstitutes.Inallsuchcases,investmentincompaniesislikelytotakeplaceonabasisthatisnotstrictlycommercial,i.e.,perhapswiththeobjectiveofsupportingaparticularlineofresearch,orpromotingnewcompaniesinaparticulararearatherthanwithaviewpurelytoinvestmentgain. PrivateEquityReturnsTheBasics33attractedmoneyentirelyfrominstitutionalinvestors,andmayinmanycaseshavebeentheonlyfundswithinthesamplethatsuchinstitutionswerepreparedeventoconsider.Clearly,then,wearefacedwiththeneedtocreateameasurethatsatisﬁestheaveragefetishbutstillgivesthebestrealisticguidetoreturnsthatwecanmanage.Thisisdonebycalculatingacapitalweightedaverage:ΣrcCWA=ΣcwhereCWAisthecapitalweightedaverage,andcisthecapitalraisedbyeachindividualfund.Thismayseemcomplicated,butinfactitisnot.Alltheformulaistellingyoutodoisﬁrsttomultiplythereturnofeachfundbyitscom-mittedcapital,thenaddallthesevaluesup,andthendividetheresultingtotalbythetotalamountofcommittedcapital.Giventheavailabilityofthenecessaryﬁguresthenthiscaneasilybedoneforanysectorwithinprivateequity,indeedsomeoftheindustrydataprovidersactuallycalculateitforyou.Thereisonesurprisingomission,however.Believeitornot,thereisnoCWAavailableforprivateequityasawhole,i.e.,thewholeassetclassonaglobalbasis.3WhenIwaspreparingmylastbookIgotaroundthisbycalculatingitformyselfbasedonthepublishedfundraisingﬁguresbyvintageyear,andIwillbeperformingthatsameexerciseagaininthisbookwhentalkingaboutprivateequityreturnsgenerally.Thedisadvantageofsuchamethodistheconverseofitsattraction.Ifyouarelookingatprivateequityasawhole,wherethesizeofsmallbutsuccessfulventurefundsmaybeswampedbylargebutrelativelyunsuccessfulbuyoutfunds,thenisthisreallyavalidwayoflookingatthings?Similarly,doesitreallymattertoanLPifsheisinvestedinonefundof$5billionandonefundof$50million,providedthatthesizeofhercommitmenttoeachis$10M?Surelyasfarassheisconcernedtheywilleachmakeanequalcontributiontoheroverallreturn?Ithinkthesequestionssuggesttheirownanswers.Ifyouarelookingattheperformanceoftheindustryasawhole,orofindividualsectorswithinit,thenaCapitalWeightedAveragecanbeasensiblewayofdoingthis,providedyoubearinmindhowithasbeencalculatedand3MultiAssetClassInvestmentStrategy,alreadyreferenced. 34PrivateEquityasanAssetClassthuswhatitistellingyou.However,IthinkIhavealreadymadeitclearthatIwouldpersonallyalwaysprefertheupperquartileasaperform-anceindicator.If,ontheotherhand,youneedspeciﬁcinformationforspeciﬁcpurposesthenyouhavetobeintelligentaboutwhatﬁguresyouprepare,andwherepossibletheseshouldmatchtheindividualrequire-mentsofaparticularinvestor.Intheabovesituation,forexample,youmightchoosetocreateanaverageofthefundsinwhichyouhaveactuallyinvestedweightedbytherelativesizesofyourcommitmenttoeach.POOLEDRETURNSPooledreturnsattempttoaddressthesameissuesasCapitalWeightedAveragereturns,butinadifferentway.Here,allthefundsarecombinedandtreatedasiftheywereonegiantfund,andtheIRRofthepooledcashﬂowsiscalculated.Obviouslylargecashﬂows,whetherpositiveornegative,willhaveadisproportionateeffect,justasthereturnsofalargefundwillhaveadisproportionateeffectwithinaCapitalWeightedAverage.Theadvantageofapooledreturnisthatitprobablymostcloselyapproximatestohowanindividualinvestorwillmeasuretheperformanceofherprivateequityfundprogramme.PooledreturnsareopentoexactlythesameobjectionsasCapitalWeightedAveragereturns,astowhichpleaseseeabove.MULTIPLESWhilecompoundreturnshavebeenuniversallyaccepted(atleastwithintheindustryitself)astheappropriatemeasureofperformance,thereis,however,atotallydifferentwayoflookingatprivateequityreturnswhichisrapidlygainingground.Aswehaveseen,privateequityfundsmaybethoughtofasaseriesofindividualcashﬂows,andIRRsareofcourseusuallythebestwayofmeasuringthese.ButIRRshaveonepracticaldrawback.Theymeasurethereturnwhichisearnedonmoneywhileitisinvestedinaproject(inthiscaseaninvesteecompany),buttheytakenoaccountofthelengthoftimeforwhichitremainsinvested.Whyisthisrelevant?ThedifﬁcultyofmaintaininganIRRincreasesdramaticallywitheachpassingyear.RememberthatanIRRisameasureofcompoundreturn,whichmeansthatthereturnmustatleastcompounditselfwitheachpassingyearinordertostaythesame.Bywayofillustration,let PrivateEquityReturnsTheBasics35Table2.3IRRtableEffectof25%compoundingon$100Afternyears12345Amount125156195244305uslookattherateofchangeof$100compoundingat25%ayear(Table2.3).Notethataninvestmentonlyhastodoubleover3yearstoproducea25%IRR,butmusttrebleover5yearstoachievethesameresult.Incidentally,Ihavechosentheseﬁguresdeliberatelysince25%isusuallytheminimumtargettransactionIRRtowhichanyprivateequitymanagerwouldadmit,and3yearsand5yearsmaybethoughtofasthetypicalholdingperiodsforbuyoutandventurefunds,respectively.Inotherwords,thetargetmoneymultipleforabuyoutﬁrmcouldbethoughtofas2×,whileforaventureﬁrmitwouldneedtobe3×toproducethesameIRR.Thereisthusanimplicittrade-offbetweenthethree-wayrelationshipofholdingperiod,IRRandmultiplewhichneedstobeunderstoodbyanyinvestorenteringtheprivateequityarena.Aventurefundwillkeepyourmoneyforlonger,butwillneedtodeliverahighermoneymultiple4thanabuyoutfund,whichmaygiveyoueachofyourdrawdownsbackinroughly3yearsonaverage.Rightattheendofscalewillbesecond-aryfunds,whichwewillbeconsideringindetaillater,butsufﬁceittosaythattheytendtoreturnmoneyintheshortesttimeofall,andthusmaybeexpectedtoproduceareasonableIRRbutarelativelylowmul-tiple.Thesophisticatedinvestorwillunderstandthesedifferences,andusethemtotheiradvantageinplanningandmanagingtheirprivateequityfundportfolio.Mentionofinvestorsbringsusratherneatlytotheotherpointaboutthetrade-offbetweenIRRandmoneymultiple.Asweshallbediscuss-inginmoredetaillater,itisverydifﬁcultindeedtogetmoneytoworkquicklyinaprivateequityfundprogramme,bothbecausefundsdrawdowntheirmoneyoverseveralyearsandalsobecauseyoucanonlycommitasmallpartofyourallocatedcapitaleveryyearifyouwanttoachieveproperdiversiﬁcationbytime.Giventhewayinwhichprivateequityfundsoperate,itisalsodifﬁculttokeepyourmoneyatwork;as4Notstrictlytrue,ofcourse,sinceIamnottakinganyaccounthereofdrawdownsforfees. 36PrivateEquityasanAssetClasswehavejustseen,abuyoutﬁrmmayactuallybeusingeachtrancheofcapitaldrawndownfor3yearsorless.SinceitisdifﬁcultforanLPbothtoputcapitaltoworkintheﬁrstplaceandalsotokeepitatwork,itisstronglyarguablethatamoneymultipleisamuchmoremeaningfulmeasurethananIRR.Certainlyitismoredesirableasatarget.ConsiderforamomentthepositionofanLPwhohasanallocatedcapitalof$500Mbutcurrentlyonlyhasabout$75Mactuallyinvested(farfromimpossibleintheearlyyearsofaprogramme).IfthatLPisofferedachoicebetweenearning35%onsomecapitalfor3yearsor25%for5years,whichdoyouthinktheyshouldtake?Theansweris25%for5years,sinceyouhavetoconsiderwhatthealternativeuseofthosefundsmightbe.Sadly,mostLPsdonothaveanyproperarrangementsinplacefordealingwithuninvestedprivateequityallocations,andeveniftheydidtheywouldhardlybeofhelpinthesituationIhavejustoutlined.Thetruthisthatmostinvestorswillonlybeabletoearneitherabondormoneymarketreturnonsuchmoney.Therefore,therationalinvestorwouldacceptanyrateofreturnthatishigherthanthat.Thatisthereductioadabsurdam,ofcourse.IamnotsuggestingthatinpracticeanLPshouldbesatisﬁedwithaprivateequityreturnof,say,9%.IfthatisallthatisonofferthenchangeswithintheGPbaseareclearlyindicated.However,thisdoesmakeaveryimportantpoint,namelythatyoucannotandshouldnotconsiderthereturnsofanyassetclassinavacuum,butonlyinthecontextofthetotalcircumstancesoftheindi-vidualinvestorinquestion.Thisraisesanotherinterestingpoint,towhichwewillreturn.Privateequityisunlikeanyotherassetclass,andoneofthedistinctionsisthebigdifferencethatwillusuallyexistbetweenallocatedcapitalandinvestedcapital.Theonlyotherassetclassthathasthistoanyrealextentisproperty,andthereonehasamyriadofindirectvehiclesandderivativeproductstoconsiderforinteriminvestmentpurposes.Thusitcouldbearguedthatallprivateequityreturnsareinasenseartiﬁcial,sincetheyarecalculatedoninvestedcapitalratherthanonthetotalityoftheprivateequityallocation.Ofcourse,onceonehasamatureprogrammethisargumentlosesmuchofitsforce,buteventhentherewillalwaysbeadifferencebetweenthetwo.Theissue,though,isnotthatthestatedreturnsareartiﬁcial,butsimplythatoneneedstounderstandthedistinctionandtakeitintoaccountinonesplanning.Ifyoubelievethatyoucanmakeanalloca-tiontoprivateequityonedayandinstantlystartearningaprivateequity PrivateEquityReturnsTheBasics37returnonyourentireallocation,thenyouareboundtobesorelydisap-pointed.If,ontheotherhand,youacceptthattheprivateequityreturnisatargettowardswhichtowork,andmakeplansastohowtodeploytheuninvestedcapitaltoadvantageintheinterim,thenyouwillwithinareasonabletimebegettingclosetoyourgoal.Privateequityisalong-termassetclass,andissuitableonlyforlong-terminvestors.Thispointwaswidelyignoredbynewinvestorswhocameintotheassetclassduringthebubbleperiod,andthenfounditeasiertoblametheassetclassfortheirpoorperformanceratherthantheirownmistakes.Enoughtheorising,however.Letusexaminewhichmultipleswecanuseforpracticalpurposesinanalysingprivateequityreturns.Iamheregoingtorestrictthediscussiontoanalysingprivateequityfundreturns.Wewillbelookingindetaillaterathowwecananalysetheperform-anceofindividualbuyouttransactionsandusethistobuildamodelofanentirefund.Imentionthisatthisstageonlybecauseweshallbemeetingsomeothertypesofmultiplesthere,andIdonotwishthistoconfusematters.So,tobeclear,thefollowingmultiplesapplytofunds,notindividualcompanyinvestments.DistributedoverPaidIn(DPI)Thisdoesexactlywhatitsays.Itcomparesthetotalamountofmoneypaidout(distributed)byafundtoitsLPstodateagainstthetotalamountofmoneypaidintothefundbyLPs.Thisisthebestpossiblemultipletouseformeasuringtheperformanceofafundonceitisattheendofitslife,sinceitshowstheperformancerelativetoallmoneypaidin,i.e.,moneythathasbeenusedtopayfeesaswellasmoneythathasbeeninvestedincompanies.Alltoofrequently,GPstrytofobinvestorsoffbyshowingthemthemultipletoinvestedcapital,whichisnotthesamethingatall.Recognisingthis,mostAmericanGPswillattempttorecyclesomeoftheirearlyrealisationsratherthandistrib-utingthemtoLPs,thuscreatingahighermultiple,butEuropeanGPshavebeenslowtocatchon.However,DPIisnotagoodmeasureintwosituations.First:wherethefundisnotyeteitherattheendofitslife,orsoclosetotheendandsonearlyfullypaidoutthatitmakeslittledifference.Second:whereafundhasfailedtoinvestallitscapital.Heretherewillhavebeenanexcessivedrainingoffees,andtheLP,havingallocatedthemoneytothisfund,willhavebeenunabletouseitwithinanotherfundofthesamevintageyear.Forthisreason,Iwouldpersonallyfavouramultiple 38PrivateEquityasanAssetClassofDistributedoverCommittedCapital.ThisiscommonlyabbreviatedasDCC.PaidIntoCommittedCapital(PICC)Thismultipleisoflittlevalueinassessingreturns.Itsimplyshowshowmuchmoneyhasbeendrawndown,andthushowmuchremainstobedrawndowninthefuture.Thismultipleisofmostuseinthesecondarymarket,whichwewillbeconsideringlater.ResidualValuetoPaidIn(RVPI)Thisisreallytheothersidetotherealisationratio.Itshowsthecur-rentvalueofallremaininginvestments(companies)withinthefundexpressedasaratiotothetotalamountpaidintodate.Thisisobviouslymostusefulasameasureearlyoninthelifeofafundbeforetherehavebeenmanydistributions,inwhichcaseitwilllargelyreﬂecttowhatextentportfoliocompaniesmayhavebeenrevalued.ItisalsooneofthemeasuresthatwillbeusedwhenlookingatanLPinterestinafundonthesecondarymarket.Thedisadvantageofresidualvalueasameasureisthatitmaygiveamisleadinglylowreturnexpectation,particularlyearlyoninthelifeofafund,becausecompaniesaretypicallysoldformorethantheircurrentvaluation,especiallyinthecaseofbuyoutfunds.TotalValuetoPaidIn(TVPI)Thisisoneofthemostusefulratios,andindeedoneofthemostusefulmeasuresofallforevaluatingprivateequityfundreturns.Totalvalueaddstogetherboththeresidualvalueandthedistributionstodate.ItisobviouslysubjecttothesamepossibledrawbacksasRVPIearlyinthelifeofafund,butifyouaregoingtousearatiobasedonpaidincapital,thenformymoneythisistheonetouse.ForthosewhobelievethatmultiplesgiveabetterideaoffundreturnsthanIRR,thentheTVPIwillbewatchedverycarefullyasthefundnearstheendofitslife,andcomparedwiththesameratioforotherfundsofthesamevintageyear.Incidentally,thisisalsoaverygoodmeasureforlookingatthedif-ferentreturnexpectations(andindeedrequirements)ofventurefundsasagainstbuyouts.Rememberthatwediscussedthetrade-offbetween PrivateEquityReturnsTheBasics39Table2.4Upperquartilebuyoutandventurereturns;IRR/multipletrade-offFundtypeIRRTVPIEarlystageventure16.7%2.29Megabuyout15.8%1.52Source:ThomsonFinancial(VentureXpert).Note:FiguresareforallrelevantUSfundswithintheVentureXpertdatabasefrominceptiontotheﬁrstquarterof2006.IRRandmultiple?Well,ifwelookatalltheUSfundsintheVenture-Xpertdatabase,weﬁndtheresultsinTable2.4.Notquiteaperfectillustrationoftheprinciple,butgoodenough,Ithink.Becauseventurefundshavelongerholdingperiods,thentheyhavetogeneratehighermultiplestoearnroughlythesameIRR.VALUATIONThevaluationofaprivateequityfundisasmuchanartasascience,andifonethinksaboutwhatitrepresents(thenetpresentvalueofastreamoffuturecashﬂowswhichareuncertainbothastotimingandamount)itisdifﬁculttoseehowitcouldbeotherwise.Notwithstandingthesedifﬁculties,however,itisanexercisewhichplayersinthesecond-arymarkethavetoundertakeonadailybasis,andwewillbelookinglaterathowtheygoaboutthis.Fromanaccountingpointofview,andalsoforthepurposesofindustrybenchmarks,thevalueofafundisusuallytakenasbeingthecombinedcurrentvaluesofthefundsremaininginvestments.Whilethisisaconvenientprocedure,itshouldberecognisedthat,likemanyaccountingmeasures,realityhasbeensacriﬁcedonthealtarofcon-sistency.Itseemsironicthatinmanycountriesaccountantsforcepensionfundstodiscountfutureliabilitiestoarriveatanartiﬁcialpresentvaluewhichgoesupanddownwildlywithprevailinginterestrates,andyetarenotpreparedtogothroughthesameexerciseforthefutureassets(cashﬂows)ofprivateequityfunds.Thereforethestatedaccountingvalueofafundwillneveractuallyrepresentitstruevalue,asanyattemptbyanLPtosellaninterestinafundwillquicklyshow.Itmaybetoolowortoohigh,butitwillneverbetherealvalue.ThingsarelesscertainintheUSAthantheyareinEurope.ThisisbecausethereisoneareaofprivateequityinwhichEuropeleadstheway, 40PrivateEquityasanAssetClassnamelyvaluationguidelines;indeed,theearlierformoftheEVCAguide-lines(whicharebroadlythesameastheBVCAguidelines)hadbeeninplaceformanyyearsuntiltheywerechangedrecently.AllEuropeanfundsnowadheretothese,andmanyEuropeanLPs,throughthemediumoftheLPAorasideletter,makeitalegalprerequisitethattheyshoulddoso.TheoriginalEuropeanguidelineswereclearandcapableofverypreciseim-plementation.Withregardtowritedowns,forexample,aGPwasleftwithlittlediscretion.Ifacompanysigniﬁcantlyfailedtoachieveabudgettargetthenithadtobewrittendownby25%,andeachtimethatafurtherbudgetismissedthenafurther25%writedownwasmade.TheNVCAguidelinesintheUSAaremuchwoollier;itsaysinsteadmerelythatavaluationshouldbereducedifacompanysperformanceandpotentialhavesigniﬁcantlydeteriorated.ThereisamplescopehereforanyGPwhodoesnotwanttoreduceavaluation;shouldisnotthesamethingasmust,andhowsigniﬁcantdoessigniﬁcanthavetobe?Thereagain,whoistosaythatacompanyspotentialhasdiminishedjustbecauseitscurrentperformancehas?Tomakemattersworse,manyAmericanGPsdonotevenofﬁciallyadheretotheNVCAguidelines,andwhenyouaddthisintotheexistingmixofcreativenon-compliancegreatinconsistenciescanoccur.IrememberthattowardstheendofthebubbleperiodaﬁrminwhichIwasapartnerhadinvestedinthreeventurefundsallofwhomhadparticipatedinthesameroundofﬁnancinginthesamecompany.Atyearend,oneofthemvaluedthecompanyat$960M,oneofthemvalueditat$480Mandthethirdonehadwrittenitofftozero.Moreworryingstillwasthefactthattwoofthesefundshadthesameauditﬁrm.Whateverthecase,ofﬁcialvaluationﬁgureswilltendusuallytounderstatethetruevalueofaprivateequityfund,particularlyinthemiddleperiodofitsexistencewhenitislargelyfullyinvested,sinceitishardertowritecompaniesupthantowritethemdown(someEuro-peanbuyoutfundstraditionallysimplykeepalltheircompaniesatcostunlesssomethinggoeswrongwiththem,inwhichcasetheywritethemdownaccordingtotheEVCAguidelines).Inotherwords,thevaluationsoftheunderlyingcompaniesthemselvesarelikelytobeunder-stated.Note:wewillbeexaminingthenewEVCAguidelinesinmoredetaillater.FEESIhopeitwillbeobviousfromwhatIhavebeensayingaboutprivateequityreturnsbeingcalculatedastheIRRoncashﬂowsthattheywill PrivateEquityReturnsTheBasics41alwaysbestatednetoffees,expensesandcarriedinterest.ThisisbecausetheIRRiscalculatedonmoneygoingintothefund(whichwillincludemoneydrawndownforpaymentoffeesandexpenses)andmoneydistributedoutofthefund(fromwhichcarrywillalreadyhavebeendeductedwhereappropriate).Thusprivateequitybench-markreturnswillalwaysbenetofallfeesandothermanagementremuneration.Thisisaveryimportantpointsincethereturnsofmanyotherassetclasses(inparticularquotedequities)arefrequentlyquotedbeforefees,e.g.,calculatedontheincreaseinvalueoftherelevantindexorport-folio.Therefore,wheneveryouseeprivateequityreturnsbeingquotedagainstotherassetclasses,notonlyshouldyouquestionwhethertheyarevintageyearreturnsbeingcomparedwithvintageyearreturns,butalsowhethertheﬁguresfortheotherassetclassarestatedbeforeorafterfees.TIME-WEIGHTEDRETURNSBeforeweclosethischapter,Imustsaysomethingonthesubjectoftime-weightedreturnsbecausethesearesometimesquotedasaper-formancemeasurementandthereisconsiderable(andunderstandable)confusionastowhattheyrepresent.Inparticular,itisnotwellunder-stoodhowthesedifferfromIRRs.Atime-weightedreturniscalculatedbytakingthereturnsofdifferentperiodsandcalculatingtheirgeometricmean.Thegeometricmeansoundscomplicatedbutreallyisnt.Itisgenerallyrecognisedasthebestwayofcalculatinganaverageofpercentageratesindifferentperiods.Itissimplythenthrootoftheproductofallthevalues,wherenisthenumberofvalues.Inotherwords,thegeometricmeanofaseriesof26valuationswouldbefoundbymultiplyingthemalltogetherandthenﬁndingthe26throot.Informulaicterms,itwouldbe:26(vvv...v12326Letusforgettheformulaandthemaths,however,andconcentrateonwhatisactuallybeingcalculatedinpractice.Effectivelywhatwearedoingisﬁndingtheaverageofthereturnsineachyearofafundslife,anditisthisthatinmyviewrenderstime-weightedreturnscompletelyinappropriateasameasureofprivateequityfundperformance,sincetheycompletelyignorethetimevalueofmoney.Foratime-weighted 42PrivateEquityasanAssetClassreturn,itisirrelevantwhetherareturnof,say,85%ismadeinyear1ofafundslifeorinyear10,whichisofcourseridiculous.Privateequityisacashﬂowbusiness.Privateequityfundsrepresentnothingexceptastreamofcashﬂowsandthetimevalueofmoneyisparamount.TheonlypropermeasureofastreamofcashﬂowsisanIRR.So,howdidtime-weightedreturnscometobeusedatall?Well,forthosewhoareoldenoughtorememberatimebeforecomputerspread-sheets,calculatingIRRscouldbealaboriousprocess,andinthedaysbeforeelectroniccalculatorscouldbemorelaboriousstill,requiringtheuseofsliderulesorlogarithmsandrepeatedtrialanderrorattempts.Atime-weightedreturnwasmucheasiertocalculatesinceallyouhadtodowaslookatonepageofyourlistoftables(theroots).Theotherreasonwasthattheywerealreadyinuseinthequotedmarkets.Herethereisatleastsomesensetothem,sincemoneycanbemovedinandoutofthecontrolofmanagers,orinandoutofdifferentstocks,atanytimebyinvestorsandthusanaveragereturnisquiteacceptable.Iftimingisoutofthemanagerscontrolthenthereisnopointincalculatingacompoundreturnovertime.Therealpityisthatthesecametobecalledtime-weightedreturnsintheﬁrstplace,sincetimeistheonethingtowhichtheyspeciﬁcallydonotapply.Forthisreason,artiﬁcialthoughitseems(logicallyitwouldseemtobetheotherwayaround!)IRRshavecometobecalleddollar-weightedreturnsinprivateequitycircles.Time-weightedreturnsareaperfectexampleofhowmanyintelligentandwell-educatedpeoplearecapableofcompletelyfailingtounder-standhowprivateequityreturnsoperate.Hopefullytheyarenowoflargelyhistoricinterest,buttheycontinuetobequotedamongthevariousindustrybenchmarksanditisimportantthatyoushouldunder-standwhattheyrepresentsinceitisalltooeasyfortheunwarytoconfusethemwithIRRs.Understandthem,yesbyallmeans.Usethem?No.Notever.Notunderanycircumstances.SUMMARYPrivateequityreturnsaremeasuredonacompound,notanannualbasis.Itisessentialtorememberthiswhencomparingthemwiththereturnsofotherassetclasses.Thereturnsofanyprivateequityfundwillbenegativeinitsearlyyearsasmoneyispaidinto(drawndownby)thefundbeforeany PrivateEquityReturnsTheBasics43moneyispaidback(distributed)bythefundasinvestmentsarerealised.Induecourse,therewillbeamomentwhenthevalueofinﬂowsexactlymatchesthevalueofoutﬂows,atwhichpointtheIRRofthefundtodatewillbezero.ThiseffectisknownastheJ-curve.Returnsaremeasuredonavintageyearbasis,i.e.,fromtheyearinwhichthefundwasformedtoaspeciﬁeddate.Thebestmeasureofvintageyearreturnsistheupperquartile.However,scepticismandsuspicionfromoutsidetheindustryfrequentlyforcetheadoptionofothermeasures.Ifso,itismostimportantthatthemeasureadoptedisaCapitalWeightedAverage,ratherthananaverageormedianreturn.Theupperquartileﬁgurestatestheperformanceoftheindividualfundatthebottomoftheupperquartile,notthepooledperform-anceofallfundswithintheupperquartile.Itgivesnoindicationoftherangeofreturnscontainedwithintheupperquartile,whichcanbehuge.Multiplescanalsobeavaluablemeasureofprivateequityfundreturns.MostusefulisTotalValuetoPaidIn(TVPI)whichmea-suresboththedistributionsreceivedtodateandtheresidualvalueoftheremaininginvestments.However,thisﬁgureisonlyreallymeaningfultowardstheendofafundslife.Thereisadirecttrade-offbetweenIRRandmultiple,withalongerholdingperiod(suchasonetypicallyencounterswithaventurefund)needingtoresultinahigherinvestmentmultipleinordertogeneratethesameIRR.ValuationguidelinesdifferbetweentheUSAandEurope.TheEuropeanonesaremorecertainintheirdrafting,andmorerigidlyapplied.However,ingeneral,allprivateequityfundswillinnormalmarketconditionstendtounder-statethetruevalueonexitoftheircurrentinvestments.Time-weightedreturnsaremisleadinglyso-calledsinceinfacttheydonottaketimingintoaccountatall.Forthisreason,theyarelargelymeaninglessandshouldbeavoided.Becauseofthisanomalousterminology,IRRsareoftenreferredtoasdollar-weightedreturnswithintheprivateequityindustryinordertodistinguishthemfromtime-weightedreturns.Time-weightedreturnsarecalculatedasthegeometricmeanofallthefundsannualpercentagereturns. 3BuyoutIwillbedealingseparatelywiththeissueofvaluation,howbuyoutswork,howandwhybuyoutreturnsaregenerated,howthesemaybemeasuredandanalysed,andhowwemightgoaboutmodellingbuyoutactivity.However,beforediscussingthehowandthewhy,wemustturnourattentiontothewhat.Whatisbuyout?Whatisabuyoutﬁrm?Cananyonedoit?Ifnot,whatarethebarrierstoentryintothebuyoutindustry?Aswesawearlier,whileitisverydifﬁculttoarriveatadeﬁnitionofbuyoutthatwillcovereverytransactionwearelikelytosee,itispossibletoadvancevariousgeneralcharacteristicseventhoughinmanycaseswewillalsohavetoacknowledgesomespeciﬁcexceptions.However,beforeweturntothoseaspectswhichtendtodistinguishbuyoutfromotherﬁeldsofprivateequityactivity,Ithinkitwouldbeusefultosetoutthedifferenttypesofbuyouttransactionsthatcanoccur.TYPESOFBUYOUTTRANSACTIONSMBOTheclassicbuyouthasalwaysbeenanMBOormanagementbuyout.Initspurestform,thisinvolvestheexecutiveteamwhoaremanagingaparticularbusinessactivitybuyingitoutfromtheparentcompany.ThiswasthebedrockofbuyoutactivityintheUK,forexample,intheearlytomid-1990s,withthemanagementteamtypicallyappointingoneoftheaccountancyﬁrmstoactforthem,drawingupabusinessplanandpitchingthedealtoselectedbuyoutﬁrms.Themanagementteamwouldberequiredtoputtheirownmoneyintothedeal,usuallyhavingtoborrowinordertodoso,buttheywererewardedwithsweetequityissuedatpreferentialratesandratchetedtopre-agreedperformancetargets.Whilestillcommon,thispureformofMBOhasbecomelesspreva-lent,sincetheincreaseinfundsizesandthustargettransactionssizes 46PrivateEquityasanAssetClasshasmadeitincreasinglydifﬁculttoﬁndbusinesseswhicharenoteither(1)toosmallor(2)havealreadybeenboughtout.Idonotwishtolabourthispoint,ortosuggestinanywaythatwehaveseenthelastoftheold-styleMBO(notleastbecausewhatisorisnotamid-marketfundisconstantlybeingredeﬁned),butinevitablywiththeriseofthemega-dealthenmanytransactionswhichwouldpreviouslyhavebeenclas-siﬁedasMBOwouldprobablynowmoreproperlybedescribedasLBOsortakeprivates(seebelow).MBITheManagementBuy-InevolvedfromtheMBO.Itissimilarinjustabouteverywayapartfromthenatureoftheteamor,viewedanotherway,apartfromthewayinwhichthedealinitiallycomestogether.Thekeydifferenceisthatinsteadofthemanagementteamofabusi-nessgettingtogethertobuyit,ateamisputtogethertobuyanothercompanyoperatinginthesamesector.Thismaybebecausetheyhavetriedtobuytheirownbusinessandbeenrebuffedbytheparentcompany,orbecausetheywantedtobuyitbutitwassoldtoatradebuyerinstead.PureMBIsarerare,andtherewasmuchhearsayevidencebackinthe1990sthattheytendedtoperformlesswellthanMBOs.Mostbuyoutﬁrmsmaintainasmallteamofindustry-speciﬁcexecutiveswhoworkwiththeminmuchthesamewayasanentrepreneurinresidenceoperatesinsideaventureﬁrm,helpingwithduediligenceanddealsourcingbutwiththeclearexpectationofleadingthemanagementteamifatransactioncomestofruitionintheirownsector.However,strictlyspeakingthesedealstendusuallytofallintotheBIMBOcategory.BIMBOAstheacronymsuggests,thesedealsareacombinationofanMBOandanMBI,whereoutsideexecutivesaregraftedontotheexistingexecutiveteaminordertofacilitateabuyout.Intruth,manybuyouttransactionsprobablyfallintothiscategoryifoneappliesthedeﬁnitionstrictly.Thiscouldrangefromtakingonaﬁnancedirectorforasmallbuyouttosupplementtheexistingﬁnancialcontroller,throughthereturnofarecentlydepartedCEOtoateamtowhomheiswellknown,totheeffectiveacquisitionbyaseniorindustryﬁgureofabusinessalongwithitsmanagementteam. Buyout47LBOThereisagreatdealofoverlapinthesebuyoutdeﬁnitionsandintruthmostpractitionersprobablyneverstoptothinkaboutwheretheircurrentdealfallsinthespectrum,andprobablywouldntcareanyway.Forthewriter,though,itisimportanttotrytoanalysethesectorasfullyaspossibleandifthisoccasionallycausesthereadersomeconfusionthenIcanonlyapologise.LBOstandsforLeveragedBuyoutandinasenseallbuyoutsareLBOssinceleverageissimplytheAmericanwordforgearing,andalltruebuyoutswillinvolvetheuseofsomeacquisitiondebt.Inthepast,thiswasmoreanissuethanitistoday,sincetherewereinmostjurisdictionsrestrictionsonthegivingofﬁnancialassistance,i.e.,theuseofthetargetcompanysownassetstosecureacquisitiondebt.However,legalreformandthegrowthofmoresophisticatedcashﬂowﬁnancinghavemadetheseissueslargelyredundant.TodayanLBOhastwomainconnotationswhichhelptodistinguishitfromotherbuyouttypes,butIstressthatthesearebothimpreciseandsubjective.Theﬁrstisthatitsuggestsabuyoutwhichhasnotbeeninitiatedbyamanagementteam,eitherexternalorinternal.Typicallytodaybuyoutdealswillbeinitiatedbythesellerappointinganinvest-mentbanktoprepareacompanyforsale,andbuyoutﬁrmsenteringthefrayalongsideindustrialpurchasers.Thesecondisthatitsuggestsatransactionwherethetargetcompanyislargeenough(ormaywellbeagroupofcompanies)thatnosinglebusinessactivityisinvolved,butratherarangeofthem.Inthesecircumstances,itmaybeconvenienttothinkofanLBOasbeingequivalenttoanindustrialacquisition,butwiththeacquirerjusthappeningtobeabuyoutﬁrm(or,morefrequentlythesedays,aconsortiumofbuyoutﬁrms).TakePrivateAgain,thereisobviouslypotentialforoverlaphere,butatakeprivateis,asthenamesuggests,abuyoutofapubliccompanyremovingitslistingintheprocess(orveryshortlyafterwardsoncevariousfor-malitieshavebeencompliedwith)inordertotransformitintoaprivatecompany.Aswewillexaminelater,thereisconsiderablescepticisminsomequartersastowhethersuchdealscanproducethesortofreturnstowhichinvestorshavebecomeaccustomedinthepast,butthisisadevelopmentwhichhasreallybeenforceduponthebuyout 48PrivateEquityasanAssetClasssectorbytheinexorableriseinfundsizes,andthusintargettransactionsize.Variousargumentsareadvancedinfavourofsuchtransactions.Theremaywellbesituations,forexample,whereveryaggressiverestructur-ingisrequiredanditisfeltthatthismightonlybeeffectivelyaccom-plishedoutoftheglareofpublicityandawayfromtherigidreportingregimetowhichpubliccompaniesaresubject.Roll-upThisusedtobemuchmorepopularthanitistoday,largelyIsuspectbecausemuchlargerfundsizesmakeitalessviableproposition.Basicallyonetargetsanindustrywhichishighlyfragmented,buyslotsofsmalloperatorsandputsthemtogether.Theattractionofsuchanapproachisthatnotonlyisitpossibletoincreaseproﬁtsexponentiallybybettermarketingandmanagementandeconomiesofscale,buttheresultinglargerentitywillmeritahigherearningsmultiple,thusresult-inginanupwardvaluationcurveratherthanastraightline.OTHER“BUYOUT”ACTIVITYIamplacingdevelopmentcapitaldealsinaseparatecategorybecauseifonestrictlyappliesthevariouscharacteristicstowhichwehavealreadyalludedinoutline,theyareclearlynotbuyouttransactionsatall.Thekeyfeatureofadevelopmentcapitaldealisthatvotingcontrolwillnotpasstothebuyoutﬁrm,althoughsomemeasureofnegativecontrolcanbegrantedbyreservingtherighttovetocertaindecisions,e.g.,relatingtocapitalexpenditure,dividendsandexecutiveremuneration.Thelackofamajorityshareholdingalsohasprofoundimplicationsfortheﬁnancialstructureofthedealsinceitwillusuallynotbepossibletouseanacquisitionvehicle/targetcompanymodelwheretheaccountscanbeconsolidatedandtheinterestonacquisitiondebtcanbesetoffattheholdingcompanylevel.Thusitisfrequentlynotpossibletouseanydebtﬁnanceatall.ThedevelopmentcapitaldealhaslargelyfallenfromfavourintheAnglo-Saxonenvironment(althoughtherearesomenotableexceptionsﬁrmssuchasSummitPartnershavesuccessfullypractiseddevelop-mentcapitaltransactionsintheUSAformanyyears).IronicallyitisincontinentalEuropeancountries,wheremoreprimitivecommercial Buyout49legalsystemshavetraditionallymadedifﬁcultthesortofdisguisedcontrolprovisionswhichdevelopmentcapitalrequires,thatthemodelhasprovedmostresilient.InFrance,forexample,itwasuntilquiterecentlynotpossibletoissuedifferentclassesofshares,ortoobtainspeciﬁcperformanceofashareoptionagreement,yetitisprobablystillthecasetodaythatmanymoredevelopmentcapitaltransactionstakeplaceinFranceeveryyearthantruebuyouts.Thetheoreticaldrawbacksofdevelopmentcapitalarefairlyobvious.Inpractice,themostserioushavebeenthediminutioninreturnscausedbythelackofthedebtlayer,andthedifﬁcultyinforcinganexitagainstthehistoricownerofthebusinesswhoismostreluctanttoputhisbabyupforadoption.Intruth,thecontinuedstrengthindevelopmentactivityincontinentalEuropeprobablyhasmoretodowithculturalthanpracticalconcerns.Inmostcontinentalcountries,particularlyFranceandGermany,controlinvestingisviewedwithgravesuspicion,asistheuseofacquisitiondebt.Sincethesearethetwomaincomponentsofbuyoutsitisperhapsunderstandablethathardlyamonthgoesbywithoutbuyoutﬁrms(par-ticularlythosewhichareviewedasBritishor,worsestill,American)beinglambastedbyleft-wingpoliticiansasvulturesorlocusts.Beforeleavingdevelopmentcapitalitisworthnotingafurtherbranchingofterminology.Thesedealsareusuallycategorisedbytheﬁrmswhichpursuethemaseithermoneyinonmoneyout,whichwillIthinkbefairlyself-explanatory.Amoneyindealiswheretheprivateequityﬁrmbuysnewsharestoinjectmoneyintothebusiness,thushelpingittogrow,usuallyincertainspeciﬁcandpre-agreedways.Forthisreasonsuchdealsaresometimesreferredtoasexpansioncapital.Amoneyoutdealiswheretheownersellssomeofhis(becauseitisalmostalwaysaman)existingsharestoraisemoneyforhimself.Intruth,mostdealshaveanelementofbothbecausefewﬁrmsarewillingtocountenanceadealwhichiswhollymoneyout.Thereisyetafurthertypeoftransactionwithwhichabuyoutﬁrmmightgetinvolved,andalthoughIhesitatetodiscussitheresinceithasfeaturedtodatemoreinlatestageventurefundsthaninbuyoutfunds,hereisprobablyasgoodaplaceasanysince,likedevelopmentcapital,ittoodeﬁespreciseclassiﬁcation.ItisacategoryofdealsthathavecometobeknownasPIPE(PrivateInvestmentinPublicEquity)andoccurswhenaparticularinvestmentinstrumentiscreatedwithinapubliccompanythatmayofferaprivateequity-typereturn.Typically,whilethecompanysequityisquotedtheinstrumentitselfisnot.In 50PrivateEquityasanAssetClasssomecircumstances(thoughtherearesigniﬁcantpotentialregulatoryproblemshere,particularlyinEurope)itmaybeapreludetoatakeprivate.Therehavebeenrelativelyfewsuchdealstodate,butwithmoreandmoremoneycomingintotheindustryitispossiblethattheremaybemoreinfuture.ESTABLISHEDBUSINESSESIncontrasttoventure,whichdealswithsmallcompaniesatanearlystageoftheirlifecycle,sometimeseventotalstart-ups,buyoutprac-titionersareconcernedwithestablishedcompanieswhichareusuallyineitherthelategrowthormaturestageoftheirrelevantproductlifecycle.Therearesoundbusinessreasonsforthis.Aswewillseeshortly,buyouttransactionsusuallyincorporateﬁnancialstructuringthatrequirescashﬂowtoservicedebt.Companieswhichareatanearlierstageofthelifecyclearetypicallycash-hungry,requiringtogrowquicklysoasnottolosegroundonthecompetition.Theymayalsoexhibitwhatwouldtoabuyoutﬁrmbeunacceptablelevelsofmarketrisk,orevenproductrisk,thusraisingthepossibilitythattheﬁrmmayactuallyfail.Growthcompaniesareattractivebecausetheyoffertheopportunityforincreasedearningswhichareoneofthethreemaindriversofbuyoutreturns.Howeverthechoiceoftherightplaceonthegrowthcurve,neithertoolatetoloseoutonthepotentialforincreasedearnings,nortooearlytogeneratesufﬁcientfreecashﬂow,isanextremelydelicateone,andanareawhereexperiencemayconferaconsiderablecompeti-tiveadvantage.Asfortheriskofoutrightfailure,thisisonewhichnobuyoutﬁrmcanaffordtocontemplate.Aswewillseewhenwecometoconsiderthebuyoutfundmodelandthenatureofbuyoutreturns,thereislittleroominabuyoutportfolioforcompanieswhichfailtoreturntheirinvestedcapital.Thusitislikely,indeedevendesirable,thattheyshoulderronthesideofcautionandthisisanareawherethenewentrantmaywellhitproblems,eitherthroughinexperience,orthroughpressuretoinvestatatimeofdealﬂowpaucity.Maturecompaniesareattractivebecausetheywillhavebecomecashcows,throwingoffcashfromwell-establishedbusinessactivitieswhichhavelostthecapacityforrapidgrowth.InastrategiccorporateportfolioasenvisagedbytheclassicBostonConsultingGroupmatrix,thesewillsupportthecashﬂowrequirementsofthestars,whichneedtogrowatleastasquicklyasthecompetitionjusttostandstillin Buyout51relativeterms.Inabuyoutportfolio,thesecompaniescashﬂowcanbechannelledintoservicingdebtandevenpayingoffloanprincipal.Thismeansboththatrelativelyhighlevelsofgearingcanbeusedinitially,andthatthecompanycanberecapitalisedperiodicallywhileitremainswithintheportfolio,usingnewdebttoreplaceequitybeingreturnedtothefund.Theserecapsareasigniﬁcantcontributortobuyoutreturns,buttheirprevalenceandimportancehasnotalwaysbeenproperlyrecog-nisedoutsidetheindustry.Forexample,theyhavebecomehugelycon-troversialintheworldofPFIandpublic/privatepartnershipﬁnancing,wheretheyhavebeenattackedbyleftwingpoliticians.Thispointstoafundamentaldifferenceofoutlookamongsttheparticipants.Thepoliticiansfocusonthepublicprojectbeingﬁnanced,whereastheprivatesectorﬁnanceprovidersarenaturallylookingforaprivateequitytypereturn,andrecapsoftenofferthequickestwayhometothisparticulargoal.Becauserecapsallowcapitaltobereturnedtoinvestorsearly,i.e.,beforeanyformalexithasbeenachievedinrespectoftheunderlyingcompanyitself,theycanhaveasubstantialimpactonthecompoundrateofreturnusedtomeasureprivateequityperformance,sincethisfocusesonthetimevalueofmoneyandherecashﬂowsarebeingdraggedtoanearlierpointonthetimeline.Therehasfromtimetotimebeentalkofbuyoutﬁrmsmovingtoanearlierstageofcompanydevelopmentfortheirinvestmentfocus.Suchtalkwasprevalentatthetimeofthetechnologybubble,withsomebuyoutﬁrmslookingatpre-IPOfundingroundsforventurecompanies,andsomeevenlookingatanumberofinternetstart-ups,frequentlyattheurgingoftheirLPs.Fortunately,however,thevastmajorityofthebuyoutsectorheldtheirdisciplineandtheamountofmoneyactuallyinvestedinsuchdealswassmall.Inretrospectitmayseemstrangethatsuchadiscussionshouldeverhavetakenplaceatall.Theskillsofbuyoutandventuremanagersaredemonstrablydifferent,andaimedefﬁcientlyatthetypesofcompaniesinwhichtheyrespectivelyinvest.Toattempttocrossbetweenthetwoseemstomakelittlesense,yetsostrongwasthepullofthenewandthefeedingfrenzywhichovertookinvestorseverywherethattherewasaseriousdangerthatmanybuyoutﬁrmscouldhavebeenpulledtotallyoffcourse,anditistothegreatcreditofthesectorthatthesesirencallswerelargelyresisted.Inthecontextoftheday-to-dayterminologicalconfusionbetweenventureandbuyoutitisthisconcentrationonestablishedbusinessesratherthanonnurturingnewandyoungonesthatisthemostcommonly 52PrivateEquityasanAssetClassmisunderstood.Ihopethatforanyonewhohasreadthischapter,thereferencetobuyoutﬁrmscomingtogethertomountamulti-billiondollarbidforaninternationalindustrialconglomerate,orpublicutilityasventurecapitalistswillinfuturebeseenasthebasicfactualerrorwhichitis.Incidentally,theinexorablegrowthinaveragesizeofbuyoutfundshasledtoquestionsofjusthowmanyestablishedbusinesseswillremainasfreshpickingsforbuyoutﬁrms.ThisisactuallyamorevalidconcernintheUSAthanitisinEurope.InEurope,industrialconsoli-dationandrationalisationisgenerallyatanearlier,oratleastless-developedstagethanitisacrosstheAtlantic.Almostwhateverbusinesssectoroneexamines(telecommunications,banking,etc.)willshowmanymoreindividualoperatorsinaneconomyofroughlyequalsize.Historicallythishasbeenpartlyduetopoliticalreasons,everycountry,orsometimesevenregion,wantingitsownairline,bank,brewery,etc.However,thebuyoutﬁrmswouldarguethatevenintheUSAtheproblemislesspronouncedthanmightbethought.Thegrowthinbuyoutfundsizeeffectivelydrivesaself-perpetuatingcycleinwhichmorecapitalbecomesavailableforinvestment,allowinglargerandlargerdealstobeattempted.Wehaveprobablynowreachedastagewherenocompanyintheworldistoolargetobesafefromtheatten-tionsofthebuyoutindustry,andthisobviouslyinturnraisesinterestingquestionsastotheinteractionofprivateequitywithquotedmarketsinyearstocome.DEBTItistheuseofdebtﬁnancethatmostobviouslydistinguishesbuyoutsfromotherprivateequitytransactionssuchasventureanddevelopmentcapital.However,forthesakeofcompleteness,Ishouldpointoutthat(1)venturecompaniescanbepartlyﬁnancedbytradecredit(e.g.,fromsuppliersofequipment)whichfromastrictlyaccountingpointofviewwouldbeclassiﬁedasdebt,andthattheverylatestagesofventureﬁnancingscanincludeconvertibleinstrumentsthatmaybestructuredasloannotesand(2)thatalthoughitisdifﬁculttoinjectacquisitiondebtintodevelopmentcapitaldealstructuresitisnotimpossible(thoughusuallyinefﬁcientfromataxpointofview).ForthepurposesofthisbookIamattemptingtoprovideasimplemodelforexplanatorypurposeswhereverpossiblebutletusbeclear Buyout53fromtheoutsetthatbuyouttransactionsarestructurallyverycomplexindeed,frequentlywithmanydifferentlayersofdebt,andthatnotwoarethesame.Indeed,itisinsuchstructuringthatalotofkeybuyoutskillslie,andintheabilitytoobtainadvantageoustermsfrombanksthroughacourseofdealingsovertheyearsthatweﬁndakeybarriertoentryfornewbuyoutﬁrms,oratleastasourceofcompetitiveadvan-tagetotheestablishedplayers.Wewillbeexamininginadifferentchapterexactlyhowbuyoutswork,andcanbemodelled,butletussimplynoteatthisstagethattherearethreemaintypesofdebtwithwhichweneedtobeconcerned.First,andthisisoftenoverlooked,thereistheexitingdebtthatwillalreadybepresentwithinabusinessforworkingcapitalpurposes.Becausethetargetcompanyisusuallygoingtobeviewedonaconsoli-datedbasiswiththeacquisitionvehicle(oftenreferredtoasNewco),bankswilltakeintoaccountthetotalityofalldebtthatistobepresentoncethedealiscompleted.Thusacompanywhichalreadyhashighlevelsofoperatingdebtwillbelessattractiveasabuyouttarget,whereasonewhichhaslowlevelsofdebt,andpossiblyevenacashpile,willbehighlyattractive.Buyoutﬁrmswillusuallyseektoreducethelevelofoperatingdebtwithinabusinessoncetheyhaveacquiredit.Sinceoperatingdebtﬁnancestheworkingcapitalcyclethenthismaylogicallybereducedinanyoneofthreeways:lowerstocklevels,fewerdebtordays(i.e.,thenumberofdaystakenonaveragefordebtorstopaytheirinvoices)ormorecreditordays(theopposite).Loweroperatingdebtrequirementwillmeanthatthebankmaybepersuadedtoissuemoreacquisitiondebtinitsplace,thusenablingsomeequitytobereleasedbacktothebuyoutfundaspartofarecapitalisation.Thesecondtypeofdebtisstraightacquisitiondebt,whichisoftenreferredtoasseniordebtbecauseitwilltakepriorityinrepaymentandonanyliquidationofthecompanytoothertypesofdebtinthebuyoutstructure.Thiswillusuallyhavesomemeasureofsecurity,thoughtypicallythesedaysthiswillnormallytaketheformofaﬂoat-ingchargeoverthecompanysassetsingeneralratherthanaﬁxedchargeoverspeciﬁcassets(sincethesewillfrequentlybesoldoffandleasedbackwherenecessarytofreeupcash).Therewillalsobecoven-antsintheloanagreementwhichwillstrictlycontrolwhatthecompanycandowithitscash,thoughsomeofthesecanbetothebeneﬁtofbothparties;acashsweepwouldbeagoodexample. 54PrivateEquityasanAssetClassThethirdtypeofdebtisvariouslyreferredtoasconvertibleormezzanine,thoughacaveatshouldbeenteredatthisstageinthatinAmericamezzaninecanalsorefertopre-IPOfundingofventurecompanies.Initsbuyoutsense,mezzaninesimplymeansthelayerofdebtwhichsitsbelowseniordebtand,incontrast,isusuallybothcon-vertibleandunsecured.Thederivationofthetermisclear:itisaﬁnan-cinglayerwhichsitsbetweenthetwoﬂoorsofthestructuringhousedebtandequity.Indeed,itsharesthecharacteristicsofboth.Mezzanineﬁnancinghasdevelopedintoaspecialistareaofitsown,withdedicatedfundsbeingraisedtooperateinthespace,andwithseniordebtprovidersbeingincreasinglyinterestedinprovidingthemezzanineelementofadealaswell.Sometimesonebankor,inthecaseofaverylargedeal,aconsortiumofbankswillcombinetounder-writethewholeﬁnancialrequirementandwillthenseektoselldownpartsofit,likeabookielayingoffhisbets,eitherhorizontally(i.e.,askingsomeoneelsetoprovidethewholeofaparticularlayerofmezza-nine)orverticallyinstrips.EARNINGSWewillbelookingatearningsindetailwhenwecometoseehowbuyouttransactionsareputtogether,andvaluationsarrivedat.Sufﬁceittosayatthisstagethatthepresenceofearningswithinacompanywillusuallypointtoanyprivateequitytransactioninrespectofthatcompanybeingabuyoutoradevelopmentcapitaldeal.However,assoofteninprivateequitythereareacoupleofexceptionswhichshouldbenoted.Somelatestageventurecompaniesmayhaveearnings.Thisisac-tuallynotarealexceptionatallbutrathertheresultofpeoplehavingtraditionallyspokenofearningswhenwhatisreallyimportantiscashﬂow.Venturecompaniesmayhaveearningsbutwillalmostcer-tainlystillhavenegativecashﬂowbecausetheyneedtoploughalltheirearningsandmorebackintothebusinessinordertofundrapidgrowth.Buyoutcompaniesrequirecashﬂowtoservicedebtandwhileitisoftenconvenientlyassumedthatforanestablishedbusinessearnings(atleastattheoperatinglevel)maybeagoodproxyforcashﬂow,thisisnotalwaysthecase.Itisalsonecessarytoconsiderthecaseofturnaroundsituations,whichIhesitatedtodescribeasadifferentcategoryoftransactionintheirownrightsincetheyarefrequentlyexecutedbybuyoutﬁrmsand Buyout551viewedinmuchthesamewayastheirothertransactions.However,aswewillseewhenwelookatvaluationandmodelling,theycanposesigniﬁcantproblemsandaregenerallyundertakenonlywithextremecaution,andeventhenonlywhensigniﬁcantsectorexpertiseisavailable.SIZEHerethereismuchthatiscontroversialandmuchthatisself-evident.Self-evidentisthattheaveragesizeofbuyoutfundshasrisensteadilyonbothsidesoftheAtlantic.Sincethereareonlytwowaysinwhichthisextracapitalcanbedeployed(eitherdoingmoredealswithinafundordoingbiggerdealswithinafund),andsincethetimeandresourcesrequiredtoexecutealargedealareinmanycasessimilartothoserequiredtoexecuteasmallone,thenunsurprisinglytheaveragesizeofbuyouttransactionshasalsorisenquiteexplosively.Weshallbelookingindetailatthewholeissueoffundsizewhenwediscusshowtoanalyseabuyoutﬁrmbutweshouldnoteherethattherapidandexplosiveriseinbuyoutfundsizehaschangeddramatic-allythesortsofdealswhichgetdone.WewillseeinalaterchapterhowEuropeanbuyoutreturnswereattheirbestintheearlytomid-1990s.Thiswasatimewhenfundsizeswerefairlysmallandﬁrmswereforthemostpartlookingtopickoffindividualsubsidiariesofpubliccompaniesor,betterstill,medium-sizedowner-managedcom-panies.Thismarketwascharacterisedbyvariousfactors.Firmswereabletoseekoutdealsproactively,andtoagreeexclusivitywithavendoroncethetargethadbeenidentiﬁed.Thiswasparticularly2prevalentatthetimeincountriessuchasGermanyandSweden,anditisnoaccidentthatitisinthesecountriesthatﬁrmssuchasDoughtyHanson,IndustriKapitalandNordicCapitalmadetheirearlystellarreturns.Todaythisisnolongerthecase,withanydealofanysizebeingputthroughacontrolledauctionprocess.Targetcompaniesfrequentlyhadlowlevelsofgearing,particularlyowner-managedcompanies,whichcouldbeverydebt-averse.This1Aswithjustabouteverythingonecansayaboutprivateequity,Idonotpretendthistobeuniversallytrue.Therearesomeﬁrmswhospecialiseinturnaroundsituationsanddonothingelse.However,theyaregenerallyfewinnumberandsmallinfundsize,andintheinterestsofspaceifnothingelse,Ihavedecidednottoconsiderthemseparately.2TherewasatthetimenophraseintheGermanlanguageforshareholdervalue. 56PrivateEquityasanAssetClassfacilitatedtheuseofquiteaggressiveacquisitiondebtprogrammes.Tobefair,thiswasalsoatimeofimaginationandinnovationwithinthebuyoutcommunity;itwasinthemid-1990s,forexample,thatwesawtheﬁrstEuropeanbuyoutevertobeﬁnancedbyaUSbondissue(DoughtyHansonwastheﬁrminquestion).Todaythisishardlyeverthecase;indeed,operationalgearingissometimeskeptatahighleveldeliberatelysimplytodeteranyacquisitivethoughtsbythirdparties.Thesecompaniesfrequentlyalsohadalayerofmanagementeffect-ivelymissingsinceinthecaseofanowner-managedcompanyhewasaccustomedtoperformingmostofthesefunctionshimselfand,inthecaseofasubsidiary,theywereusuallyperformedattheholdingcompanylevel.Thusonemightﬁndaﬁnancialcontrollerwhereaﬁnancedirectorwasrequired,andsoon.Byreplacingthismissinglayertheskill-baseofthebusinesscouldoftenbedramaticallyincreased,thusfacilitatingbothrevenueandearningsgrowth.Inaddition,workingcapitalprac-ticeshadnormallynotbeenthemoststringent,andextracashﬂowcouldbesqueezedouttoserviceandretiredebt.WhatIhavejustdescribedwasalegendarygoldenageofEuropeanbuyoutactivity,ahappyhuntingtimewhengreatreturnscouldbemade;fundsfrequentlyreturnedwelloverthreetimestheircapitaltoinvest-ors.Theseconditionsnolongerapply,andbuyoutﬁrmshavehadtohonetheirskillstosqueezeoutvalueinotherways.Therearethosewhoclaimthatinlargepartthistransitionhasbeenforcedupontheindustrybytheriseinfundsizes,whichinturnmakeitunrealistictopursuesmallercompanies(Bridgepoint,whoexecutealargenumberoftransactionswithinafund,areanotableexception,butmostbuyoutﬁrmshavebeendriventodoingroughlythesamenumberofdealsasbefore,butofacorrespondinglygreatersize).However,manyﬁrmshavebeenloathtoadmitthisopenlyandthuswehavetherathersillyspectacleofsomebilliondollarfundsclaimingthattheyaremid-market.Ofcourse,itisentirelypossiblethatthedeﬁnitionofwhatisorisnotmid-marketmayhavechangedsigniﬁcantly,butitisdifﬁculttobelievethatifthemid-marketcouldbeefﬁcientlyservedbyafundofnomorethanabout$250Mafewyearsagothenitcanequallywellbeservedbyafundatleastfourtimesthatsizetoday.Giventheeffectofgearing,onemightbetalkingaboutadifferenceinenterprisevalueofthetargetcompaniesbetweenabout$25Mandanythinguptoabout$200M.ItmaybeconvenienttoadopttheclassiﬁcationusedbyVenture-Xpert,sinceweshallbeusingtheirﬁgurestolookattheperformance Buyout57ofbuyoutfundslater.Theycurrentlyclassanythingover$500Maslargeandanythingover$1billionasmega.Withduerespect,Icannothelpfeelingthatthesedeﬁnitionshavebeenovertakenbyevents,butIwillhappilyadoptthemasamatterofconvenience.Theywouldclassify$250Mto$500Masmedium,andanythinglessthan$250Massmall.Myownviewofthemid-marketwould,asIpointoutabove,probablyonlyextendabouthalfwayintotheirmediumclassiﬁcation,butIdonotthinkthatwewilldoanyundueviolencetotheconceptbyacceptinga$500Mfundsizeasitsupperlimit.Thesearchforthemid-marketinprivateequitytoday,intheUSAaswellasinEurope,isbeginningtoresemblethequestfortheholygrail;everybodywantsit,butmanyarebeginningtowonderwhetheritactuallyexists.Acommonpatternistoseeaﬁrsttimefundraisearelativelymodestamountandthen,drivenbytheLPfeedingfrenzycreatedbymid-marketfever,raisesomemultipleofthat2or3yearslater.ThustheultimateironyisthatmanyLPswillnotinvest(becausemanyhaveblanketbansagainstﬁrsttimefunds)whentheﬁrmisgenu-inelyabletopursuemid-marketopportunities,butwillinvestwhenitisnolongerabletodoso(and,perversely,thatveryinabilityiscreatedbyLPbehaviour).Acynicmightsaythatthebuyoutindustrytodayislikeaclothesshopwhichonlystocksonesizelarge.However,buyoutsupporterswouldsaythattheabilityofbuyoutactivitytoincludeeventheworldslargestcompanieshasforcedthemtobecomemorecompetitiveandtogivemoreregardtoshareholdervalue.Thisisundoubtedlytrue,andthereisnowtalkofjug(juggernaut)fundsofperhaps$100billion,fromwhosereachnocompanyintheworldwouldbeimmune.Myownviewisthattheindustryhasbecomesomethingofavictimofitsownsuccess,thoughmostEuropeaninvestorshavebeenveryslowtorealisethis.In1998,forexample,over50%ofthemoneyraisedbyfundsmanagedintheUKwascontributedbyAmericaninvestors,andnearly375%byforeigninvestorsintotal.Bethatasitmay,weareclearlycaughtupinanupwardspiraloffundsizes.Forexample,letuslookattwotypicalbuyoutﬁrms,onefromeachsideoftheAtlantic:PermiraandBlackstone(seeTable3.1).Weseefromtheseﬁguresthatthefundsizeofeachﬁrmhasincreasedbyafactorofabout15intheperiodinquestion,butthatEuropeanfund3ReportonInvestmentActivity,BritishVentureCapitalAssociation,2000. 58PrivateEquityasanAssetClassTable3.1BuyoutfundsizeintheUSAandEuropeFundPermira($M)Blackstone($M)I1000(1997)810(1987)II3850(2000)1300(1993)III6400(2003)4000(1997)IV14000*(2006)6500(2002)V15000*(2006)*Target.Note:Calculatedat$1==0.78.sizehasgrownmuchmorequicklyasPermiraraisedtheirﬁrstfundonlyin1997(whentheyspunoutofSchroders)whileBlackstoneraisedtheirsaslongagoas1987.Consequently,Permirasfundsizehasgrown15timesinlessthan10yearsandoveronlyfourfundcycles.ThisisaparticularlygoodexampletotakesinceSchroders(astheythenwere)andApaxusedtobeseenasveryhighqualityplayersincertainspe-4cialistsectorswithinthemid-market,butbothnowhavebeendriventolargedealsbytheincreaseintheirfundsizes.5Arecentarticleconﬁrmedwhatonehadalreadysuspected:bymid-2006,privateequityﬁrmsaccountedformorethan15%ofM&Aactivityworldwide.Norwillthingsstopthere.Wehavealreadymen-tionedthepossibilityofjugfundswhichmaygrowasbigas$100billion,andthisraisesimportantissuesforinvestmentgenerallywhichliebeyondthescopeofthisbook.Whathappenswhenasigniﬁcantportionoftheworldsquotedequityhasbeentakenprivatebyprivateequityﬁrms?Justhowmuchmoneycanthebuyoutindustryabsorbbeforecost-adjustedreturnsregresstoocloselytoquotedindices?Whathappensifawholegenerationofseniorbuyoutmanagers,madewealthybylargemanagementfees,retiremoreorlesstogetherleavingalargeamountofcapitalinlessexperiencedhands?Yes,thesequestionsarealarmist,buttheyarecurrentlybeingaskedanditwouldbewrongofmenottorecordthefact.CONTROLAswehaveseenalready,controlistheoneelementwhichreallydoesdistinguishbuyoutsfromotherformsofprivateequityactivity.Indeed,4Apaxalsousedtodotrueventuredealswithinthesamefundasitsbuyouts.5TheTimes,4July2006. Buyout59incertainquartersthephrasecontrolinvestingisvirtuallysynony-mouswithbuyout.Controlwillalmostalwaystaketheformofhavingamajorityoftheissuedsharesinthecompany.However,itispossibletohaveaminorityholdingyethaveamajorityofthevotes,eitherbecausecertainshareshaveweightedvotingrightsorbecauseothershareholdersarecontractuallyboundtovotewiththebuyoutﬁrminrespectofatleastpartoftheirshares.Thisvariesfromcountrytocountry,though.Insomecountriestherecanbelegaldifﬁcultiesaboutenforcingthesesortsofagreementsandonecanalsoencounteranunwillingnessonthepartofthebuyoutﬁrmtobeseentobethrowingtheirweightaround.Wehavealsoreferredalreadytonegativecontrol.Thisiswherearightofvetoisreservedovercertaindecisions,typicallyexecutivesal-aries,sharedividends,capitalexpenditure,borrowing,andchangesinbusinessactivity.Atonetimethesetoocouldbedifﬁculttoenforcesinceinmanycasestheyrestonthelegaldeviceofadifferentclassofsharesandnotallcountriesallowedthecreationofthese.Now,though,theseproblemshavelargelydisappeared.InthedayswhentheclassicMBOwasthenorm,thequestionofnegativecontrolwaskey,andadelicatebalancehadtobestruckbetweenallowingthemanagementteamthefreedomtorunthebusinessandprotectingtheinterestsoftheequityinvestor(thebuyoutfund),particularlyifthingsdidnotruntoplan.Therighttodismisssomeoralloftheexecutiveswasobviouslytheclassicstickingpointinthesenegotiations,andwasfrequentlyresolvedbytheadoptionofpre-agreedperformancemilestones,usuallyintheformofmanagementbudgetsandearningsprojections.Whiletheadvantageofbeingabletocontroltheday-to-dayopera-tionsandkeystafﬁngofthetargetmayseemobvious,therealbeneﬁtofhavingcontrolistheabilitytoexittheinvestmentexactlywhen,andhow,onewishes.Sincethismaybelessobvious,itmayperhapsbehelpfultosetthehistoricalperspectivewhichoneusedtoﬁndparticu-larlyincontinentalEurope.Here,wherenon-controlinvestingusedtobemuchmoreprevalentthancontrolinvesting,theformerholdingcompanyorowner-manageroftheﬁrmwouldfrequentlyremainasasigniﬁcant,sometimesevenamajorityshareholder.Whileday-to-daydisagreementscouldhopefullyberesolvedunderthenegativecontrolprocedures,therealfunwouldbeginwhentheendoftheprivateequityinvestorstargetholdingperiod(usually3years)approached.Atthispoint,theowner-managerwouldbefacedwiththeprospectofhavingtosellhisremainingsharesandﬁnallyretire.Often,this 60PrivateEquityasanAssetClasswouldbesomethingwhichhehadbeenunwillinglydeferringforsometime,andperhapshewouldhavebeenpersuadedintotheprivateequitydealintheﬁrstplaceonlybythelureofgeneratingsomefreecapital.Foraholdingcompany,theymighthavebeenpreparedtobringajuniorpartnerintothebusiness,buttheprospectofthecompanynowbeingboughtbysomeonewhomightintroducerestructuringandredundan-ciesinatownwheretheystillsawthemselvesasthemoralguardiansoflocalinterestsmightlookaverydifferentkettleofﬁsh.Iftheprospectivepurchasewasforeignor,evenworse,American,thentheproblemwascompoundedmanytimesover.Whiletherewereexitprovisionsintheoriginalcontract,privateequityﬁrmswouldbeloathtoenforcetheseastheywantedtobeseenasafriendlypartnerwithwhomtodobusinessinthatcountrybyotherprospectivesellers,andinanyeventtherewereusuallynolegalprece-dentsavailabletogiveguidanceastoexactlytowhatextentalocalcourtmightbepreparedtograntenforcementofthesenovelprovisionsinfavourofaforeignvulturecapitalist.Onecouldthusbetreatedtothespectacleofprivateequityﬁrmandfellowshareholdersdancinganincreasinglydistractedminuetaroundeachothertotherivalthemesofexit,delayandpossiblecompromise.Itisdifﬁculttoover-emphasisehowimportantanissuethiswasfortheprivateequityindustry,atleastinEurope.Ionceheadedinateamwhichwasattemptingtocreateanoperationalriskmodelforassessingbuyoutanddevelopmentcapitaltransactionsandfactorssuchasthelackofcontrolwerekey.Atransactionwhichwas(1)aminoritydeal,(2)inacontinentalEuropeancountryand(3)purchasedfromanowner-managerwhoremainedinvolvedwiththebusinesscouldexpecttoscoreveryhighly(i.e.,badly)comparedwith,say,aclassicMBOintheUKwherethebuyoutﬁrmcontrolledover90%oftheshares.Otheraspectscouldbedifﬁcultwithoutoverallcontrol,too.Owner-managers,forexample,areusuallydebt-averseandsotheirbusinessesarefrequentlycashﬂow-inefﬁcientfromastrictﬁnancialtheoryview-point.Theywillalsooftenhaveirrationalattachmentstocertainbusi-nessactivitiesorproductlineswhichmaypreventthesefrombeingeliminatedorrationalisedwhenlogicwouldotherwisedemandthis.Aboveall,theywilloftenresisttheintroductionofhighqualityseniormanagement,especiallyaCEOtotakeovertheday-to-dayrunningofthebusiness.Happily,timehasmovedonandthereistodaygeneralrecognitionthattheinterestsofallpartiesmustbeadequatelyprotected,andthat Buyout61controlinvestingcanandshouldbethenorm.However,historyiscyclicalandInowseeexactlythesamesortsofissueswhichplaguedcontinentalEuropeinthepastrearingtheirheadsanewindevelopingprivateequityareassuchasAsiaandLatinAmerica.Forthoseinsuchplaceswhoarewillingtolisten,theEuropeanexperiencehassomevaluablelessons.BARRIERSTOENTRYAsthebuyoutmarkethasmaturedanddeveloped,thequestionofbar-rierstoentryhasbecomeafrequenttopicofdiscussion.Thereisgeneralacceptancethatasithasmatured,themarkethasbecomemoreperfectinﬁnancialtheoryterms.Thereismuchlessscopeforexclusive,proactivelysourceddeals(indeed,virtuallynoneatthetopendofthemarket).Pricingandvaluationdataismuchmorewidelyavailable.Mostvendorsarenowmuchmoresophisticatedwhenitcomestodealingwithprivateequitypurchasersthantheywere10or15yearsago.BothEuropeandNorthAmericaarenowcoveredandservedbyaverycompetitiveandefﬁcientinvestmentbankingsector.Thisisnotallbadnewsfortheprivateequityindustry.Theothersideofthecoinisthatprivateequitybuyersarenowwidelyacceptedasanestablishedpartofthelandscapeandindeedatleasttwoorthreeofthemareroutinelyincludedinthelistofpotentialpurchaserstowhomeverybookissent.Inmostcountries,anyperceivedstigmawhichmayoncehaveattachedtosellingabusinesstoaprivateequityﬁrmhasnowlargelydissipated.Indeed,somegovernmentshavewill-inglyembracedprivateequityconsortiaasameanstoprivatisecertainutilities(theItaliangovernmentbeingoneobviousexample).Sowhatdoesallthismeanfornewentrantstothemarket?For,defyingstrictbusinessschooltheoryabouttheundesirabilityofenter-ingamaturemarket,thatisexactlywhatteamsregularlyattempttodo.Inmanycases,ofcourse,thesewillnotbeﬁrsttimefundsstrictlyso-calledsincetheymayrepresentabreakawayfromoneormoreestablishedﬁrms.Ithinktheanswertothisquestiondependsuponexactlywhatthenewentrantisseekingtoachieveand,inparticular,onwhatpartofthemarkettheyareseekingtoaddress.Ihavealludedalreadytothevan-ishingmid-marketandIthinkthispointisparticularlyrelevanthere.Asthelargerﬁrmsgetevenlargerandmovetotargetbiggerandbiggerdeals,theyleavesomethingofavacuumbehindthem.The 62PrivateEquityasanAssetClassclassicprivateequityfundeconomicmodel(certainlythetheoreticalideal)isfortheGPstobemotivatedbycarry,withthemanagementfeesimplycoveringtheiroperatingoverheads.Inverysimpliﬁedterms,thisisanessentialelementofwhatyouwilloftenhearreferredtoasalignmentofinterestsintheGP/LPrelationship.However,itwouldbeidletosuggestthatthishasrepresentedevenanapproximationoftherealsituationinthebuyoutarena(ventureisadifferentmatter)forsomeyears.Inpractice,ﬁrmsaredrivenbythelureoflargerproratamanagementfeestoraiselargerandlargerfundsandthisinturnnecessitatesthemmovingtotargetlargerandlargerdealsinordertodeploytheextracapital.Yes,LPswilltosomeextentbeabletoreducethepercentagefeeratesonlargerfunds,butsuchisthebargainingpowerofthebestbuyoutﬁrms(becauseoftheweightofthecapitaltryingtocrowdintoeachnewfund)thatusuallyattheendofthedaytheymanagetoachieveasigniﬁcantfeeincreaseoverall.Therearesomehonourableexceptionshere.Someﬁrmsoffsetfeesandincidentalincomewhichtheymayreceivefromportfoliocom-panies,and/orbearthecostofabortedtransactionsinsuchawaythatthenetfeeimpactonLPscanbesigniﬁcantlyreduced.However,itisundeniablethattherearemanybuyoutprofessionalsonbothsidesoftheAtlanticwhohavebecomeverywealthyonmanagementfeeproﬁts,andwhiletheyaretobecongratulatedassuccessfulbusinessmen,thisisalongwayfromwhattheidealprivateequityfundmodelenvisages.Thisratherlengthydigressionhasbeenembarkeduponsimplytoexplainthedynamicwhichpullsbuyoutﬁrmsinexorablytowardslargerfundanddealsizes.IknowofoneEuropeanbuyoutfundwhosefundsizeincreasedbyafactorof25injusttwofundcycles.Thereforeifonewassittingdownasastrategyconsultantlogicallytoplanhowanewprivateequityﬁrmmightbestenterthemarket,amid-marketfocuswouldseemtopresentthemostattractiveoption.Thisdoesoccasionallyhappenanddespitethefactthatamid-marketfocusnormallyrequiresahighlylocalisedgeographicalapproach(usuallysinglecountrywithinEurope)theseofferingsarerightlyregardedashighlyattractiveinprinciple,thoughonealwayshastobalancetheﬁrsttimefundfactoragainsttheattractivenessofthemarketniche.Indeed,manyinvestorshaveablanketbanonﬁrsttimefundsandwhiletheywouldarguethatthisisasensibleprecautiontominimiserisk,mypersonalfeelingisthatablanketbangoestoofarandpreventsinvestorsfrombeingabletotakeadvantageoftheocca-sionalnuggetthatsurvivesrigorousduediligence. Buyout63Soforamid-marketﬁrmthemainbarriertoentryistheﬁrsttimefundfactor.Atthetimeofwriting(Summer2006)themid-marketisunderstandablyviewedasahotsector,theonlyargumentbeingoverexactlyhowtodeﬁneit.Ifateamcanovercometheﬁrsttimefundissuesthentheyhaveaverygoodchanceofattractingfunding.Oncehavingdoneso,theyarelikelytoﬁndrichpickings,sincethebulkofthebuyoutcapitalavailablewillbetargetedatmuchlargercompaniesthantheyareseeking.Thisisprobablyaclassicexampleofamoreextremeversionofthe80/20rule(wewillencountersomethingsimilarinventureinadifferentcontext):probablyabout95%ofavailablebuyoutcapitalinEuropeandNorthAmericacombinedistargetedatnomorethan5%oftotalcompaniesbynumber.Forateamattemptingtoenterthelargebuyoutsector(andattheriskofputtingmyheadonthechoppingblockIwouldcertainlycategoriseanyfundsizeofatleast$1billionaslarge,andpossiblylessdepend-6ingonthegeographicfocus),theissuesareverydifferent.Wehavealreadytouchedontheissueofdealﬂow.Thesedaysalmostalldealswillgothroughtheinvestmentbankingnetworkandthevendorwillnormallystipulatethatnomorethanthreeorfourpotentialpurchasersofeachtype,includingprivateequityhouses,shouldbeincluded.Thus,theabilitytofeatureontheinvestmentbankshitlistiskeyandwillbelargelydeterminedbyatrackrecordofpasttransac-tions.Anynewentrantisthuslikelytobeindangerofhangingaroundtheedgesofthefeedingtray,eithertryingtopersuadeanestablishedplayertoadoptthemasaconsortiumpartner,orbeingleftthecrumbswhicheveryoneelsehasrejected.Anelementoftheserelationshipswhichisoftenoverlookedisthatitisthesesameinvestmentbankswhowillbepitchingforthejobofarrangingexitsforthebuyoutﬁrmsfromtheircompanies,eitherbywayofsaleor(moreusually,sinceoftenthebuyoutﬁrmswillfre-quentlyhandletheirownsales)IPO(ﬂotation).Onewouldnotwishtosuggestthattherewouldeverbeanyovertconnectionbetweenthetwo,buthumannaturebeingwhatitisthenanexistingand/orpotentialrelationshipwithabuyoutﬁrmforIPOworkislikelytoweightheavilywithaninvestmentbankwhenselectingalistofaddresseesfortheirnextbook.6Asalwayswithprivateequitythereareexceptions.AﬁrmsuchasBridgepointraisesalargefundbutundertakesalargenumberoftransactions,andisthereforeprobablystillmid-marketdespiteitsfundsize,butthisisverymuchtheexceptionratherthantherule. 64PrivateEquityasanAssetClassSimilarissueswillapplytothequestionofdebt.Contrarytopopularopinion,thereisonlysomuchacquisitiondebtavailableinthebuyoutmarket,andbankswillbeconstantlyadjustingtheirpositionastheyearprogressesbysyndicatingwithotherbankstomakesuretheywillbeabletomeettheircommitmentsshouldmoredealsthananticipatedactuallycomplete.Thus,notonlyaretheyunlikelytobeeagertoﬁnanceanewbuyoutﬁrmwheretheymaybeincompetitionwithanestablishedone(sincetheywilljudgetheestablishedonetobethemorelikelytoemergeastheeventualwinner)butthismaywellbereﬂectedinthetermsandgearingoffered.Sincethesearekeyfactorsintherela-tiveperformanceofbuyouttransactionsthenbankingrelationshipsingeneralarelikelytoproveadifﬁcultobstacletoovercome.Thereistoothequestionofraisingcapitalintheﬁrstplace.Idonotwishtosuggestthatthisisaninsuperableobstacle,sincenewplayersdoinfactsuccessfullyenterthebuyoutarenaalmostyearly.However,itmustbethecasethatifaninvestorwhohasaﬁniteamountofmoneytocommitisconsideringtherivalattractionsofanestablishedplayerandanewentrantthentheyarelikelytofavourtheestablishedplayer,particularlyiftheyhaveanexistingarrangementwiththem.Infact,thesituationislikelytobeevenmoredepressingforthenewentrantsincetheinvestormayalreadybefacedwithadifﬁcultchoicebetweentwoﬁrms,bothofwhomtheylike,butbothofwhomtheycannotaccom-modatewithintheircashﬂowconstraints.SUMMARYItusedtobepossibletoclassifymostbuyoutsneatlyintocat-egoriessuchasMBO,MBI,etc.buttodaythesituationismorecomplex,perhapsbecausetheaveragebuyoutismuchlargerthanusedtobethecase.Abuyouttransactionwillalwaysinvolveanestablished,proﬁtablebusinessthoughthelatterconditionmayobviouslynotapplyinthecaseofaturnaroundtransactioninrespectofatroubledcompany.Abuyoutwillinvariablyinvolvetheuseofdebt.Indeed,todaysﬁnancialengineeringsolutionsforbuyoutswillofteninvolvevariousdifferentlayersofdebt,rangingfromstraightseniordebtsecuredonassetsofthecompanytopurecashﬂowlendingwithequitykickers(mezzanine). Buyout65Buyoutproperlyso-calledwillalwaysbecontrolinvesting.Devel-opmentcapitalmaybedistinguishedfrombuyoutonthisgroundandalsobecauseitmaybemuchmoredifﬁcult,forlegalandaccountingreasons,tointroducesigniﬁcantacquisitiondebt.Cashﬂowiskeytobuyouttransactions,sincesuccessdependsontheabilitytoservicedebt,andasmuchdebtaspossible.Recapitalisations(recaps)offeranalternativetoanexitwheretheexitwindowmaybetemporarilyclosedorwherecashﬂowlevelsmayhaveexceededexpectations.Recapscanhaveahugeeffectonbuyoutreturns,afactwhichisnotwidelyappreciated.TheVentureXpertdeﬁnitionofamid-marketfund($250Mto$500M)mayhappilybeadopted,sincethiswillmakeitmucheasiertoworkwiththeavailableﬁgures,thoughmyownestima-tionwouldbealittlelower.Evenadoptingthisdeﬁnition,genuinemid-marketfundsarebecomingrarecomparedwith10yearsago,particularlyinEurope.Themainsector-speciﬁcbarriertoentryforanewbuyoutﬁrmistobreakintothedealﬂowchannel,muchofwhichisnowlargelycontrolledbyarelativelysmallnumberofinvestmentbanks.Thisistrueevenmovingdownthesizescale,thoughitbecomesalessseriousproblemasthenumberofintermediarieshandlingsmallerdealsbecomeslarger. 4HowtoAnalyseBuyoutsMyaiminthischapteristoexplainhowbuyoutsactuallywork.NotsomuchhowtheyareputtogetherwehavealreadycoveredthatinChapter3butwhatdrivestheirreturnsandhowpeopleactuallymakemoneyoutofthem.Onceweunderstandthis,wewillbeinapositiontomoveontodiscussinghowtoanalyseabuyoutfund.Inthatlastsentenceyouwillalreadyhaveabsorbedonekeypoint,probablywithoutrealisingit.Allprivateequityfundanalysisshouldbebottomup;inotherwords,itisonlybyanalysingtheindividualtransactionswhichcompriseit(andknowinghowto)thatoneisabletoanalysethefunditself.Ofcourse,themanagerofthefundwillhavecarriedoutitsownﬁnancialanalysisofthedealbeforeenteringintoitanditcanbeveryinstructivetoasktoseethisifoneisintheprocessofactuallyperform-ingduediligenceontheprivateequityﬁrmconcerned.Theanalysiswillmodelthepricetobepaidforthecompany,takingintoaccounthowthisistobeﬁnanced,thelengthoftheperiodforwhichitwillbeheld,theexitpriceandtherepaymentofrestructuringofanyﬁnancingintheinterim.ThiswillproduceamodelledtransactionIRR.ThiscanbeinstructivebothintermsofwhattargetIRRtheﬁrmiswillingtoaccept(aretheyaimingtoolow?,aretheyjustdesperatetoputmoneytowork?,arenon-commercialconsiderationsatwork?,etc.)butalsointermsofhowrealisticyoufeeltheirvariousassumptionsare(aretheyassuminganincreaseinmultiple?,whatlevelofgearingaretheypre-paredtoaccept?,whatdebtﬁnancetermsaretheyexpecting?,etc.).Thesearejustafewofthemanysmallpiecesofthejigsawwhichbuilduptogiveyouapictureofabuyoutﬁrm.Bytheway,theparagraphaboveisdeliberatelyandnecessarilysim-plistic.Inpracticetherewillbemuchmoretothemodellingprocessthanthis.Awiderangeofpossiblescenarioswillbeconsideredandarangeofpossibleoutcomesproduced.Forexample,relativelysmallchangesintheﬁnancialengineeringofthedealcanhavealargeimpactontheﬁnalresult.However,adetailedstudyofthiswouldrequireabookalltoitself,andwouldgowellbeyondthescopeofthepresent 68PrivateEquityasanAssetClasspublication.Thepurposeofthisbookistoexplainthebasicprinciplesofbuyoutanalysis.Thegoodnewsisthatoncearmedwithathoroughunderstandingofthese,thereisnolimittothesophisticationofthemodelyouchoosetobuild.Itwillhopefullycomeassomethingofarelief,therefore,tohearthattherearereallyonlythreemaindriversofbuyoutreturns:earnings,multipleandleverage.Actuallythereisofcourseafourth(time)butaswewillbedealingincompoundreturnsthiswillautomaticallyformpartofourcalculations.Itneedstobebornestrictlyinmind,however.Thetimevalueofmoneyisanenemyaswellasafriend.Itisthemouseinthelarderofyourportfolio,nibblingawayatthecheeseofyourreturns.Thelongeryouareforcedtoholdacompanyforthesamemultiple,theloweryourIRRwillbe.Thesooneryoucanexitit,thehigheryourIRRwillbe.EARNINGSAgainImustbeginwithashortterminologicaldetour.Thewordearn-ingsisusedinmanysenses.Whileitisgenerallysynonymouswithproﬁts,Ihaveactuallyhearditappliedtoturnover(American:rev-enues),particularlywithregardtoventurecompanies.Soletusbeclearfromthestart;wearetalkingaboutearningsinthesenseofproﬁts:theturnoverofabusinesslessitscostsofdoingbusiness.Evenhere,however,thereisconsiderableconfusion,sincetherearevariousdiffer-enttypesofearnings.Thewayinwhichthewordearningsonitsownisusuallyusedinﬁnancialcirclesisinthesenseofthatproﬁtwhichisavailablefordis-tributiontoshareholders,i.e.,afterdeductionnotjustoftheoperatingcostsofthebusinessbutalsoaftertakingintoaccounttax,interestanddepreciation.Thisisoftenreferredtoasnetproﬁts,thebottomline,proﬁtsattributabletoshareholders(UK)orearningsavailabletocommonshareholders(USA).Notehoweverthateventhismeasurecanbemisleading,sinceitcanbeheavilyinﬂuencedbyone-offitemsthatarenothingtodowithproﬁtsgeneratedbythecompanysordinarycourseofbusiness,suchasanotionalgainonthesaleofanassetinexcessofitsartiﬁciallydepreciatedaccountingvalue.Notwithstanding,thisistheﬁgureusuallyusedtocalculateearningspershareandthusthePEratio(thepriceofashareoveritsearningspershare,orthevalueofacompanyoveritsearnings). HowtoAnalyseBuyouts69Thereareproblemsinanyeventwithusingthisnumberforbuyoutanalysispurposes.Theﬁnancialengineeringwhichgoesintoabuyoutwillalmostcertainlydramaticallyaltertheoveralldebtstructure,andthusthelevelofinterestpayments.Sofaraspossible,thebuyoutﬁrmwillwanttoensurethatallavailableearningsareusedtoserviceacqui-sitiondebt,soastokeeptheamountofequityﬁnancerequiredtoanabsoluteminimum.Thus,isitreallymeaningfultobelookingatearn-ingsafterinterest?Similarly,becauseloaninterestpaymentswillnormallybetaxdeductible,thebuyoutstructurewillnormallyalsodramaticallyreducetheamountoftaxpayable.Thus,isitmeaningfuleithertolookatearningsaftertax?Also,aswehaveseen,earningstakeintoaccountthingssuchasdepreciationandwillusuallynotthereforebethesameascashﬂow.Becauseoftheneedtoservicedebt,itisactuallythelevelofcashﬂowwithwhichabuyoutﬁrmwillbemostconcerned,andifearningsarenotagoodapproximation,thentheirvalueforanalysispurposesishighlyquestionable.Inthelightofallthesedrawbacksyoumaybewonderingwhyweareconcerningourselveswithearningsatall.Alas,privateequity,likepolitics,istheartofthepossibleandtherearefrequentlytrade-offstobemadebetweenwhatissub-optimalyetpossibleandwhatisoptimalbutnotpossible.Brieﬂy,therearegenerallyspeakingnopubliclyavail-ableanduniversallyconsistentorcomparablemeasuresofearningssavethosewhichwehavealreadydiscussed.ThusoneoftheveryfewwaysinwhichwecanlookatthepricepaidorrealisedforabuyoutcompanyasagainstthevaluationofacomparablequotedcompanyisbymeansofaPEratio.Asamatterofpractice,therefore,itisverydifﬁculttobuildanysuchfunctionalityintoabuyoutmodelunlesswehaveresorttoit.WhichPEratioshouldweapply?Ifthetransactionisatakeprivatethenofcoursewehaveanobviousanswer:thePEratioofthecompanyitselfintheperiodleadinguptothetransactiontakingplace.Yetevenheretherecanbeproblems,especiallyifthedealhaselementsofaturnaroundaboutit,inwhichcasethelastavailableproﬁtsmaybehistoricallylow.Similarly,aswehavealreadydiscussed,theﬁgurescouldbeinﬂuencedbynon-cashﬂowitems(suchasdepreciation)orevennon-businessearningsitems,suchasproﬁtsmadeonthesaleofassets,ortheproceedsofalawsuit.Wherenosuchcontinuitybetweenquotedandprivatecompanystatusispresent,weareforcedtotakeeitherthemultipleofacomparable 70PrivateEquityasanAssetClassquotedcompanyorthatofthesectorwithinwhichthebuyoutcompanywouldresidewereititselfquoted.Theformerisopentochargesofsubjectivityandinconsistency,whichcanbeparticularlygraveifthereisalargerangeofmultipleswithinthesector,orifthereisnodirectlycomparablequotedcompanyofasimilarsizeorscopeasthatofthebuyoutcompany.Bearinmind,too,thatPEratioscanbeinﬂuencedbythingsasdiverseastheperceivedqualityofthemanagementteam,itslevelofgearing,itsdegreeofexposuretooverseasearnings,oritsattractivenessasabidtarget.Sectormultiplesappeartomakemoresense.Atleastherethereistheadvantageofconsistency,andvariationwithinthesectorissmoothedouttoacertainextent.Herethetwomainpotentialdrawbacksareeitherwherethebuyoutcompanyisforsomereasonmuchmoreattractivethanthequotedsector(perhapsbecauseitisenjoyinghighergrowththanotherwisecomparablepubliccompanies),orwherethereisconfu-sionorambiguityaboutwhichsectoracompanymightﬁtinto.Forexample,supposeacompanyisusingproprietarycomputertechnologytomakeavailableﬁlmpreviewsviatheinternetandcable.Isitmedia,ITortelecoms?Inmanycasesthereisnoclearansweranditislefttotheindividualcompanyitselftosuggestitsownclassiﬁcation(inwhichcasetheywillobviouslychoosethatwiththehighestsectorPEratio!).So,aswithsomanyaspectsofprivateequity,byallmeanstakefulladvantageofalltheavailabledata,butbeawareofwhatliesbehinditandofwhatallowanceshavetobemadeforitbeingpossiblyunreliableorevenoccasionallymisleading.Ifitsanyconsolation,whenaPEratioworksforanalysispurposesthenitcanworkverywell.Ifabuyoutfundweretotakeprivateapubliccompanyata35%premiumtoitsPEratio,andtherewasnoobviousindicationthatthecompanywasartiﬁciallylowlyrated,thenthiswouldclearlyraisesomeveryobviousissuesastovaluation.EBITAnEBITratiowouldappeartobeabetterbet.EBITstandsforEarn-ingsBeforeInterestandTax,andthuswouldseemtoaddresssomeoftheaboveissues.CertainlybuyoutﬁrmsareunderstandablysuspiciousofPEratiosbeingusedforanalysispurposesbyinvestors,andhaveastatedpreferencefortheEBITratio.Thetwoproblemswiththishavealreadybeentouchedupon. HowtoAnalyseBuyouts71First,itstilldoesnottakeaccountofthingslikedepreciation,whichcanbesigniﬁcantifacompanyhasrecentlyspentheavilyonnewequip-ment.Second,theEBITﬁgureisnotusuallyreadilypubliclyavailable(thoughitcanbecalculatedfromacompanysaccounts)andisthusdifﬁcultfromthepointofviewofplugginganumberdirectlyintoacomputermodel.Inthepast,IhavesoughttoaddressthisissuebyassumingthatEBITwillbeapre-statedpercentageofearnings,andthusifonehasoneﬁgureonecancalculatetheother.Thisisfarfromideal,butisprobablyanacceptablecompromise.Atleastitdeliversconsistencyoftreatmentacrossthewholedatabasepopulation.Also,ifabuyoutﬁrmknowsthatyouaregoingtocalculateapossiblyerroneousEBITﬁgureanyway,thenitisremarkablehowkeentheycanbecomeactuallytoprovideyouwiththecorrectﬁgure!Awordofwarning,though,forthosewhochoosetotrythisapproach.Pleasebearinmindthatlevelsoftaxandinterestdifferwithlocationandcurrency,asdothoseofcapitalallowances,soyoucannotjusttakeaparticularﬁgureandapplyituniversally,evenwithinthesameregion.Theremay,forexample,beasigniﬁcantdifferencebetweenGermanyandtheUK.EBITDAEarningsBeforeInterest,Tax,DepreciationandAmortisationisclaimedtobeapurecashﬂowmeasuresinceitexcludesnon-cashﬂowitemssuchasdepreciation,etc.Inotherwords,iteliminatestheeffectofbothﬁnancialstructuringandaccountingpolicyanddecisions.However,thisisnotstrictlytrue.WhileEBITDAisabetterindicatoroflikelycashﬂowthananyoftheotherearningsmeasureswehavebeendis-cussing,itdoesnottakeintoaccountthingssuchasrequiredcapitalexpenditureorworkingcapital.Ofcourse,apuristwouldsaythatthispointiswellunderstoodandthatallEBITDAissupposedtobeisatoplineentryfromwhichtostartyourcashﬂowcalculations.EBITDAisanearningsmeasurethatwasmoreorlessinventedbythebuyoutindustryinthelate1980s,initiallyintheUSAandtheninEurope,astheywerelookingforameasurethatcouldspeciﬁcallyindicatetheabilityorotherwiseofacompanytoservicecertainlevelsofdebt.Suchwasitseffectivenessthatitbegantobeadoptedbyindustrialcompanies,especiallythosethatwereburdenedwithhighassetvaluesandconse-quentlyhighdepreciationnumbersstretchingoverlongperiods. 72PrivateEquityasanAssetClassWhilethisliesoutsidethescopeofthebook,youshouldbeawarethatdangersaboundintryingtouseEBITDAfornormalcompanyvaluationpurposes.Sinceitisanon-GAAPmeasureitisnotgovernedbyuniversalaccountingconventionsandcompaniesarethuslargelyfreetoincludeorexcludewhattheylike,evenchangingthewayinwhichtheycalculateitfromoneperiodtothenext.Forbuyoutpurposesitsobviousadvantageisthatitmirrorsexactlyhowabuyoutﬁrmwilllookatatargetcompany.Aswewillseelaterinthischapter,leverage,ordebt,makesahugedifferencetobuyoutreturnsandabuyoutprofessionalwillbeprimarilyconcernedintheiranalysiswithhowmuchacquisitiondebtacompanycansupport.ItsdisadvantageisthesameasforEBIT:onecannotjustpickuptheFTandﬁndacompanysEBITDAﬁgureorindeedmultiple.ThusoneisforcedbackontothePEratioformostbasicmodellingexercises,thoughthereisnothingtostopyouadoptingtheroughruleofthumbapproachwhichwecameacrosswhendiscussingEBIT.However,pleasebeawarethatthereisevenmoremarginforerrorhere,sinceEBITDAwillbeverysigniﬁcantlyaffectedbytheageandvalueofthecompanysassets.AbuyoutﬁrmwilltypicallybehappytorevealanEBITDAmultipletoitsLPs,andwhilethisisﬁneforanalysingthedealitself,itislargelyvaluelessunlessonehassomecomparableEBITDAﬁguresforsimilarcompanies.Itisherethatthemodellingprocessislikelytobreakdown(unlessyouareluckyenoughtohaveaccesstosomeanalystsresearchontherelevantsector)andyouwillﬁndyourselfbeingforcedbacktothesectorPEratioasadefaultvalue.EARNINGSGROWTHEarningsgrowthistheholygrailofbuyoutinvesting;theabilitytogrowtheproﬁtabilityofaninvesteecompanyistheonethingthateveryLPlooksforwhenselectingabuyoutfund,anditisaccordinglysome-thingatwhichyouranalysisshouldlookverycarefullyindeed.Ithinktheimportanceofthisspeaksforitself.Ifabuyoutﬁrmcangrowtheearningsofabusiness,thentheyhaveagoodchanceofbeingabletomakemoneyonthesaleofthatbusinessinanymarketconditions.Consequently,manybuyoutﬁrmswillclaimtohavesectorexpertise,andhaveexperiencedseniorindustrialexecutivesavailableasadvisers,oreventogointocompaniesandrunthem.Some,suchasApaxand HowtoAnalyseBuyouts73Permira,gofurtherandsubdividetheirﬁrmintoanumber(usuallyaboutﬁve)ofsector-speciﬁcteams.Thebestbuyoutreturnsaremadewhenallfourofthebuyoutfactors:earnings,multiple,leverageandtiming,allworktogether,butifonewasforcedtochoosejustoneofthesethenearningswouldbetheonetoachieve.Apartfromanythingelse,increasedearningswilloftenpresentanopportunitytorecapitaliseacompany,astowhichseebelow.However,thereisoftenatrade-offherewhichisnotfullyappreciated.Abuyoutﬁrmwilloftenbeatleastasfocusedongrowingthecashﬂowofabusiness(freeingupworkingcapital)asonearnings,andoftenearningsgrowthwillcomeataprice;itmaybenecessarytobuynewequipment,forexample,ortogrowtheworkforcetoexpandintoanewarea.Thisrequiresmoney.Speciﬁcallyitrequiresworkingcapital,andportfoliodecisionswithinabuyoutﬁrmarethereforecomplexones,especiallyastimeswingèdchariotwillalwaysbehoveringoverhead.Shouldweviewthisasaninvestmenttoturnquickly,inwhichcaseweforgetexpensiveexpansionwhichwillhavenoeffectonshort-termearnings,orshouldweinvestjudiciouslybecausewebelievethatwecangrowtheearningssigniﬁcantlyovera3-to4-yearperiod?Infact,thedecisionwilloftenbeevenmorecomplexthanthis,sincetheﬁrmwillalsohavetoconsidertheshapeandtimingoftheirport-folioasawhole,theremainingcapitalandlikelycashﬂowsofthefundwithinwhichthecompanysits,andmarketconditions.Thereis,forexample,littlepointindecidingtoturnacompanyquicklyifexitconditionsarecurrentlyunfavourable.Theremaybethepossibilityofmergingthecompanywithanother,orsellingoffindividualbusinessunits.Theremaybemonopoly(US:anti-trust)considerationstoworryabout.Thereisthesituationof,andrelationshipwith,theprovidersofmezzanineandseniordebt,etc.Itrustthateventhisbriefsurveywillbeenoughtoconvinceyouthatthereismuch,muchmoretotheskillsetofabuyoutﬁrmthanjustbuyingacompany,loadingitupwithdebt,andsittingbackfor3yearstoseewhathappens.Anobviousquestionhereishowshouldwetreatinﬂation?.Theansweristhatitprobablydoesntmattersolongasyoudoitconsistentlyacrossyourmodeltoallbuyoutfunds.Youcaneitherignoreitcom-pletelyorapplyittoearningsbyindexlinkingthemtosomethingsuchastheRPIofthecountryconcerned.Thisisofmoreimportancewhenanalysinghistoricreturns,someofwhichweremadeintimesofveryhighinﬂation. 74PrivateEquityasanAssetClassMULTIPLEWehavementionedvarioustypesofmultiplesalready,soletusbeclearwhatwearetalkingabouthere.Weareconsideringearningsmultiples,inotherwordsthatmultiplewhichisappliedtowhatevermeasureofearningswecaretoadoptinordertoreachthepriceagreedtobepaidforthecompany.Attheriskofstatingtheobvious,theresultingvalua-tionwillalwaysbethesame.Whatwillbedifferentineachcasewillbethemultiplierandthemultiplicand:Earnings×Earningsmultiple=EBIT×EBITmultiple=EBITDA×EBITDAmultipleForexample,ifacompanyhasbeenboughtfor$200M,andweknowthatitsearningswere$15ManditsEBITwas$25M,thentheearningsmultiplewillbe13.3andtheEBITmultiplewillbe8.Thevaluationnumberisﬁxed,thevariousearningsmeasuresaregiven,whiletheothernumbers(themultiples)arevariable.Anobviouswayinwhichbuyoutﬁrmscanmakemoneyistosellacompanyatahighermultiplethanthatatwhichtheyboughtit.Thisistheprivateequityequivalentofafreelunch.Evenifyoudonotmanagetoincreasetheearningsofacompanyatall,youwillstillmakemoney.Therearetwopossiblereasonsforthis,largelydependingonwhetherthecompanywasboughtinanimperfectoraperfectmarket.MultipleIncreaseinanImperfectMarketInﬁnancialtheory,aperfectmarketisonewhereallinvestmentsareequallyaccessibletoallinvestors,andallinvestorshavefullandequalknowledgeofallrelevantinformation.Arguably,thereisnosuchthingasatrulyperfectmarket,butitiscertainlythecasethatsomemarketsarelessperfectthanothers.Ifacompanyisboughtprivately,i.e.,otherwisethanthroughamarketonwhichitssharesarepubliclyquoted,inprinciplethiswillalwaysbeatransactiononanimperfectmarket.Itistruethatthisdis-tinctionisblurring,chieﬂybecauseanyprivatetransactionofanyappreciablesizewillnowbesubjecttosomeformofauctionprocess.However,therearelimitstosuchopenness.Onlyacertainnumberofpotentialpurchaserswillbeadmittedintotheprocess,whichusuallymeansthatonlytwoorthreebuyoutﬁrmswillbeincludedinthelistofpossiblebuyerstowhomthebookissent.Anotherissue,less HowtoAnalyseBuyouts75prevalentthanbeforebutstilldiscernible,iswhereapotentialbuyerwillbepreferredbecauseofnationality,orsomeothersuchquality(forexample,abankmaynotwishtosellasubsidiarytoanotherbank).ThisusedtobeaparticularprobleminFrance,wheremostlargecom-panieswereatonetimepara-statalandwhenoccasionallyonehadtobedisposedofbecauseitcouldnotbeproppedupforanylongerthereusedtobeearnesttalkaboutﬁndingaFrenchsolution.ThisgaverisetothetermFrenchauction,whichmeantanauctioninwhichthehighestbidderisnotguaranteedtowinandwheretheauctionmaybereopenedsothatthepreferredbiddercanbegivenanopportunitytomatchtheotherbidder.Therewerealsoinstanceswheretriﬂingtech-nicalirregularitiesinthebiddocument,orissueswhichhadnotevenbeenraisedduringtheofferingstage,wereusedtodisqualifyparticularcandidates.Therearesomeinstanceswherethetransactionhasclearlybeenboughtinimperfectmarketconditions,andwewillseeinalaterchapterhowsuchconditionsdominatedbuyoutreturnsinEuropeinthelate1980sandearly1990s,forexample.Letussimplynoteforthepresentthatanycompanywhichisboughtonanexclusivebasis(i.e.,wherethevendoragreestodealonlywithoneparticularpurchaser)willbydeﬁn-itionbeimperfect.Insuchcircumstancesanincreaseinmultiplemayoccursimplybecausethecompanyinquestionhasbeenboughtonalowermultiplethanitshouldactuallyenjoy.Thismayseemunlikelytoacontemporaryreader,butitmustberememberedthatthebuyoutenvironmenthaschangeddramaticallyinrecentyears,notleastbecauseofmuchhigheraveragefundsizes.Sohasthedealenvironmentinmanycountries.InGermanyandItaly,forexample,onlyasmallnumberofcompanieswereactuallyquotedcomparedwiththeUK,andeventhenthesewouldusuallycontainablockingfamilyinterest(suchasstillexistswithinBMW,forexample)makingthecompanyimmunetotakeover,andthusmeaningthatitwouldbequotedonalowermultiplethanshouldbethecaseanywaybecauseoftheabsenceofabidpremium.GiventhattheaverageGermanvendor15yearsagowasalsoobsessedwithsecrecy,andadesirenottobeseentobemakingalargeproﬁton1aﬁnancialtransaction,thenitwillbecomemorecredible,Itrust,that1TheGermanlanguageatthistimecontainednowordorphrasemeaningshareholdervalue.ThisabsencemaybeinstructiveinunderstandingtheattitudeadoptedbymanyGermancorporategroupsatthetime. 76PrivateEquityasanAssetClassbuyoutﬁrmscouldanddidregularlybuycompanieseffectivelyatanundervalue.Intheseimperfectmarketconditions,anincreaseinmul-tiplecouldbeachievedsimplythroughlistingthecompanyinduecourse,atwhichtimeitwouldsimplybeacquiringthemultiplethatshouldprobablyalwayshavebeenappliedtoitintheﬁrstplace.Marketconditionswerereﬂectedintheanalysisproceduresofbuyoutﬁrmsatthetime,whichwouldalwaysincludeatleastonescenarioinwhichtheexitmultiplewouldexceedtheentrymultiple.Signiﬁcantly,multipleincreaseisnolongerroutinelyassumedinbuyoutanalysis.Theotherwayinwhichmultipleincreasecanoccurisbythebusi-nessbeingmademoreattractiveinsomeway(perhapsbysellingoffamaturebusinessunitandretaininganexciting,high-growthone)orevenjustbigger.Largecompaniesgenerallycommandhighermultiplesthansmallerones,whichopensuptheinterestingprospectofcompanyvaluebeinganupwardcurveratherthanastraightline.Roll-upsareaverygoodexampleofhowthismaybeexploited.IrememberoneinstanceinItalyduringtheearly1990swhenasmallroadhaulagecompanywasboughtandnolessthanabout18subsequentacquisitionswereboltedontoit.Ofcoursetherecomesasizebeyondwhichmultipleincreaseisunlikelytooccur,anditisalmostcertainlythecasethatthemega(>$1billion)fundshavereachedthispointwithregardtothesizeofcompanywhichtheyneedtotarget.So,apartfromrareinstanceswhereitmaybepossibletorepositionacompanyintoadifferentsectorwhichcommandsahighermultiple,thenthissortofincreaseisinfuturelikelytobeofbeneﬁtonlytothemid-market.Withoutwishingtomuddythewaters,itmaybebothconvenientandappositetothinkofthesetwotypesofmultipleincreaseasbetaand2alphainquotedmarketterms.Thewayinwhichamultiplegoesupanddownwiththemarketissystemic,justlikethesortofbetareturnwhichwillbeearnedbybuyingthemarketindex.Theotherwayissomethingwhichitisopentothemanager(buyoutﬁrm)tocontrol,inﬂuenceorcreateandthusrepresentsanadditional,non-systemicsourceofreturn.Aswithallinvestmentmanagerselection,itisthissortofalphareturninwhichoneisparticularlyinterested.2Iamofcourseawarethatthesetermscanunfortunatelybeusedinanumberofdifferentways.Forexample,Betacanbeusedasameasureofthevolatilityofanyonestockagainstamarketportfolio,andtherearedifferentconnotationsagainwhenconsideringtheanalysisofinvestmentmanagers.ThatiswhyImakethepointaslightlyaspossible,butIdothinkitisaninterestinganalogy. HowtoAnalyseBuyouts77MultipleIncreaseinaPerfectMarketForourpresentpurposes,itisgenerallysafetoassumethatanycompanywhichhasbeentakenprivatehasprobablybeenboughtinperfectmarketconditions.Thesamecanprobablybeassumedforthesakeofargumentwherealargecompanyhasbeentakenthroughanauctionprocess.However,thepossiblereservationssetoutabovemustalwaysbeborneinmind.Insuchconditions,thereareonlytwowaysinwhichamultipleincreasecanbeachieved.Beforeweexaminethese,though,pleasebearinmindthatanyincreaseatallwillbemuchlesslikelyifacompanyhasbeentakenprivate,sinceinordertobuyitintheﬁrstplacethebuyoutﬁrmwillhavehadtopayapremiumtothequotedmultiple(varyingwithtimeandmarketconditions,buttypicallyanywherebetweenabout15%and30%).Theﬁrstandmostobviousiswherethereisageneralincreaseincompanyvaluationsresultinginhigherearningsmultiples.Instricttheorythisshouldonlyhappeninperiodsoffallinginterestrates(ifyoulookatearningsmultiplestheotherwayroundyoucanviewthemasameansofimplicitlydiscountingthefuturevalueofacompany;iftherisk-freeratefallsthensodoestheratebywhichyoushoulddis-countthecompanysfuturevalue,resultinginahigherpresentvalueandahigherearningsmultiple),butunfortunatelyforﬁnancialtheoristsmarketsdonotalwaysbehavesorationally.Ageneralincreaseinmul-tiplescanbeindicativeofnothingmorethananeedtojustifyhighervaluationsbroughtaboutbyaperiodofirrationalexuberance(inwhichcaseitisprobablyagoodtimetobesellingratherthanbuying).Generalmarketchangecanbequitedramaticwhenithappens.Forexample,ifonelooksattheS&P500,itsoverallPEratiowasabout17in1968,hadfallentoabout7by1975,andthenremainedfairlylowbeforeacceleratingsteadilythroughoutthe1990stohitapeakofover40in2003,buthassincefallenbacktolessthan20again.Thussome-thinglikea1998vintageyearbuyoutfund,whichwouldhopefullybesellinghigharoundthe2003peak,willprobablyturnouttobeagoodperformer.Whilea2002vintageyearbuyoutfund,whichwouldhavebeenbuyinghighforitsﬁrstcoupleofyears,maywellturnouttobetheopposite.Inpassing,Ishouldwarnagainstreadingtoomuchintoquotedmul-tipleswhenitcomestotheanalysisofprivateequityreturnsingeneral.Manyverycleverpeoplehavetriedtoﬁndtrendsandcorrelations 78PrivateEquityasanAssetClassbetweenpatternsofquotedandprivateequityreturnsandhavelargelyfailed.Thereasonsarepartlythatprivateequityfundsinvestacrosslongperiods,andthereforetendtobelargelyunaffectedbyshort-termpublicmarketmovements(unlesstheyareextremeandpartofalargerphenomenon,suchasthecollapseofthetechnologybubble)andpartlythatpeoplespricingexpectationsdonotmovestrictlyinlinewithcurrentmultiples,butlagthembyasmuchasayearortwo.IfavendoristoldinacertainyearthathecansellhisbusinessonanEBITmultipleof12,thenheisgoingtoholdontothisexpectationevenifinthefollowingyeartheappropriatesectorEBITmultiplemayhavedeclinedto10.Thus,buyoutﬁrmsareoftenunabletotakefulladvan-tageofperiodsoflowmultiplesbecausebythetimevendorsvaluationexpectationshavestartedtoadjust,multiplesareusuallyontheriseonceagain.LEVERAGELeverage,ortheuseofdebttohelpﬁnanceanacquisition,issometimesalsocalledgearingandthisisaverygoodwayinwhichtothinkaboutit.Ifanengineeraddsanadditional(smaller)gearwheeltoanexistingone,thenheknowsthatbysodoingheisincreasingthenumberoftimesthespindleattachedtothesmallerwheelwillrotaterelativetotherotationsofthelargerone,thusincreasingthespeedofthewholemechanicalprocessinvolved.Ifabuyoutprofessionalgoesinforﬁnan-cialengineering,thisinvolves,initssimplestform,addingdebtintotheﬁnancingmixtoincreasetheimpactoftheunderlyingequity.Soitisquiteapttothinkofdebtasanextragearwheel,whichdoesnotaffecttheperformanceoftheequity(justasthesmallergearwheeldoesnotaffectthespeedofthelarger,originalgearwheel),butdoesgreatlyincreasetheimpactwhichitisabletohaveontheoverallreturnofthetransaction,justasthesmallergearwheelenablesthelargeonetohaveamuchgreaterimpactonthespeedoftheprocess.Theprincipleissimpleandwellknown.Ifabusinessisboughtfor$100Mandsoldfor$150M3yearslater,andisﬁnancedentirelywithequity,thentheequityreturnwillbeamoneymultipleof1.5×(150M/100M)andtheequityIRRwillbejustunder15%.Replacehalfoftheequitywithdebt,however,andtheequitymultiplebecomes3×(150M/50M)whiletheequityIRRincreasestoabout44%.Seehowdramaticistheeffectthatleveragemayhave,andnowimaginewhatmighthappenifyoucouldreplacenotjusthalftheequitywithdebt, HowtoAnalyseBuyouts79but90%ofit.(Justtosatisfyyourcuriosity,themultiplewouldnowbe15×andtheIRRwouldbeover145%.)Suchthinﬁnancingstructures(i.e.,havingverylittleequitycom-paredwiththeamountofdebtinvolved)arethedreamofbuyoutﬁrmsandIhaveseenmanyovertheyears,buttheopportunitiestoemploythemarebecomingless,partlybecausemostbusinessestodaywillalreadyhavequitehighlevelsofoperatingdebt(ifonlytomakeatakeoverorbuyoutalessattractiveprospect!)andpartlybecausesomecountriesarepursuingtougherandtougherthinequitytaxrulesunderwhichitcanbedifﬁculttomakeloaninterestfullydeductible.Wehavediscussedseniordebtandmezzanineinoutlinealready,andIdonotproposetogointothisanyfurther,sincethisisabookaboutprivateequity,notﬁnancialengineering.Sufﬁceittosaythatthisisaverycomplexarea,andthattheﬁnancialstructureofabuyoutwillalmostalwaysbefarmorecomplicatedthanthesimplisticdebt/equity/mezzaninebreakdownthatIhaveusedforillustrativepurposes.Theremaywellbedifferentlevelsofseniordebtandmezzanine.Therewillalmostalwaysbeaseparateworkingcapitalfacility.Theremaybefactoringofinvoices,orothertradeﬁnancesuchasoperatingleases.Theremaybesaleandleasebackofcertainassets.Certainlytherewillalwaysbeaseparatestripofsweetequityforthemanagementteam.However,incomplexityliesopportunity,andinﬁnancialengineeringweﬁndawayinwhichanexperiencedandskilfulbuyoutteamcanexploitboththeirﬁnancialexpertiseandtheirstandingwithﬁnancialinstitutionstoaddsigniﬁcantvaluetoadeal.RECAPITALISATIONRecapitalisationsorrecapsareaverysigniﬁcantbutlittleappreciatedcontributortobuyoutreturns.Essentially,allthathappensisthatwheretheﬁnancesofthecompanyhaveimprovedtotheextentthattheyhavebeenabletopaydownpartofthedebt,and/orwillbeableinthefuturetosupportalargerburdenofdebt,thenthecompanyisrecapitalised.Someoralloftheequityisreleasedbacktothebuyoutfundandreplacedwithdebt.Again,theprocesscanbemuchmorecomplexthanIamheredescribing,butwhatisimportantforthepurposesofthisbookisthatyoushouldunderstandtheeffectwhicharecaphasratherthanexactlyhowonemightgoaboutit.Byreleasingsomeoralloftheequitybacktoinvestorsthefundisnowessentiallytherefornothing.Theeffectistwofold.First,a 80PrivateEquityasanAssetClasspositivecashﬂowispulledintothereckoningearly(i.e.,wellaheadoftheexiteventwhichwouldotherwisehavetriggeredit),thusboostingtheIRR.Second,themultiplewhichwillbemadeoneventualexitisenhanced.Inthepast,recapswereusuallyresortedtowhentheexitroutewasblocked,ascanhappen,forexample,whentheIPOwindowisclosed,and/orattimesofdepressedpublicmarketvaluations.Forthisreason,littleunderstoodbythoseoutsidetheindustry,thereturnsof1997and1998vintageyearbuyoutfundswillnotactuallybeasbadashadoriginallybeenfeared.Findingthemselvesindangerofbeingstuckwithinvestmentsfor5yearsormore,mostbuyouthouseswentinforrecapsfairlyheavilybetweenabout2000and2003.However,sosuccessfulhasthetechniqueprovedthatmanybuyouthousesnowlookforrecapopportunitieswithintheirportfoliosasamatterofcourse(inLondon,CVCwereoneofthepioneersofthisapproach).Itisworthnotinginpassingthatthetechniquehasnotbeenwellreceivedwhenusedinpublic/privatepartnershipprojectssuchasPFIintheUK.Manyleftwingpoliticianshavenotyetfullyacceptedtheideaofprivateﬁnancingbeingusedinpublicsectorsituations,andtherehavebeenvocalprotestsattheuseofwhatisafterallastandardprivateequitytechniquewhenappliedtothingslikehospitals.FulldiscussionofPFI-typeﬁnancingliesbeyondthescopeofthisbook(althoughitisarguablyaformofprivateequity),butIbelievetheparadoxofpoliticianswantingtoattractprivateequityintopublicprojectsbutbeingunwillingtoacceptthesortofreturnswhichareexpected,andthetechniquesrequiredtoachievethem,throwsintoquestionthewholefutureofsuchfunding.IntheUKwehavealreadyseenthegovern-mentrepeatedlydelayadecisionontheSaintBartholomewsHospital(Barts)projectfornoapparentreasonotherthanbackbenchunrest.Itfollowsfromallthisthatwhateverbuyoutmodelyoucreatemustbecapableofhandlingrecaps.Inotherwords,youcannotjustassumethatabuyoutwillbeanentrytransactionandthenanexittransaction3yearslater.Youmustbeabletoaccommodatechangesindebtandequitylevels,andmapallcashﬂowsinvolved.TIMINGWenotedatthebeginningofthischapterthattimewasthefourthbuyoutdriver,butonethatrarelyneedstobeconsideredexplicitlysince HowtoAnalyseBuyouts81itwillbeanautomaticoperatorincalculatingtheIRRswithwhichwemeasureprivateequityperformance.However,itisworthjustrunningthroughthisveryquicklytobesurethatthedifferentimplicationsoftimingareproperlyunderstood.Firstofcoursethereistimeinthesenseofabsolutetimetheday,themonth,theyear,etc.Marketconditionswillvaryfromoneyeartoanother,bothinthepublicmarketsandwithrespectspeciﬁcallytoprivateequity,evenatthefundraisinglevel.Forexample,healthcaremightbepopularoneyearandtheGermanmid-marketthenext.Howshouldonechangeonesbehaviourtoadapttothesechangingconditions?Theshortansweristhatyoushouldnt.Markettimingisonetech-niquewhichcanbealmostguaranteednottoworkinprivateequity,anditisnotdifﬁculttounderstandwhy.IfIraiseahealthcarefundtodayIamgoingtobemakinginvestmentsforatleastthenext3years,andamlikelytobesellinganycompaniesoveraperiodstartinginabout4yearstimeandgoingoutperhapsasfaras12yearsintothefuture.HowcanIoranyoneelsepossiblyknowwhatconditionsaregoingtobelikein3yearstime,letalone10or12?Markettimingsimplyisnotpossible,andifyoueverhearanyoneataconferencesayinganythingsuchasnowisabadtimetobeinvestinginbuyoutorwehavegoneoverweightintelecomsbecausewereallylikethesectorthenyouwillknowthatyouhavestumbledacrosssomeonewhounderstandsnothingaboutprivateequity.Atwhateverlevelyouareinvestinginprivateequity(company,fundorFundofFunds)itisimperativethatyouputyourmoneytoworksteadilyyearafteryear.Weshallbelookingatthisinmoredetailinalaterchapter,butthereisanimportantlessontobelearnedhere.Diver-siﬁcationshouldoccurnaturallyinanyprivateequityinvestmentpro-gramme(largelyasaresultofthenumberofunderlyingcompanies)butofallthedifferenttypesofdiversiﬁcation,byfarthemostimportantisdiversiﬁcationbytime.Ifyouareproperlydiversiﬁedacrossvintageyearsthenthereturnsofthegoodtimeswillmorethancompensatefortheoccasionalbadtimes.If,ontheotherhand,youchoosetoblowyourwadinlessthanasingleyearonaportfolioofalmostexclusivelyinternet-biasedUSventurefunds,asmanydidin1999/2000,thenyoucannotbeheardtocomplainifthingsgodisastrouslywrong.Sadly,humannaturebeingwhatitis,theydocomplain,andvociferouslyatthat.Itisapparentlyeasiertoblameanentireassetclassforsomesupposedlyinherentdefectthantoadmitthatyougotthingshopelesslywrong. 82PrivateEquityasanAssetClassThenthereistimeinthesenseofthelifeofafund,orafundpro-gramme.Thishasprobablyalreadybeendealtwithinthecommentsaboveaboutdiversiﬁcationbytime.Ifyouarerunningabuyoutfundyoumustkeepyourdisciplineandmakeyourinvestmentsroughlyequallyovera3-yearperiod.Nomatterhowattractivetheprospectsyoumayseeinyearone,youmustmaintainyourdiscipline.Then,oncetheinvestmentcycleiscomplete,therewillbegintheperiodinwhichyoulookﬁrsttodevelopyourcompaniesandthentoharvestthem.Thisisanartinitself.Whichcompaniesshouldyouselectfortheinvestmentofmoretimeandmoneytohelpthemgrow,andwhichshouldyoulooktosellquickly?CantheformermaintaintheirIRRsoverlongerperiods?Willthelattercontributeenoughtotheeventualfundmultiple?Soﬁnallywehavecomespeciﬁcallytothequestionoftheholdingperiodofeachindividualcompany.Aswenotedearlier,lengthofholdingperiodisthecontinuumalongwhichtheIRR/multipletrade-offoperatesandeverybuyoutprofessionalwillbeacutelyawareofitatalltimes.Asaroughruleofthumb,abuyoutfundwillgenerallyexpecttoholdtheircompaniesforanaverageofabout3years,andaventurefundforabout5.Ifyouranalysissuggestsalongeraverageholdingperiodthenyoushouldbevigilantaboutﬁndingoutwhythisis,andwhateffectithashadonIRRsandmultiples.MODELLINGANDANALYSINGBUYOUTFUNDSNowwearereadytostartpullingtogetherwhatwehavebeendiscuss-ing.Allowmeﬁrstofalltointroducetheconceptofenterprisevalue.Thissimplymeansthetotalvalueofthebusiness,orthepricewhichispaid.Theequityvalueistheamountofequitywhichhasgoneintothedeal,so:Equityvalue+Debt=EnterprisevalueTheconceptofenterprisevalueiscentraltoanybuyoutmodel.Thisistheamountofmoneyforwhichanybusinessisactuallysoldandwhich,afterrepaymentofoutstandingdebt,willbelongtotheshareholders.Iamusingequityanddebthereasiftheywerehomogeneousgenericexpressionsbutifyoubearinmindallthatwehavealreadycoveredyouwillrealisethatyouwillhavetodistinguishbetweendifferentclassesofequity(usuallythemanagementssweetequityandthentherest)andvariouslayersofseniordebtandmezzanine.Convertibleshares(US:convertiblestock)shouldtypicallybetreated HowtoAnalyseBuyouts83asmezzanine.However,remembertotreatanyconvertiblesorothermezzaninewhichisprovidedbythefundasopposedtooutsidesourcesaspartofthefundsinvestmentinthedealwhencalculatingthefundstotalreturn.Itisﬁnetocalculatethemezzanineandtheequityreturnsseparatelyifyouwish,butinpractice,LPswillonlybeconcernedaboutthetotalreturn.Afterall,themezzanineisusuallyjusttakingtheplaceofequitywhichthefundwouldotherwisehavebeencompelledtosubscribe.Atthetoplevelofanalysis,however,thefourvalueswhichareessen-tialtoourworkingsareenterprisevalue,earnings(whichevermeasureyouchoose),earningsmultipleanddebt.Thedebtﬁgurewillbethetotalofallnon-equityﬁnancingandwillincludeallmezzanine.Inotherwords:Enterprisevalue−Equityvalue=DebtTheseﬁguresneedtobecapturedbothonentry(purchase)andexit(saleorIPO).Asalreadynoted,themodelmustalsobeableofaccommodatinginterimcashﬂowssuchasrecaps,butthiscanhappenseparatelyonatimeperiod-basedmodel.Theimportantpartofthebuyoutmodelisanalysingtheperformanceofonebuyoutfundagainstanother.Therearesomeobviousthingsthatcanbedone,allofwhichcangivecluestohowabuyoutﬁrmoperates,anystrengthsorweaknesseswhichitmayhave,andanyproblemswhichitmightbeencountering.Averageleverage,andaverageholdingperiod,aretwoexamples.Theseandothervaluescanofcoursebecombinedand/orcalculatedacrossmorethanonefundtogiveapictureofaﬁrmstotalhistory.Averageleveragewillbe:ΣDebtnΣEnterprisevaluenexpressedasapercentage,wherenisthenumberofcompanies.However,whereafundhasoneortwoverylargetransactionsthenitmaybemoremeaningfultotakethecapitalweightedaverage,particularlyiftheyhaveeitherunusuallyloworunusuallyhighlevelsofgearing.Averageholdingperiodisbestcalculatedbynumberofquarters,andwillsimplybe:ΣHoldingperiodn 84PrivateEquityasanAssetClassTheinterestingpartthoughistoseehowwecananalysehowabuyoutﬁrmisaddingvaluetoitsinvestments.Inparticular,towhatextentcanweidentifythealpha-typeelementsofearningsgrowthornon-systemicmultipleexpansion?Acoupleofimportantpointsneedtobemadeherebeforewebegin.First,ifyouareplanningtotakeinﬂationintoaccountthenthisiswhereyouneedtodoit,byindexingtheearningsoverthelengthoftheholdingperiod.Second,themathematicalpuristsamongstyouwillnoticethatthereisanelementofdoublecountingaboutsomeofthecalculations.Thisisacknowledgedanddeliberate.Theproblemisthatyouhavetwovariables(earningsandmultiple)inoperationindependentlyanditisimpossibletoarriveatﬁgureswhichaddto100%withoutalittlebitofjiggery-pokery.Tocomplicatemattersstillfurther,thelevelofdebtwillactasagearingfactoronbothmultiples,andmayalsochangeitselfduringthelifetimeofthetransaction.ThisisaproblemonwhichIhaveworkedalongsidesomeveryclevermathemati-cians,includingonefromHarvardandonefromTrinityCollege,Dublin,3yetnonehavethusfarbeenabletoarriveatanyﬁnalconclusion.SoIhaveadoptedasimplisticsolutionwhichworks,atleastintermsofaddingupto100%andinmitigationIwouldsayonlythatifandwhenanyoneﬁndsabettersolutionIwillhappilyandgratefullyadoptit.Asyouwillseewhenyouconsiderthebasicalgebrathatfollows,theeffectofmultipleexpansionshouldlogicallybecalculatedonthegoinginearnings,otherwisethereisalwaysgoingtobeanelementofdoublecounting.However,ifyoudothat,youareleftwithanawkwardsortofremainderwhichdoesnotseemtoﬁtlogicallyanywhereandendsupgettingascribedtotheeffectofdebt(sincethisistheonlyotherwayofdealingwithit).Theothervalidobjectionisthatthealgebraunderstatestheeffectofdebt.Strictlyspeakingweshouldcalculatethetransactiontwice,onceasitactuallyoccurredandonceonanotionallydebt-freebasisandthencomparethedifferenceinthetworesults.Strictlyspeaking,yes,ifwewantedtolookatthetotaleffectofdebt,butwedont.Wewanttoanalyseonebuyoutagainstanother,andallbuyoutsaregoingtohavehighlevelsofdebt,soitisartiﬁcialtoexcludeitalltogether.Rememberwearecalculatingthelevelofgearingforeachdealanditwillbeeasytocheckforcorrelationbetweenhighdebtlevelsandhightransactionreturns.3Forthemathematicallycurious,thisissimilartoFoucaultsfamousthreebodiesproblem. HowtoAnalyseBuyouts85However,havingconsideredsucharithmeticalniceties,letusnowignorethemandgetonwiththealgebra.Let:ImpactofEarningsIncrease=AImpactofMultipleIncrease=BImpactofDebt=CGoingInEarnings=E1GoingInMultiple=M1GoingInDebt=D1ExitEarnings=E2ExitMultiple=M2ExitDebt=D2Foreachportfoliocompany:A=(E2×M1)−(E1×M1)B=(E2×M2)−(E2×M1)C=D2−D1Eachcanthenbeexpressedasapercentageofthetotal,e.g.A100×ABC++Iamdeliberatelykeepingthisallataverystraightforwardlevel,sinceIwanttomakesurethatthebasicmethodologyisunderstood.Onceitis,theonlylimitisyourimagination!Youmightchoosetoanalysereturnsbydealsource,country,transactionsize,fundsize,oranyoneofamyriadotherconsiderations.Forthemoment,letuslookataworkedexamplejusttomakesurethateverythingisclear.Letusassumethatacompanywithearningsof$10Misboughtfor$80M,thusonanearningsmultipleof8.Itisheldfor3yearsandthensoldfor$117M,bywhichtimeitsearningshaveincreasedto$13M,andsotheexitearningsmultipleis9.Theoriginalpurchasepriceisfundedby$70Mofdebtand$10Mofequity.Letuslookattwodif-ferentscenarios:onewherethereisnochangeinthelevelofdebtduringtheholdingperiod,andonewhere$20Mofdebtispaidoffattheendofyear2. 86PrivateEquityasanAssetClassScenarioOneGoingInEarnings$10MExitEarnings$13MGoingInMultiple8×ExitMultiple9×EnterpriseValue$80MEnterpriseValue$117MCapitalStructure:CapitalStructure:Equity$10MEquityValue$47MDebt$70MDebt$70MEnterpriseValue$80MEnterpriseValue$117MGain($47M−$10M)=$37MMoneyMultiple($47M/$10M)=4.7×IRRYr0Yr1Yr2Yr3−$10M00$47M68%ContributionofEarningsIncrease($13M×8)−($10M×8)=$24MContributionofMultipleIncrease($13M×9)−($13M×8)=$13M$37MContributionofEarningsIncrease=($24M/$37M)×100=65%ContributionofMultipleIncrease=($13M/$37M)×100=35%ScenarioTwoGoingInEarnings$10MExitEarnings$13MGoingInMultiple8×ExitMultiple9×EnterpriseValue$80MEnterpriseValue$117MCapitalStructure:CapitalStructure:Equity$10MEquityValue$67MDebt$70MDebt$50MEnterpriseValue$80MEnterpriseValue$117MGain($67M−$10M)=$57MMoneyMultiple($67M/$10M)=6.7× HowtoAnalyseBuyouts87IRRYr0Yr1Yr2Yr3−$10M0$20$67M124%ContributionofEarningsIncrease($13M×8)−($10M×8)=$24MContributionofMultipleIncrease($13M×9)−($13M×8)=$13MContributionofDebtDecrease($70M−$50M)=$20M$57MContributionofEarningsIncrease=($24M/$57M)×100=42%ContributionofMultipleIncrease=($13M/$57M)×100=23%ContributionofDebtDecrease=($20M/$57M)×100=35%SUMMARYFundanalysismustbebottomup,i.e.,modellingtheindividualbuyouttransactionsinordertobuildupapictureofthefundasawhole.Thefourdriversofbuyoutreturnsareearnings,earningsmultiple,debt(leverageorgearing)andtime.BuyoutsaremeasuredbothbyIRRandbymoneymultiple.Beawarethatthereisaninherenttrade-offbetweenthetwoovertime.Whenmodellingbuyouts,pseudo-cashﬂowmeasuressuchasEBITDAaretheclosesttowhatbuyoutﬁrmsthemselveswilluse,butlackofconsistencyandpublicavailabilityofsuchﬁgureswillusuallydrivethemodellerbacktoearningsandPEratios.Theabilitytogrowtheearningsofacompanyisthemosthighlyprizedofbuyoutﬁrmabilities,andyouranalysisshouldfocusonidentifyingthis.Beaware,though,oftheeffectofinﬂation,espe-ciallywhenmodellingreturnsfromthelate1980sandearly1990s.Multipleincreasecanbethoughtofasbothsystemic(beta-like?)andnon-systemic(alpha-like?).Thelatterisobviouslypreferableand,likeearningsgrowth,representsahighlydesirablebuyoutﬁrmexpertise. 88PrivateEquityasanAssetClassDebtplaysakeyroleinthegenerationofbuyoutreturns,operatingasgearingtoenhanceequityreturns.Thewayinwhichdifferentlayersofdebtandmezzaninecanbestructuredintoadealisacomplexsubjectandrequiresseparatestudy.Timingislargelyimplicitinbuyoutreturns,sincetheyarecalcu-latedbyatimeperiod-basedmeasure(IRR).However,therearesomeexplicitconsiderationswhichwillimpactondecision-makingandreturns,suchasthestageofafundslifecycle,andprevailingmarketconditions.Theeffectsofearningsincrease,multipleincreaseanddebtreduc-tioncanandshouldbebrokenoutandanalysed.Otherkeyfactorstocaptureandanalyseincludethegearingratio,lengthofholdingperiod,typeofdeal(MBO,MBI,etc.),dealsource(proactive,auction,etc.),countryandfundsize.Giventhemathematicalcomplexitiesintroducedbymultiplevari-able,somedegreeofalgebraicsimpliﬁcationisrequired.However,oncethebasicsaregrasped,thereisnolimittothecomplexityofmodelwhichmaybecreated. 5BuyoutReturnsHavingexaminedhowbuyoutreturnsaregenerated,andthushowtheymaybeanalysedbothwithinasinglefundandalsobycomparisonbetweendifferentfunds,itistimetolookatwhatreturnstheassetclasshasactuallygenerated,andhowweshouldviewthese.USVERSUSEUROPEANBUYOUTFormanyyearsduringthe1990stherewasanaxiombuyoutinEuropeandventureintheUSwhichwasoftenusedtoexpressinvestorsinstinctivebeliefastowherethebestreturnsweretobefound.Wewillbelookingatventurereturnsinalaterchapter,soletusfocusforthetimebeingonthebuyoutpartofthismaxim.ThebeliefwasthatEuro-peanbuyoutreturnsgenerallyout-performedUSbuyout.Well,letstakealookattheﬁgures(Table5.1).Asyoucansee,theaxiomaticviewseemstoholdwater.Foreveryvintageyearsave1993and1998theEuropeanupperquartileﬁguresaresigniﬁcantlyhigher.Ofcourse,therearethosewhoarguethatlookingatupperquartileﬁguresisinherentlyundesirableforallsortsofreasons,notleastthatoneislookingatthereturnsofasinglefund.However,theCapitalWeightedAverageﬁgurestellaverysimilarstorysaveonlythathereitisthe1999ratherthanthe1998vintageyearreturnthatislessgood.Rememberpleasethatwearelookinghereatvintageyearreturns,thatisthecompoundreturntodate(inthiscase30thJune2006)ofallqualifyingfunds(i.e.,USorEuropeanbuyoutfundsasappropriate)thatwereclosed(born)inthatyear.Itmaybeeasiertoseetherelationshipbetweenthetwosetsofﬁguresifwesetthemoutasgraphs(Figures5.1and5.2).Eachgraphshowsbroadlythesamestory.YouwillseefromTable5.3onpage104thatthereisasigniﬁcantdifferenceintheTVPI(moneymultiples)generally,particularlytheCapitalWeightedAverageandparticularlyafter1993.Signiﬁcantbothinrange(in1994forexample)andineffect,sinceitisgenerallymultiplesthatdriveIRRs,ratherthan 90PrivateEquityasanAssetClassTable5.1USandEuropeanbuyoutreturns;IRRbyvintageyear(%),calculatedto30.06.2006USUSEuroEuroCWAUQCWAUQ199010.9012.508.5019.40199110.0013.9014.5021.50199224.4029.7028.1032.30199321.6026.1017.6022.80199416.8021.6042.5049.20199511.7013.6044.1020.3019966.1010.4018.6022.9019979.5010.7012.3024.1019980.7012.505.4011.5019996.809.602.8011.00Source:VentureXpert.504030USCWA20EuroCWAIRR(%)1001990199119921993199419951996199719981999Source:ThomsonFinancialVentureXpert.Figure5.1BuyoutreturnstoJune2006byvintageyear,CapitalWeightedAverageIRR605040USUQ30EuroUQIRR(%)201001990199119921993199419951996199719981999Source:ThomsonFinancialVentureXpert.Figure5.2BuyoutreturnstoJune2006byvintageyear,UpperQuartileIRR BuyoutReturns91viceversa(thereismorethan89%correlationbetweentheCWATVPIduringthe1990sandtheCWAIRRforthesameperiod).Thediffer-enceinbuyoutreturnsbetweentheUSAandEuropecanclearlybetracedtothisfundamentaldifference.InEuropeintheearlyandmid-1990stherewerevariousfundswhichachievedatleast3×.Idonotsaythatthiswasaregularoccurrence,butitwasfarfromrare;Icanrememberseveralinstancesoffthetopofmyhead.WithUSbuyoutfunds,aswithEuropeanfundstoday,thatsimplydidnothappen.Byabout2000expectationswereforbuyoutfundstoachieveabout1.9×,whiletodayIwouldgoevenlowerthanthatforthemegafunds.Weshallbelookinglateratthephenomenonoffallingbuyoutreturns.Forthetimebeing,letusfocusonthedifferencebetweenthesehistoricEuropeanandUSﬁguresandtrytothinkofsomepossibleexplanationsforthedifference.BUYOUTSKILLBASESLetmedisposeofonepossiblesuggestionveryquickly.Thereisabso-lutelynodifferencebetweenthequalityoftheskillsandexpertiseofbuyoutprofessionalsoneithersideoftheAtlantic,neitherhasthereeverreallybeen,certainlynotduringtheperiodwearediscussinghere,althoughitisbroadlytruethatbuyoutactivity(certainlyinanyrealvolume)startedintheUSAandthenspreadtoEuropeviatheUK.Nearly$50billionhadalreadybeenraisedbyUSbuyoutfundsprior1to1990,comparedwithperhapsaslittleas$6billioninEurope,buttherewerebythatdateanumberofveryactiveandveryprofessionalEuropeanbuyoutﬁrmsbasedinLondonsuchasBCpartners,Doughty2Hanson,DukeStreet,CVC,Permira,Apax,CinvenandCandover,whileinScandinaviabothIndustriKapitalandNordicCapitalcom-mencedoperationsin1989.Theskillsinvolvedinoperatingasabuyoutprofessionalarepro-found,andcanconferasigniﬁcantstrategicadvantage,andwhileI1MyowncalculationsbasedonThomsonFinancialsVentureXpertsystem,whichmayslightlyunder-statetheEuropeanﬁguresforthisearlyperiod,asnotallEuropeanbuyoutﬁrmsregisteredtheirdatainthosedays.2Forthesakeofconvenience,Ihaveusedthepresentnamesofallthesegroups.DoughtyHansonwerepreviouslyCWBCapitalPartners,DukeStreetwerebornoutofHambrosEuropeanVentures,CVCwereoriginallypartofCitibank,andPermirawerepreviouslypartofSchroders. 92PrivateEquityasanAssetClasswouldbethelasttobelittlethem,manyofthemareessentiallyﬁnancialinnature,whichiswhybuyoutﬁrmsfavouryoungaccountantswhentheyrecruitentrylevelpersonnel.Foranyonewithagoodlevelofﬁnancialeducationtheseskillscanbelearntandquicklydeveloped.Ofcoursethereareothers,suchastheabilitytosourcedeals,andwhenandhowtoexitthem,whichrequireconsiderablejudgementandexperi-ence,butthesetoocanbelearnt.SufﬁceittosaythatIhaveneverhearditsuggestedbyanyonethatduringthe1990sEuropeanbuyouthouses(atleastthemajor,independentonesthoseattachedtocontinentalEuropeanbanksmaywellhavebeenadifferentstory,butthesewerefrequentlypractisingdevelopmentcapitalratherthanbuyoutanyway)hadlowerlevelsofprofessionalskillsthantheirUScounterparts,orindeedviceversa.So,whateverthereasonforthedifferinglevelsofreturns,weneedtolookbeyondtheﬁrmsthemselves,atthebroaderenvironmentwithinwhichtheywereoperating.Wealsoneedtobealivetowhatlessonsthismayhaveforuswhenlookingatbuyoutconditionstoday.IMPERFECTMARKETSThemostfrequentlyheardexplanationfortheveryhighEuropeanbuyoutreturnsoftheearlyandmid-1990swastheimperfectmarketsissuetowhichIhavealreadyalludedinanearlierchapter.USmarkets,bothpublicandprivate,sotheargumentgoes,weremuchbetterdevel-opedby1990thantheirEuropeancounterparts,certainlysofarascontinentalEurope(thatis,EuropeexcludingtheUK)wasconcerned.ThustheabilitytosourceadealproactivelyandbeabletotransactitonanexclusivebasiswasstillverymuchaliveinEuropeatatimewhenithadalreadylargelydisappearedintheUSA,certainlyinrespectofabusinessofanyrealsize.Likeallgeneralisations,thisoneislargelytrue.Nobodywoulddeny,leastofalltheprivateequityﬁrmsinvolved,thatalotofthebuyoutsincountrieslikeGermanyandSwedenintheearly1990sfellfairlyandsquarelyintothiscategory.Theywererarelyputthroughanysortofauctionprocess,thevendorwasfrequentlyeitherafamilyownerorasociallyembarrassedlocalcorporategroup,andasaresulttheywereoftenboughtforvalueswhichinretrospectseemgeneroustothepur-chaser.However,ontheothersideofthecoin,itshouldberememberedthatthesebusinesseswereusuallysubjecttoallsortsofrestrictionswhichwouldsimplyhavebeenunfathomabletoanyUSpurchaser,such BuyoutReturns93astheextremedifﬁcultyinsomecountries(legal,politicalandcultural)ofanysigniﬁcantrationalisationinvolvingredundanciesand/orplantclosures.Thecontinentalsocio-economicmodelatthattime,evenmorestronglythantoday,heldthatacompanyexistedtoprovideemploymentandretirementsecuritytothelocalcommunityatleastasmuchastomakeaproﬁtforshareholders.Germancompaniesinthe1980s,forexample,werecustomarilyrankedontheirturnover(salesrevenue)andtheirnumberofemployees,notontheirproﬁts(theﬁguresforwhich,bytheway,werenotusuallypubliclyavailable).Thus,thiscombinationofhistoricalcircumstancesmightbethoughtofasasortofhappyhuntingtimeduringwhichbuyoutﬁrmswereabletoconcludedifﬁcultbutattractivedealslargelyundisturbed.However,theseconditionswerelargelyconﬁnedtoScandinaviaandGerman-speakingEurope.CountriessuchasFranceandItaly,forexample,werelargelyuntouchedbylargebuyoutactivityatthistime,althoughthischangedasthedecadeprogressedand,indeed,oneofthemostspectacularlysuccessfulbuyoutsofalltimetookplaceinItaly(theYellowPagesdeal,thechiefbeneﬁciariesofwhichwereBCPart-nersandInvestitoriAssociati).USbuyoutﬁrmswereperhapsslowerthantheymighthavebeenintryingtoaccessthisparticularhoney-pot,aninterestingparallelwithUSventureﬁrms,whohavealsobeenveryslowtoseekdealsoutside3theirownimmediategeographicalenvironment.Itwasonlyinthelate1980sthatthelargeUSbuyoutﬁrmsbegantosetupEuropeanopera-tions,andeventhenthesewerefrequentlystaffedlargelybyAmericansatseniorlevel,withallinvestmentdecisionsbeingtakeninAmericabyAmericans.Thisisoftencitedasareasonwhytheyfounditverydif-ﬁcultatﬁrsttoaccessdealsincontinentalEurope,particularlythosewhichhadapoliticalelement(whichsomanydid),butinfairnessIbelievethiswasaproductofdeepanti-Americansentiment,par-ticularlyasuspicion(oftenunfounded,butnotalways)thatwhattheAmericanﬁrmwasafterwasaquickturn,aftermassassetsalesandredundancies,andwouldhavehappenedanyway.Whateverthecase,itiscertainlytruethatAmericanﬁrmslargelymissedoutontheseearlyopportunitiesandthiswouldthusdeﬁnitelybeoneplausiblereasonforthedifferenceinhistoricreturns.3Thoughthisiseasiertounderstandinthecaseofventurecapital,sincehands-oncompanybuildingskillsarebestexercisedfacetoface. 94PrivateEquityasanAssetClassEARNINGSMULTIPLESThinkingbacktoourdiscussionaboutthedriversofbuyoutreturns,itwouldbeinstructivetolookathowthedifferentdriversmighthavecontributedtothehistoricsituation,butImustenteranimmediatecaveathere.Thissortofinformationisavailable,insofarasitexistsatall,onlywithinthebuyoutmodelsofprofessionalFundsofFundsandothersophisticatedLPs.Theprivateequityindustrydoesnothandletheconceptoftransparencyverywell;indeed,therearesomeUSventureﬁrmswhoinsistonstrictsecrecyfromtheirLPsonpainofpossibleexpulsionfromtheirfunds.Theybelievethattheyhaveallsortsofgoodreasonsforthis(chiefamongwhichistheproblemofper-formancedatafallingintounsophisticatedhandswhichdonot,forexample,understandtheeffectoftheJ-curve,orthedifferencebetweenannualandcompoundreturns),butwithrespectIdisagree.Investorstodayexpecttransparencyacrossallassetclassesandareentitledtogetit.TherearelegitimateconcernsamongGPsthatdatamaybecomparedacrossﬁrmsinwayswhicharenotfairandconsistent,eitherbecauseithasbeenpreparedondifferentbasesintheﬁrstplace,orbecausetheanalysissystemsusedbyindividualinvestorsmakedif-ferentassumptions,orcategoriseinformationindifferentways.Buyoutﬁrms,forexample,canbeextremelysensitiveaboutthewayinwhichgearingratiosorearningsmultiplesarecalculated,andastotheattri-butionofparticulardealstoparticularindividualswithintheﬁrm.However,theselegitimateconcernscanbeaddressedgivengoodwillandprofessionalismonbothsides,anditisahugepityforthoseofuswhotakeagenuineinterestintheanalyticalsideoftheindustrythatthereissolittledataavailablewithwhichtowork.Thefactthatunderlyingdataisnotavailableisamajorstumblingblock,butnotacompleteimpasse.Therearewaysinwhichwecanimplyorinfertheactionofbuyoutdrivers,soletusdothebestwecanwiththeinformationatourdisposal.Aswediscussedinanearlierchapter,thereisarelationshipbetweenquotedearningsratiosandthosewhichareappliedtoprivateequitytransactions.Whilethislinkexists,letusremindourselvesofitslimita-tions.Itworkswellwhenapubliccompanyisbeingbought,asthecompanywillhaveitsownirrefutablyrelevantmultiple.However,evenhereonehitsproblemsimmediately,sincethebuyouthousewillbethinkingintermsofEBITDA,whichmaypaintaverydifferentpicturetotheearningsusedforthePEratio.Whenthetransactionisanything BuyoutReturns95otherthanatakeprivate,therewillbeargumentsaboutthecomparativefactors(size,growth,businessactivities)andtherewillalsobeatimelagbetweenpubliclyquotedsectorschangingandprivatecompanyvendorspricingexpectationsmakingasimilaradjustment.Insomecasesthislatterphenomenonmaybesoextremethatthevendorwillsimplyrefusetosellatanyreasonableprice,nomatterhowirrationalsuchbehaviourmaybegivenhisownparticularcircumstancesorthoseofthecompany.Eventakingallthisintoaccount,however,wecanattheveryleastsaythatprivateequitymultiplesareheavilyinﬂuencedbypubliclyquotedPEratios,andthataccordinglyanyriseorfalloveraperiod(particularlyifitwasafairlysteadyriseorfall,soasnottoconfusepeoplesvaluationexpectationstoomuch)inthelatterwouldalmostcertainlybereﬂectedintheformer.AsyoucanseefromFigure5.3,thePEratiooftheFTSEindex,whichwemaytakeasaproxyfortheEuropeanbuyoutindustrysinceitislikelytobetheindextowhichtheywouldturnﬁrst,rosesteadilyduringthe1990s,andsoonewouldexpecttheearningsmultiplesavail-ableforbuyouttransactionstohaverisensteadilyaswell.TheonlyproblemwiththisanalysisisthatthecomparableUSratiosalsoincreasedsteadilythroughoutthe1990s,andsoUSbuyoutfundsshouldhavebeenequallyabletoproﬁtfromrisingearningsmultiplesastheirEuropeancounterparts.Thefactthattheyapparentlydidnot(or,at40.0035.0030.0025.00FTSE10020.00S&P10015.0010.005.00-94959697989900Figure5.3PEratios19942000,FTSE100andS&P100 96PrivateEquityasanAssetClassleast,nottothesameextent)suggeststhatwhiletheremustlogicallybesomeforcetothisargument,itisatbestapartialexplanation.Infact,ifonetriestomeasurethecorrelationbetweentheFTSEPEratiosfortheperiod1994to2000againstﬁrsttheCapitalWeightedTVPIforEuropeanbuyoutfundsandthentheCapitalWeightedIRRforthesamevintageyears,onearrivesatﬁguresof−78%and−77%,respectively(runningthesameﬁguresforUSbuyoutgivesabroadlysimilarresult:−75%and−70%,respectively).Inotherwords,notonlyistherenocorrelation,butthereisastrongnegativecorrelation.ItthereforeseemsmorelogicaltoascribeatleastapartoftheassumedmultipleincreaseintheEuropeanarenatoimperfectmarketsyndrome.Ifoneisbuyingonamultiplethatdoesnotfullyreﬂectthevalueofthebusinessonapublicmarket,andsubsequentlydisposesofiteitherbyﬂoatingitonapublicmarketorbysellingitsemi-publiclyinawayinwhichthepublicmultiplewillbeusedasacomparator,thenthisclearlyopensupthepotentialforgreatergain.Onespeciﬁcsituationmeritsdiscussion,sinceithadamajorinﬂu-enceonthereturnsofanumberofLondon-basedbuyoutfundsinthemid-1990s.TheConservativegovernmentdecidedtoprivatisetherail-waysandchosetodosobyofferingthevariousindividualcompaniesintowhichassetsandrouteshadbeenbundledforsalebytender,ratherthanofferingtheirsharesonthestockexchangeastheyhaddoneinpreviousprivatisationssuchasBritishTelecom.TheLabouropposition,unabletohalttheprocessbecauseoftheir(then)minorityinparlia-ment,threatenedtocompulsorilyrepurchasethecompanieswhentheyreturnedtopower.Becausethevarioustransactionswerethussubjecttoahugeamountofpoliticalrisk(ageneralelectionwasintheofﬁng),thiswasreﬂectedintheprice,aswasthegovernmentsdeterminationtoberidofthemwellaheadofanypossiblepoliticalinterferencebythethenopposition.Intheevent,compulsoryrepurchaseideaswerequietlyabandonedafterLabourselectionvictoryin1997,andthebuyoutﬁrmsinvolvedhadanywayalreadybeenabletosellthecom-paniesonalmostatonceforgreatlyenhancedprices(gearedbysub-stantialamountsofdebt)andreaprewardsthatwerealmostembarrassingevenbythestandardsoftheprivateequityindustry.CityofLondonhumourbeingwhatitis,thevariousparticipatingfunds(whoincludedCandoverandCharterhouse)promptlybecameknowncollectivelyastheGreatTrainRobbers,areferencetoafamousandhighlyroman-ticised(suchaccountsconvenientlyignorethefactthatthetraindriver BuyoutReturns97laterdiedofhisinjuries)Britishcrimewhichcaughtthepublicimagi-nationinthe1960s.ImentionthisbecausethesevariousrailwaydealshadahugeimpactonthereturnsofvariousEuropeanbuyoutfunds,bothbecauseofthe4gainsthatweremadeandalsobecausetheholdingperiodsinvolvedwereunusuallyshort,thusboostingIRRsaswellasmoneymultiples.Thisshouldbeborneinmindwhenlookingat1994,sinceCandoverandCharterhousebothhad1994vintageyearfunds.The1995ﬁguresarealsoalittlestrange,particularlysincetheCapitalWeightedAverageissomuchabovetheupperquartilefund.Thereisonespeciﬁcissuewhichneedstobepointedouthere,althoughIamnotsureexactlyhowgreataneffectithad.Apaxraisedafundin1995whichwasscheduledtoinvestinbothventureandbuyoutdeals(aswastheirpracticethen)butbecauseofthewayinwhichtheVentureXpertfundsdatabaseworks,thiswholefundwasclassiﬁedasabuyoutfund,whichmeansthatthe1995vintageyearEuropeanbuyoutreturnsincludetheresultsofsomeverysuccessfulventureinvestments,suchasAutonomy,DrSolomonsandQXLRicardo.Imentionthisforthesakeofcompleteness,butitisunlikelytobeasig-niﬁcantfactor.Thoughlessthan$2.5billionwasraisedforEuropeanbuyoutthatyear,ApaxVwasonlya$300Mfund.Itmayactuallybemoreofanissueforthe1995Europeanventureﬁgures,whichpresum-ablydonotbeneﬁtfromthesecompaniesbeingincluded.EARNINGSGROWTHEarningsgrowthcancomeaboutinthreeways.First,thereisthegrowththatwouldhaveoccurrednaturallyanywayfromhigherrev-enues(perhapsasaresultofanewproductcomingonstream)orlowercosts(forexampletheremovalofthesortofhiddencoststhatoftenaccompanyfamilyownership).Second,thereisgrowthcausedbytheeffectsofinﬂation.Lastly,thereisthesortofalphaearningsgrowthtowhichwealludedinanearlierchapterwhichisbroughtaboutbythespeciﬁcactionsofthebuyoutgroup.Withoutunderlyingdataofthenecessarycomplexitywecanonlyattemptconjectureshere.Theﬁrsttypeofgrowthcanprobablybe4Anequityinvestmentof£70MinEversholt,arollingstockleasingcompany,allegedlyturnedintoover£450M:Redfacesoverrailprivatisation,SundayTimes,1997. 98PrivateEquityasanAssetClassdiscountedasadistinguishingfactor,sincelogicallyitwouldhaveoccurredtothesameextentinboththeUSAandEurope.Indeed,giventhattheUSAledthewayintotheintensivecomputerisationofbusinessprocesseswhichoccurredduringthe1990sthen,ifanything,IthinkthisfactorshouldhavefavouredAmericanratherthanEuropeanreturns.However,Ithinktheremayhavebeensigniﬁcantdifferencesinboththeothertwoareas.The1990sbeganasahighinﬂationdecadeinEurope,particularlyintheUK(lesssoincountriessuchasGermany,whereitwasheldincheckbyhighinterestratestotheultimatedetrimentandeffectivecol-lapseoftheEuropeanMonetarySystem)butendedasalowinﬂationdecade.Thus,someargue,therewasaperiodduringtheearly1990swheninﬂationcouldhaveplayedakeyroleinearningsgrowth,whichwouldmeanthattheglorydayreturnsof1994and1995,whilestillveryimpressive,mayactuallybeslightlylesssothantheyappeartobe.However,Idonotwishtooverplaythis;highinﬂationwasmuchlessofafactorincontinentalEuropethanintheUK(thoughtheUKatthetimeaccountedforabouthalfofallEuropeanbuyoutactivitybyvalue).Infact,ifonelooksattheofﬁcialUKgovernmentﬁgures(thevariousdifferentmeasuresfortheRetailPriceIndex)itisclearthatthiscanhavehadlittlerealeffectonproceedings.Withthepossibleexceptionof1995,inﬂationcanhavehadlittleimpactonthestand-outvintageyearsinquestion,andifitwasasigniﬁcantfactorthenonewouldhaveexpectedthevintageyearreturnsfor1996and1997tohavebeensimilarlyboosted,whichtheywerent.Thus,Iaminclinedtodismissinﬂationasafactorwhichcouldprovideanysigniﬁcantexplanation.Thesecondfactorisinmyjudgementmuchmorelikelytohavebeensigniﬁcant.Companiesboughtfromfamilyvendors,andevensomewhichhadbeenownedbypubliccompanieshadpursuedadeliberatepolicyofkeepingearningsincheck,usuallybyaggressiveassetacquisitionprogrammes,inordertoavoidasmuchaspossiblehighratesoftaxation.ThiswasaparticularprobleminGermany,wheretherealcostofuniﬁcationonaone-to-onebasisbetweentheDeutsch-markandtheOstmarkhadbeenbadlyunder-estimated(orperhapsjustsweptunderthecarpetatthetimeforpoliticalreasons).Sothiswasonereasonwhyitmighthavebeenquiteeasytoincreaseearnings. BuyoutReturns99Anotherwastheconditionwhichafﬂictsmostowner-managedcom-panies,namelyamissinglayerofmanagement.Regardlessofwhattitlesareinuse,theretendstobeaFinancialControllerratherthanaFinanceDirector,forexample,andasimilarsituationinalltheotherdisciplines.Oftensimplyreplacingthismissinglayerofmanagementcanyieldquitespectacularresults.Yetanotherhasbeenreferredtoobliquelyelsewhereinthisbook.InEurope,theprocessofindustrialconsolidationwhichtookplaceintheUSAinthe1960sand1970shadbeendelayed,andarguablystillhasnotbeenproperlycompleted40yearslater.Inpartthiswasduetonationalandlocalpride;everycountrywantsitsownairline,andeverytowninBelgiumandGermanywantsitsownbrewery,andpreferablytwoorthree.InpartitwasalsodowntotheheterogeneousnatureofEuropeitself,afactorwhichisoftenoverlookedbyAmericans,whoﬁnditdifﬁculttoconceiveofasituationwhereyoucandriveafewmilesdowntheroadandbeconfrontedbyadifferentlanguage,cur-rencyandlegalsystem,togetherwithcompletelydifferentculturalmoresandpurchasinghabits;thewhitesausage/blacksausageborderinGermanyisperfectlyreal,forexample,eventhoughitisnotmarkedonanymap.Thatbeingso,itwasfrequentlypossibletobuyacompanyandputittogetherwithanotherbusinessinanothercountry,orspinindividualbusinessunitsoffforsuchapurpose,somethingthatwouldprobablyhavebeenpoliticallyimpossibleforthepreviousownereventocontem-plate.Indeed,sometimesthispossibilitywasexplicitlydiscussedatthetimetheoriginalbuyoutwasdone,andthevendorkeptastakeinthebusinesspreciselytoderivesomeﬁnancialbeneﬁtfromthiswhenithappened.Becausetheconsolidationprocesswasstillinitsinfancy,thesizeofthebusinessunitsinvolvedrarelygaverisetoanyseriousmonopoly(anti-trust)problems.Compareandcontrastthatwiththesituationtoday,wheremuchlargerfundsizeshaveledtomuchlargertransactionsizes,whichinturnfrequentlyraisesigniﬁcantlegalandregulatory5issueswheneveranymergeriscontemplated.5Insomecases,whereautilityhasbeenpurchased,orwhereabusinessmayhavemonopoly-likeissues,governmentpricingrestrictionsmayalsobeinforce.Thiswasafactor,forexample,intheUKYellowPagesdealinwhichApaxparticipated. 100PrivateEquityasanAssetClassLEVERAGEInasense,leverage,inﬂationandinterestratesareallinter-related.MonetarypolicyinEuropeintheearly1990swastoattackhighinﬂa-tionwithhighinterestrates.Suchanapproachwillinturnpromptlowearningsmultiples,sincetheperceivedrisk-freeinvestmentreturn,andthusthediscountrateappliedtofuturecashﬂows,ishigh.So,inasenseitisacaseofwhatyougainontheswingsyouloseontheroundaboutasfarasbuyoutfundsareconcerned.Atthebeginningofthe1990sonecouldlooktoinﬂationtoﬂatteronesearningsgrowth,andbuyonlowearningsmultiples.However,highinterestratesmadeaggressiveleveragedifﬁcult,oratleastveryexpensive.Bytheendofthe1990s,Europe(particularlytheUK)hadbecomealowinﬂation,lowinterestrateenvironmentwithplentifuldebt6availableatreasonableprices,andmuchhigherearningsmultiplesthan10yearspreviously.Thus,onewouldexpecttheretohavebeenachangeintherelativeimpactofthebuyoutdriversoverthecourseofthedecadeinEurope,withearningsgrowthandmultipleexpansionplayingalargepartearlyon,butdiminishingtowardstheendoftheperiod,perhapswithgearinglevelsrising.AsIhavesaidalready,itisagreatpitythatthisinforma-tionisnotfreelyavailable,inwhichcasewewouldbeabletoknowforsureratherthanhavingtoguess,buttheseseemreasonableassumptionstobedrawing.Ifso,thenthisisoneareawheresomeofthedifferencecouldbeexplained.TheUSAdidnotexperienceanythingasextremeastheBritishconditions,andinparticularneitherinﬂationnorinterestratesevergotashighastheydidintheUK.So,thismightexplainsomeofthedifferentialearlyinthedecade.Theﬂyinthisparticularointment,however,isthatbecauseUSinterestratesweretypicallylower,thenitshouldhavebeenthatmucheasiertogearcompaniesupwithdebt.However,thismightinturnbearoutonesinstinctiveviewthatearningsgrowthandmultipleexpansionhaveahigherpotentialtoinﬂuencebuyoutreturnsthandoestheeffectofsomeextraleverage.Idonotwishtolabourthesepoints,sincewearehereforcedintotherealmofpurespeculation,buttheyareimportantissueswhichoneshouldbearinmindwhenanalysingbuyoutreturns.6TheactualeconomiccycleswithinEuropeweredifferent,particularlyasbetweentheUKandGermany.Generallyspeaking,theUKwentfromlowgrowthtomedium/highgrowth,whiletheGermaneconomydidmuchtheopposite,butthatismuchlessrelevantforourpurposes. BuyoutReturns101Thereisoneextrapointthatfallstobemadeaboutleverage.Withtherisingtransactionvaluesbroughtaboutbylargerfundsizes,theamountofacquisitiondebtavailableatanyonetimeisnotinﬁnite.Rememberthat,atleastintheearlystages,theremaybetwoorthreedifferentbuyoutfunds(or,moreusuallythesedays,consortiaofbuyoutfunds)chasingaparticulardeal,andeachwillneedtohaveitspotentialfundingﬁrmlyinplacebeforemakingaformaloffer(indeed,thisisusuallyaspeciﬁcrequirementofthesaleprocess).Thus,ifthereareanumberoflargedealsinthemarketatanyonetime,andparticularlyifthebiddingprocessinrespectofmostofthemhasnotyetbeennar-roweddowntoonepreferredpurchaser,thenthebankswhichhabituallysupplythisacquisitiondebtstarttocomeunderpressure,andmayhavetostarttweakingtheirtermstoregulatesupply,orevendecidingnottoproceedwithaparticulardeal(thesedaystherearealsosomefairlysophisticatedunderwritingandsyndicationtechniquesenteredintobetweenbanks).Havingthestature,credibilityandtrackrecordtoensurethatyouarethebidderproceededwithratherthanthebidderwhoisdumpedbythebanks,isinfactasigniﬁcantbutlittlerecognisedstrategicadvantage.FUNDSIZEWehavealreadynotedthephenomenonofrisingbuyoutfundsizesandconjecturedwhethertheremaybesomeconnectionbetweenfundsizeandreturn.Thismaybeofparticularinterestfortheperiodundercon-sideration,sincetherewasastarkdifferencebetweenEuropeandtheUSA.TheaveragesizeofEuropeanbuyoutfundsraisedbetween1990and1999waslessthan$250M,whereasforUSbuyoutfundsraisedduring7thesameperioditwasnearly$370M.Tothrowthisintostarkercon-trast,USbuyoutfundsraisedatotalof$348billionduringthe1990s,whileonly$66billionwasraisedinEurope.Inotherwords,theAmeri-canbuyoutindustrywastryingtoputoverﬁvetimesasmuchmoneytoworkduringthe1990sasweretheirEuropeancounterpartsinaneconomicblockofroughlyequalvalue.GiventhatbycommonconsentthereweremorepotentialbuyoutcompaniesinEuropeat7AllﬁguresinthischapteraretakenorcalculatedfromThomsonFinancialsVentureXpertsystemunlessspeciﬁcallystatedotherwise. 102PrivateEquityasanAssetClassthistime[sinceindustryconsolidationinjustabouteverysectorwaswellbehindthatintheUSA,thusmeaningtherewerealargernumberof(generallysmaller)playersineachcase]thenIthinkthisfactorissigniﬁcant.ItisnotjustthatAmericanGPshadmoremoneytoputtowork(whichwouldraiseobviousimplicationsthattheymayhavebeenlessprice-sensitive,sincetheycouldaffordtobelesschoosyinthefaceofgreatercompetition)intotal,andtheEuropeansless.ItisalsothatthevastmajorityofEuropeanbuyoutcapitalwasbeingtargetedatwhatwewouldtodaycallthemid-market.Therewereonly14megafunds(morethan$1billionfundsize)raisedinEuropebefore2000,whereastherewere85intheUSA.Duringthe1990s,theamountofcapitalraisedbymegafundsintheUSAﬂuctuatedbetween11%and55%,whereasinEuropeitwaszeroforﬁveoftheyearsinquestion(Table5.2).Table5.2TheimpactofmegafundcapitalinEuropeandtheUSA19901999EuropeYear#Funds#MegaTotalcapitalMegacapital%($M)($M)199021025880019912101376001992100120100199314015180019942015186177934.31199520024740019962917753203826.28199738413489724053.671998505167871038061.83199949314033548539.09USAYear#Funds#MegaTotalcapitalMegacapital%($M)($M)19907419101.201015.5011.1619913617889.701944.5024.65199264414120.104855.0034.38199376218413.003151.4017.121994105526087.706524.8025.0119951111032999.6014404.7043.651996102426791.206746.1025.1819971281457101.1028147.0049.2919981832288312.7046288.7052.4119991412267483.8037205.5055.13 BuyoutReturns103Ofcoursewehavetokeepthingsinproportion.WearetalkingaboutasmallersamplesizeinEurope,becauseofayoungerandthussmallerindustry.Evenbytheendofthedecade,thenumberofEuropeanbuyoutfundsislessthanwasthecaseinAmericaatthebeginningofthedecade(althoughthedifferenceislesspronouncedthanitseems,becauseoftheabsenceofsomeEuropeanfundsfromtheVentureXpertpopulation).However,thereisnogettingawayfromthefactthatwearetalkingaboutloweraveragefundsizesandverysigniﬁcantlylesstotalcapitalinEuropethanintheUSA.TherewasalsomarkedlylessincidenceofmegafundsinEuropeduringthe1990s(theﬁgurespickupafter2000).SinceweareclearlyalsolookingathighervintageyearreturnsinEurope,letusdigalittledeeperandseeifitispossibletoestablishanyspeciﬁcconnections.YouwillseefromTable5.3thatitlooksasthoughoursuspicionswerecorrect.Herewetakefourmainmeasuresofreturn:moneymul-tipleandIRR(bothCapitalWeightedAverageandUpperQuartileineachcase)andmeasurethecorrelationinthevintageyeardataseriesagainstthesameseriesforaveragefundsizeandtotalfundcapital.LetslookattheAmericanﬁguresﬁrst.Herethereisaveryclearandverystrongnegativecorrelationwitheveryreturnmeasureagainstbothourfundraisingﬁgures.Ifaveragefundsizeisbiggeronevintageyearthantheyearbeforethenitishighlylikelythatanyofthereturnmeasureswillbelower,andthesameholdstruefortotalcapitalraised.ForEuropeanfundsduringthesamevintageweseethesamere-lationship,althoughthedegreeofnegativecorrelationislower,signiﬁ-cantlysowhenmeasuredagainstaveragefundsize.IsuggestthatthismerelyreﬂectsthelowerincidenceofmegafundsinEuropeduringthe1990s,whichwehavealreadynotedabove.InboththeUSAandEuropethenthemessageseemstobethatfundsizeandcapitalavailabilityaretheenemyofreturns;themorethecapitalavailableforinvestment,andthehighertheaveragefundsizethenthelowerthereturnsofthatvintageyeararelikelytobe.InEurope,atleast,therehasbeenastrongconnectionbetweengrowthinthetwocapitalmeasures.Asamatterofinterest,letuslookatwhathashappenedtobuyoutfundraisinginrecentyears(Table5.4).YouwillseethatinEuropesince2000bothtotalcapitalandthepercentageofthetotalrepresentedbymegafundshavemorethandoubled,whileintheUSAthetotalhasincreasedbynearly50%whilethemegafundpercentagehasremainedbroadlythesame.Inother 104PrivateEquityasanAssetClassTable5.3Impactofaveragefundsizeandtotalcapitalonbuyoutreturnsbyvintageyear19901999YearUSbuyoutEuropeanbuyoutCWATVPIUQTVPICWAIRRUQIRRAvg.sizeCWATVPIUQTVPICWAIRRUQIRRAvg.size××(%)(%)($M)××(%)(%)($M)19901.801.7210.9012.501231.451.778.5019.4012319911.461.9610.0013.902191.702.0714.5021.506619921.942.3824.4029.702212.542.8828.1032.3012019932.052.2121.6026.102421.992.4217.6022.8010819941.561.9616.8021.602482.782.9542.5049.2025919951.461.8711.7013.602972.191.8944.1020.3012419961.241.496.1010.402631.781.9618.6022.9026719971.371.359.5010.704461.572.1312.3024.1035519981.011.560.7012.504851.221.555.4011.5033619991.281.306.809.604791.101.372.8011.00287Correl.−0.71−0.66−0.57−0.44−0.35−0.28−0.29−0.09avg.sizeCorrel.−0.74−0.67−0.65−0.47−0.63−0.56−0.53−0.43capitalSource:Owncalculations,primarydatafromThomsonFinancialsVentureXpertsystem.Note:Correl.capitalisthecalculatedcorrelationwithtotalbuyoutfundcapitalraisedforthatregioninthatvintageyear(notshown). BuyoutReturns105Table5.4TheimpactofmegafundcapitalinEuropeandtheUSAbyvintageyear20002005EuropeYear#Funds#MegaTotalcapitalMegacapital%($M)($M)200072723088794634.422001505265001791767.612002445192331059255.072003373236601562066.022004351115603586437.592005567535763871472.26USAYear#Funds#MegaTotalcapitalMegacapital%($M)($M)2000150299357763738.6068.112001120247617347027.4061.742002119103779514293.8037.82200398115346833544.5062.742004146218544747199.5055.2420051743113918499766.8071.68Source:OwncalculationsbasedondatafromThomsonFinancialsVentureXpertsystem.words,intheUSAtheimpactofthemegafundsappearstohavereachedaplateausomeyearsago,whileinEuropeitisonlynowﬁndingitsappropriatelevel.Thusifthereisanydifferenceinreturnsduepurelytotheperformanceofmegafundsrelativetotheothers,thenonewouldexpectthistohavearoughlysimilarimpactinbothEuropeandtheUSAfromnowonwards.Thisalsomeansthatifourabovehypothesisabouttheinversere-lationshipbetweenaveragefundsizeandreturnsiscorrect,thenEuro-peanbuyoutreturnsareduetodeclinesteadilytowardsthesortoflevelsbeingachievedintheUSA.Infact,thereissomeevidencetosuggestthattheymayactuallycrossover.Ihaventshownitinanyoftheaboveﬁgures,largelyforreasonsofspace,butifwelookattheperiod19901999morecloselyweﬁndthatinAmericathereareonlytwoyearsoutofthesamplewhentheCapitalWeightedAverageIRRisbelowtheaverage,whereasinEuropetherearesix.ThissuggeststhatthelargerfundshavedonebetterintheUSArelativetoEurope,andthusthatastheimpactontotalreturnsofthe 106PrivateEquityasanAssetClasslargerfundsinEuropegrows,wecanexpecttotalEuropeanbuyoutreturnstodiminishdisproportionately.TheﬁguresaregiveninTable5.5foryoutojudgeforyourself.Admittedlythisisaprettyroughandreadyindicator,particularlyasEuropeanmegafundscanhavehadnoimpactatallonﬁveoftheyearsinquestion,butIsuggestthattheﬁguresinrespectofthelastfouryearsofthedecade(whentheyundoubtedlydidhaveanimpact)maybesig-niﬁcant.Thereisanotherwayinwhichwemightbeabletocheckthistheory,andthatisbylookingatthereturnssinceinceptionofdifferentsizesofbuyoutfundineachregion.InTable5.6,thepooledreturnreferstotreatingalltheconstituentfundsasiftheywereonegiantfundandthencalculatingtheIRRofthetotalcashﬂows.TheUSﬁguresshowasteadydeclineinreturnsasfundsizeincreases.TheEuropeanﬁguressuggeststhattheremaybeahotspotforfundTable5.5RelativeimpactofmegafundsinEuropeandtheUSA,relationshipoftheCapitalWeightedAverageIRRtotheaverageYearUSbuyoutEuropeanbuyoutAverageCWACWA/Avg.AverageCWACWA/Avg.IRR(%)IRR(%)%IRR(%)IRR(%)%19904.1010.90265.8510.808.5078.7019918.2010.00121.9513.6014.50106.62199220.2024.40120.7922.4028.10125.45199319.3021.60111.9220.1017.6087.56199415.2016.80110.5327.4042.50155.1119959.8011.70119.3925.9044.10170.2719967.906.1077.2228.0018.6066.4319974.909.50193.8816.1012.3076.4019985.200.7013.465.805.4093.1019994.206.80161.904.702.8059.57Source:OwncalculationsbasedondatafromThomsonFinancialsVentureXpertsystem.Table5.6Pooledandupperquartilereturnssinceinception(%)USApooledEuropepooledUSAUQEuropeUQMedium($250M17.513.421.818.3$499M)Large($500M12.718.914.715.7$999M)Mega(>$1B)11.3−26.819.1−9.3 BuyoutReturns107size,withreturnsdecliningbothaboveandbelowit.Unfortunatelyitisnotpossibletoinvestigatethisanyfurtherwiththelevelofdataavail-able,butmyinstinctsuggeststhat,ifso,itisprobablysomewherearound$350Mto$600M.Incidentally,thisisclearandstrongevidencefortheexistenceofthefabledmid-marketopportunityinEurope,andforthefactthatmostGPshavenowmovedwellaboveit.IwouldbecautiousaboutreadingtoomuchintotheseﬁguresasfarasEuropeanmegafundsareconcerned;37outof55are5yearsoldorlessandthusmostunlikely,giventheeffectsoftheJ-curve,tobeshowinggoodreturnsyet.However,theydosuggestcauseforsomeconcern.Afterall,atleast11oftheother18areinmeaningfulreturnterritory,andyetthemaximumrecordedIRRsofarisjust23%,andIwouldsuggestthatthisisstillmoreindicativeevidencethat(1)buyoutreturnsdeclinewithrisingfundsizeand(2)EuropeanmegafundshaveyettomatchtheperformancelevelsoftheirUScounterparts.WHATCANWEEXPECTFROMBUYOUTRETURNSINFUTURE?Wehaveadvancedthehypothesisthatfundsizeistheenemyofreturns.Letuscheckthisalittlemore,andthenconsiderwhatimplicationsthismayhaveforreturnsinthefuture.LetuslookagainatEuropeanreturnsduringthe1990s.FirstIwouldliketographaveragefundsizeagainsttheCapitalWeightedIRRforsamevintageyear.SeeFigure5.4.Thisgraphisinteresting,butthetrendlineissomewhatspoiledbytheoutlierinthetopright-handcorner.Iwonderifyoucanguesswhatthisis?Yes,itistheeffectoftheGreatTrainRobbersdistortingtheﬁguresfor1994.Justforfun,letsleaveitoutandtryagain.SeeFigure5.5.Thetrendlineismuchmoresigniﬁcantnow,clearlyindicatingwhatwesuspected,namelythataveragefundsizecanhaveadirectinverserelationshipwithfundreturns.NowletstakealookatUSbuyoutreturnsandseeifwecandiscernasimilarpattern.SeeFigure5.6.Ifanything,thetrendisevenclearerhere.So,itlooksasiftherecanbelittledoubt.Ingeneral,ahigheraveragebuyoutfundsizewillresultinlowerfundreturns,regardlessofwhetherthebuyoutactivityinques-tionistakingplaceinAmericaorEurope. 108PrivateEquityasanAssetClass400350300250200150Averagefundsize($M)1005000.005.0010.0015.0020.0025.0030.0035.0040.0045.0050.00CapitalWeightedIRR(%)Figure5.4Europeanbuyoutreturns19901999byvintageyear400350300250200150Averagefundsize($M)1005000.005.0010.0015.0020.0025.0030.0035.0040.0045.0050.00CapitalWeightedIRR(%)Figure5.5Europeanbuyoutreturns19901999byvintageyear,butexcluding1994Ofcourse,thetrendlinewhichwehavebeenaddingisanartiﬁcialconstruct,andisintendedtogivenomorethanageneralindicationoflikelyfuturereturns.Nobodyissuggestingthatreturnsaregoingtoheaddownwardsinastraightlineuntiltheydisappearthroughtheﬂoorandbecomenegative.Whatisbeingsuggestedisthatthegeneraltrend BuyoutReturns109600500400300Averagefundsize($M)20010000.005.0010.0015.0020.0025.0030.00CapitalWeightedAverageIRR(%)Figure5.6USbuyoutreturns19901999byvintageyearofbuyoutreturnshasundoubtedlybeendownwards,thatthisdownwardtrendhasadirectinverselinktothegrowthbothinindividualfundsizesandtheamountofcapitalbeingdeployedbytheindustryasawhole,andthatallthreeofthesetrendsarelikelytocontinueintothefuture.RECENTFUNDRAISINGLEVELSLetuslook,forexample,atwhathashappenedtobuyoutfundraisingsincetheendoftheperiodwehavebeenexamining,i.e.,from2000onwards.Togetaproperfeelingforthedataseries,Figures5.7and5.8showthetotalamountsraisedbythebuyoutindustryinEuropeandAmericaforthe10-yearperiodsince1996.YouwillseethattherehasbeenadramaticincreaseforEurope,fuelledinlargepartbymegafundssuch8astheonecurrentlybeingraisedwithastatedtargetof−11billionbyPermira.In2005,megafundsaccountedforover70%ofthetotalcapitalraisedinEurope,havingbeenatzeroasrecentlyas1995.Itisthisdramaticshiftinbalance(byfundsizeatanyrate)infavourofthemegafundswhichisoneofthemostintriguingpartsoftheongoing8WritinginAugust2006. 110PrivateEquityasanAssetClassEuropeanBuyoutFundraising60,000NetPeriodAmount50,000Raised(USDMil)MegaAmount40,00030,000USDMil20,00010,000019751984198519861987198819891990199119921993199419951996199719981999200020012002200320042005Figure5.7CommitmentstoEuropeanbuyoutfundsbyvintageyear,showingtheamountsraisedbymegafundsAmericanBuyoutFundraising160,000140,000NetPeriodAmountRaised(USDMil)120,000MegaAmount100,00080,000USDMil60,00040,00020,000019751984198519861987198819891990199119921993199419951996199719981999200020012002200320042005Figure5.8CommitmentstoAmericanbuyoutfundsbyvintageyear,showingtheamountsraisedbymegafunds BuyoutReturns111BuyoutFundraising:USVSEurope140000120000EuroUS10000080000600004000020000075845619998988788901111999899123111999999456111999999789111999990012111900000345222000002202Figure5.9TotalamountscommittedtoUSandEuropeanbuyoutfundsbyvintageyearequation.ThereissimplynoprecedenttoguideusinhowthismightaffectEuropeanreturns,sinceitisaveryrecentphenomenon.However,rememberthattheavailabledata(whichisadmittedlylargelyyoungandthereforeunreliable)seemstosuggestthatmegafundsmaynothaveperformedaswellinEuropeastheyhaveinrelativetermsintheUSA.Finally,lookatthewayinwhichthegapinoverallsizeofthetwomarketsisnarrowingbothquicklyandsubstantially.Itwouldbelogicaltoexpectthemtobeaboutthesame,sincetheyareoperatingineco-nomicblocksofroughlyequalsize,andtheyappeartobeheadedinthisdirection.Givenourearlierhypothesisabouttotalbuyoutcapitalbeinganotherdriveroflowerbuyoutreturns,thenthiswouldseemtosoundyetanothernoteofcautionaboutfutureEuropeanbuyoutreturns,atleastforthelargerfunds(Figure5.9).SOMECONCLUSIONSANDPREDICTIONSSo,ouranalysisoftheavailabledatastronglysuggeststhatthedown-wardtrendinbuyoutreturnsissettocontinue,butletuskeepthisconclusionincontext.First,Istronglysuspectthatthedownwardtrendisnotastraightline,assuggestedbythegraphingtechniqueswehave 112PrivateEquityasanAssetClassbeenusing,butacurve,andthatwherethecurvebottomsoutwillhavealottodowithwhereaveragefundsizesendup.Also,becauseoftheeffectoftheJ-curve,itmaywelltake4or5yearsafterithasinfactbottomedoutforthisfacttobecomeapparent;itmay,forexample,havebottomedoutalready,thoughIdoubtitsince(atleastinEurope)Ibelievethatthereisstillscopeforconsiderableupwardexpansioninfundsizes.Second,Ihavelittledoubtthatbuyoutreturnswillcontinuetoout-performquotedequityreturns(andparticularlyactivelymanagedquotedequity)onatruecost-adjustedbasis.However,inthecaseoftheverylargestbuyoutfundsthedifferentialbetweenthetwowillnarrowconsiderablycomparedwithwhatwehaveseenhistorically.IhaveinvariousarticlessaidIthinkitlikelythatinfuturelargebuyoutreturnsmaybenomorethanabout150basispointsabovequotedequitiesandIamcontenttostickwiththispredictionforthepresent.Third,wemustnotethecontinuingspreadofsyndication,whichwillhaveanongoingtendencytoreducedifferentiationamongstfundreturns.Thishasbeenanissueforsomeyears;forexample,aslongagoasthelate1990sthereweretwoLondon-basedﬁrmswhichhadco-investedwitheachothersooftenthatinvestorsbegantorealisethatitwasinadvisabletoinvestwithboth.Morerecently,thePhilipssemi-conductortransactionsawBainCapitalandApax,whohadbeenpartofanunsuccessfulconsortium,beinginvitedtoparticipateintheequitybythesuccessfulconsortiumofKKR,SilverLakeandAlpinvest.Whiletherehavebeenisolatedexamplesofthisbefore,theextensionofsyndicationacrossconsortiathreatenstocommoditisebuyouttransactionsandreducestillfurtherthechanceofstand-outreturnsbyanyoneﬁrm.Fourth,andlestitbesuggestedthatIamuniformlynegativeaboutthefutureoflargebuyoutreturns,letmesaythatthereareasmallnumberofsuchﬁrmswhohaveout-performedtheirpeersinthepastandwillcontinuetodosointhefuture.Withoutmentioninganynames,couldIadviseLPstolookforthoseﬁrmswhichhaveshownthedisci-plinetostickwiththeirbasicinvestmentmodeltoatleastsomelargedegree,limitingtheirfundsizeinconsequence.Remember,theinvest-mentmodelshoulddrivethefundsize,notviceversa.Wheneverabuyoutﬁrmislookingtoraiseanewfundwhichisconsiderablybiggerthantheirpreviousone,orlookingtocloseafundaboveitsoriginaltargetsize,besuretoquizthemverycloselyastohowtheirinvestmentmodelhaschanged,andwhy. BuyoutReturns113Finally,though,letusremember,lestwebeaccusedofspreadingdoomandgloomabouttheprivateequityindustry,thatweareactuallytalkingaboutaverysmallpartofthatindustryindeed.Sincethebegin-ningof2001,fundsinexcessof$1billionhavemadeup44%ofthetotalfundcapitalraisedintheglobalprivateequitymarket,butlessthan6%bynumber.So,evenifyouhavereservationsaboutthereturnslikelytobeearnedbythemegafunds(reservationswhichtheaboveanalysiswouldappeartosupport,atleastinpart),thenyoucouldsimplyinvestintheother95%ofthemarket,whichbythewaywouldhavegivenyouwellover3000fundsfromwhichtochoose!SUMMARYHistorically,Europeanbuyoutfundshaveconsistentlyout-performedUSbuyoutfunds.Inparticular,Europeanbuyoutfundsenjoyedaperiodofsigniﬁcantout-performanceinthemid-1990s,withboth1994and1995beingstand-outvintageyears.Whilenospeciﬁcunderlyingdataisavailable,itislikelythatearningsgrowthandmultipleexpansionwerethemaindriversofthisEuropeanout-performance.Theseinturnwerefacilitatedbytheexistenceofmarketimperfec-tionsinEurope,leadingtobuyoutﬁrmsbeingabletobuycom-paniesonaproactiveandexclusivebasisthathadlargelyceasedtobeavailablebytheendofthedecade.NocomparableconditionsexistedintheUSAatanytimeduringthedecade.Theavailabledatastronglysuggeststhatthereisadirectinverserelationshipbetween(1)buyoutreturnsbyvintageyearand(2)bothtotalcapitalraisedandaveragefundsizebyvintageyear.Inotherwords,ifeitherthetotalcapitalraisedinanyonevintageyear,ortheaveragesizeofthefundsraisedinanyonevintageyearishigherthanthecorrespondingtotalfortheyearbefore,thenthereturnsofthefundsraisedinthevintageyearinquestionarelikelytobelowerthanfortheprecedingvintageyear.Thusaperiodofsteadilyincreasingfundsizeswouldseemtosignalaperiodofsteadilydecliningreturns.Europewascomparativelylittleaffectedbythemegafundeffectduringthe1990s,buttheEuropeanfundraisingpatternhaschangeddramaticallyinrecentyears,sothatin2005,forexample,mega 114PrivateEquityasanAssetClassfundsaccountedforover70%ofallEuropeanbuyoutcapitalraised.Onemustbecautiousaboutdrawingﬁrmconclusions,sincemuchoftherelevantdataisyoungandthereforeunreliable,butmegafundsappeartohaveperformedsigniﬁcantlybetterrelativetootherfundsintheirmarketintheUSAthantheyhavetodateinEurope.Itseemslikelythatbuyoutreturnsareinlong-termdeclineinEurope,andthatthisdeclineisparticularlysigniﬁcantforfundsoflargersize.Thedeclineisprobablyadownwardcurveratherthanastraightlineandisregressingtowardsboth(1)USbuyoutreturnsand(2)quotedequityreturns.Forthelargerfunds,thereislikelytobelittledifferencebetweenUSandEuropeanreturnsinfutureyears.TheIRRsofsuchfundscurrentlybeingraisedwillprobablystruggletoout-performquotedequitiesonacost-adjustedbasisbymorethanabout150basispoints.Theremaywellbeasmallhandfulofﬁrmswhoareabletoout-performtheirpeers.Logicallythesewillbethosewhoavoidexces-siveexposuretosyndicationandseekoutdealswhichcanbeexclusivetotheirfund.Thosewhoareconcernedbythepossiblelowreturnpotentialofmegafundsshouldrememberthatsincethebeginningof2001theyhaverepresentedlessthan6%ofglobalprivateequityfunds,whichwouldleavewellover3000otherfundsfromwhichtochoose. 6VentureCapitalWHATISVENTURECAPITAL?Justaswehavealreadydoneforbuyout,wewillnowtakeacloserlookatventurecapital.Whatisit?WhatarethequalitiesthatcharacteriseaventureÞrm?Cananyonedoit?Ifnot,whatarethebarrierstoentry?Whatarethecurrentissueswhichconcerntheventureindustry?Thiswillbeanimportantchaptersincearguablythereisnosingleareaofthewholeinvestmentuniversethatismorewidelymisunderstood,ormoreunfairlyviliÞed.AglancebackatTable1.1willremindthereaderofthosethingswhichtendtodistinguishventuretransactionsfrombuyouts,anditwillbeusefultobeartheseinmind.Itistimetoamplifytheseverycon-siderablyaswelookatthetypesofventuredealsandÞrmsthatonemayactuallyencounterinpractice.Unlikebuyouts,whichmaybeclassiÞedbroadlybythetypeandsizeofthedeal,mostventuretransactionsareverysimilarintheirform,whilevariationsinsizetend(exceptduringperiodsofirrationalexuber-ance)tobeafunctionofstage(seebelow).Itisthereforemuchmoreusefultocategorisethemintermsoftheirsectorandstage.However,geographyalsoplaysapart,particularlywhenwelookathistorictrends(thoughIbelievethatthiswillplaymuchlessofaroleinthefuture,andmayindeedevenbecomeirrelevantasventurecapitalbecomesatrulyglobalindustry)andwewillneedtolookinparticularatthedifferencesbetweenthetraditionalÒUSÓandÒEuropeanÓventuremodels.Ishouldmentiononepointbeforewebegin.InChapter1Ipresentedbuyoutandventureastwodistinctandseparateentities,andindeedtheyare.However,aswithmuchofprivateequity,thetruthoftenliesnotinblackorwhitebutintheinterveningshadesofgrey.Iwillbediscussingearlystageventurecapitalalmostexclusively,partlybecauseitrepresentswhathasbecomeknownastheclassicUSventuremodel,butalsobecauseitistheeasiestwithwhichtodemonstratethewayinwhichventuredealsareactuallytransactedanddeveloped,andlastbut 116PrivateEquityasanAssetClassnotleastsimplybecauseitissomuchfun.However,aswewillsee,thereareÞrmswhichquitelegitimatelyspecialiseinlaterstageventureandheretherigiddifferentiationswhichIlaiddownearlierbegintocreakattheseamsalittle.Forexample,thewayinwhichreturnscanbeearnedacrosstheportfolioisdifferent(moreuniforminthecaseoflaterstage,moreexplosivelybinaryinthecaseofearlystage)anddebtcanentertheequation.TherearespecialistprovidersofventuredebtbothintheformofequipmentÞnance(althoughtraditionallyintheUSAthishasbeenhandledbytheequipmentmanufacturersthem-selves)andintheformofworkingcapitalfacilitiesforcompanieswhichhavealreadybecomeproÞtable,oratleastcashßowpositive.Imentionthispointattheoutsetforthesakeofcompleteness,butIwillnotbeseekingtolabourit,notleastbecauseIdonotwanttoconfusetheverysigniÞcantdistinctionsbetweenwhatreallyaretwoverydifferentinvestmentareas.Witnessthefactthatitisalmostunheard-offorthesameprivateequityÞrmtoconductbothventureandbuyouttrans-actions,atleastwithinthesamefund(Apaxdidsountilrecently,butthisisaveryrareexceptionindeed;averyfewothers,suchasDoughtyHansonandCarlyle,havedonesobutwithseparateteamsandseparatefunds).BACKINGNEWAPPLICATIONS,NOTNEWTECHNOLOGYBeforewebeginourdetailedlookatventure,however,letusclearuponewidespreadmisconception.Thereisapopularbeliefthatventurecapitalexiststofundthedevelopmentofnewtechnology.Thisisquitesimplyuntrue.Indeed,IamnotawareofasingleprofessionalventurecapitalistwhowouldbepreparedtoinvestinpuretechnologyriskoftheÒwhenIswitchiton,willitwork?Óvariety.Whataventuremanagerislookingforissomeonewhoislookingtodevelopanewapplicationofanexistingtechnology,whichhasitselfbeentriedandtested.Theyare,inotherwords,notpreparedtotaketheÒwhenIswitchiton,willitwork?Ótechnologyrisk,buttheyareprepared,ifappropriate,totaketheÒwhenIshowittopeople,willtheybuyit?Ómarketrisk.YouwillnoticethatIsaidÒifappropriateÓ.Inthesetwowordsliethefurtherlevelofdistinctionbetweenwhatventurecapitalactuallyisandwhatthemisinformedbelieveittobe.VenturecapitalistsarelookingforanewapplicationofanexistingtechnologythataddressesacommerciallysigniÞcantneedorproblem.Ideally,theentrepreneurs VentureCapital117willhaveworkedinanindustrysectorandwilltherehaveexperiencedaparticularproblemtowhichtheybelievetheynowhavetheanswer;thiswill,forexample,betheclassicmodelofaventure-backedenter-prisesoftwarecompany.Unfortunately,manyideaswhichareputforwardforventurefundingaretechnologyfocusedratherthancom-merciallyfocused.AsoneformerchairmanoftheIrishSoftwareAsso-ciationtoldmealittlewhileago:ÒeveryyearIseetwohundredsolutionsinsearchofaproblemÓ.Theworldisfullofengineerswhobelievetheycanbuildabettermousetrap,butitisnotthefunctionofventurecapitaltosupporttheirendeavours.ThewordsÒcommerciallysigniÞcantÓalsomeritfurtherconsider-ation,sinceitisherethatmuchofaventureÞrmÕsduediligencemaytakeplace.Ifaventurecompanyistoproducethesortofpotentialreturnsforitsinvestorsthattheventuremodelrequires(wewillseelaterthatthisisabout25timescapitalinvested)thenitneedstobeabletogrowquicklytoasigniÞcantsizeandthusthesizeofthepotentialmarketrepresentedbytheidentiÞedneedorproblemiscrucial,asisthelikelypresenceofanycompetitors.ThewordÒsizeÓherenotonlyreferstothetotalityofthemarket,butalsothenumberofparticipants;aproductorserviceforwhichtheremayonlybeadozencustomersworldwide(albeitanycustomerislikelytobepreparedtopaylargeamountsofmoneyforit)isclearlyaninherentlyriskierpropositionthanonewhichcanbemarketedtotensofthousands.Giventheabove,itisunfortunatethatsuchajaundicedandinaccur-ateviewofventurecapitalshouldstillprevail.Yes,ofcoursethereisriskininvestinginventurecompanies,butgiventherightinvestmentplanningtechniquescapitalriskcanbereducedtovirtuallynothingat1theLPlevel,andgiventherightmind-setandexperienceitisactuallysigniÞcantlylowerthanpeoplemaybelieveevenatthelevelofasingleventurefund;Iknowofoneprofessionalventurefundinvestorwhooveraperiodofmorethanadecadedidnotinvestinasinglefundwhichfailedtoreturnitscapital.Wewilllookatthisinmoredetailwhenweconsiderventurereturns.Historically,thiswasnotalwaysthecase,themostobviousexceptionbeingdrugdiscoveryprojects,althoughthepuristmightarguethatevenherethisisrarelytotalinnovation,sincetheresearchteamwillfre-quentlybemovingonwardsoroutwardsfromproteinorchemical1SeeMultiAssetClassInvestmentStrategy,alreadyreferenced. 118PrivateEquityasanAssetClasscombinationswhicharealreadyknowntohavecertainproperties.However,theventureindustry,particularlyintheUSA,hasshownanenviableabilitytodevelopandevolvebyabandoninganythingwhichdoesnotworkwell,andeventhisareahasnowbeenlargelyabandoned,atleastintermsofearlystagedeals.Again,wewilllookatthispointinmoredetaillater,sinceitisonewheregeographyhasaparttoplay.Justtobeclear,then,thereareactuallytworeasonswhyprofessionalinvestorswillshuntechnologycreation,asopposedtotechnologyappli-cationordevelopment.TheÞrstisthetechnologyriskissue.ThesecondisthattheresearchteamsinvolvedwillusuallybepreoccupiedwithinvestigatingaparticularscientiÞcareawithoutanyparticularideaofhowthismightbeappliedtocommercialuses.Itwasnotable,forexample,howlittlesuccesswasenjoyedbythevariousÒnanotechnol-ogyÓfundswhichwentoutfundraisingafewyearsago.CLASSIFICATIONBYSECTORHavingdisposedofthismisconception,letusturnnowtoexaminingthedifferentsectorswithinwhichventureoperates.Therearebasicallythreeofthese:IT,Telecommunications(Telecoms)andLifeScience(sometimescalledHealthcareorBiotech).HistoricallyasigniÞcantamountofventurefundingwasalsodirectedtowardsretailproductsandservices(abrandedchainofsteakrestaurantsintheUSAcomestomind),butIdonotproposetoconsiderthisfurtherasitisnowlargelyofonlyhistoricinterest.Ofcourse,manyinternet-relatedprojectsareaimedattheretailmarket,butIwillconsiderthesewithintheITand/orTelecomssectors.ITSometimesjustreferredtoasÒtechnologyÓdeals,theseweretradition-allydividedintoÒhardwareÓandÒsoftwareÓ(sincethetechnologyreferredtorefersexclusivelytocomputers).However,ImustsayrightattheoutsetthatitisbecomingincreasinglydifÞculttodistinguishbetweenITandTelecomdeals.Thesecategoriesweredreamtuptwodecadesago,whentheaveragePCcouldhavean8-bit4MHzprocessorandonly64KBofmemory.Thecomputerthenwasseenasameansofstoringandprocessinginformationandwastypicallyusedforword-processingandspreadsheetwork.Today,ofcourse,thecomputeris VentureCapital119viewedprimarilyasacommunicationdeviceattachedtoaglobalnetwork,andprocessingandstoragecapabilitiesareregardedascom-modities,andcheapcommoditiesatthat.So,whileIwillhonourtheconventionsofventuredealclassiÞcationforthepurposesofthisbook,pleasebeawarethattodaytheissueisfrequentlynotclear-cut.Howwouldyouclassify,forexample,anewemailapplicationforMicrosoftOutlook?Oranewdevelopmentinwirelessnetworking?Intheearlydaysofventurecapital,technologydealscouldencom-passthedevelopmentofanewcomputeritself,ornewcomputerperi-pherals(therewererepeatedattempts,forexample,todevelopanalternativetotheQWERTYkeyboard),butitisextremelyunlikelythatsuchprojectswouldevenrateameetingwithaventureÞrmthesedays.Thereisgeneralacceptancethatthebasicinfrastructureofcomputertechnologyiscastinstone,andthattheglobalmarketisdominatedbyahandfulofimmenselypowerfulplayers.Thereisperhapsoneexcep-tiontothis,anditliesintheÞeldofmemory.Thecomputerharddisksuffersfromaparticularprobleminthatthespeedatwhichdatacanbemovedaroundandprocessedwithinthecomputerismanytimesfaster(somepeoplesuggestbyasmuchasamilliontimes)thanthespeedwithwhichthediskcanbemechanicallyaccessed.Thismightbethoughtofasasortofholygrailofcomputerdesign,sinceevenasmallimprovementcouldhaveadramaticeffectonperformance.Therearecurrentlyexperimentstakingplacewithdifferentstoragemediaandtechniques;however,thisprobablyfallsfouloftheÒtechnologyriskÓobjectionsreferredtoaboveandisbestlefttotheR&Ddepartmentsofbigcomputercompanies.Thesedays,hardwaredealsaremorelikelytofeaturechips,dataconnectorsandsoforth,althoughtherecanbesomehardcoreproduc-tionengineeringinvolvedaswell,suchasvacuumautomationsystemsforchipandstoragediskmanufacturing.ItisthishardwaresectionwhichperhapsstraysmostinsidiouslyintotheTelecomssector.Howwouldoneclassifythingssuchasradiobasebandprocessorsforwire-lessnetworks,orsomeoftheadvancedlasercomponentsforÞbreopticcommunication?ThelatterisalmostcertainlyÒTelecomsÓ,buttheformercouldreallybeeither.Softwarecompaniescanfallintovariousdifferentcategories.Firsttherearetheso-calledÒtoolsÓcompanieswhichprovideutilitieswhichcanbeusedinthedesignbothofhardwareandsoftware(particularlywherethelatterisobjectoriented),andalsointheconstruction 120PrivateEquityasanAssetClassandoperationofsystems.Wheretheseareusedtodiagnoseandcureparticularoperatingproblems,theyaresometimesreferredtoasutilities.Secondthereistheworldofintegratingsoftware,whichhasbecomeaveryhotarea.BanksandÞnancialinstitutionsareaparticularmarkethere.Mostbankshavelegacysystemsgoingbackmanyyears(datingfromthedaysofgreenscreens!)andhaveovertimeboltedonothersystemsaroundthem,resultinginahugemish-mashoflargelyincom-patiblesystems.Formostbanksitiscurrentlyimpossibletopulltogetheronscreenthefullinformationforanyonecustomerifthatcustomerhasaspreadofaccountsrangingacross,say,currency,tradeÞnance,leasing,investments,etc.Thesewillmostlybedealtwithseparatelyandinmanycasesatleasttwoofthevarioussystemswillbeunabletospeaktoeachother.ThisisanotherÒholygrailÓareabutsubjecttoalargeCatch-22.Whilebankswouldlovetohaveanintegratedsystemtocopewiththedemandofnewregulatoryenvironments(suchasBaselII),theyareunderstandablyreluctanttoclosedowntheirlegacysystemsandsubjectthemselvestothedisruptionwhichweallknowattendstheintroductionofanewcomputersystem,particularlysinceduringanysuchperiodofdisruptiontheycouldhardlyavoidbeinginbreachofexactlythoseregulatoryrequirementswhichtheywereseekingtosatisfy.ThishasinturnledtosomeinnovativeproposedsolutionsintheformofsoftwarethatcanactasaÒfront-endÓ,makingitlookasifanintegratedsystemwereinplacebutinfactoperatingmoreasareportingagent,burrowingintoeachsystemtoextracttherequiredinformation.Operatingsoftwareusedtoformquitealargepartofventureport-folios,butthisisanotherareawhichhasbecomeoflargelyhistoricinterestsincemostoperatingsoftwareisnowproprietaryandthesectorisdominatedbyonehugeplayer,withwhomfewarepreparedtotangle.KleinerPerkins,oneofthemostsuccessfulventureÞrmsinhistory,hasamaximÒdonÕtstandinthepathofanoncomingtrainÓ,whichmeansÒneverinvestinanythingwhichmaycompetewithMicrosoftÓ.Applicationsoftware,too,hasbecomelessattractiveoflate.Anearlysuccessstory(Sage,whichdevelopedsomeoftheÞrstPC-basedaccountingpackageswouldbeagoodexample),thishasbecomeincreasinglystandardised,basedontheWindowsplatformandbundledwithnewcomputers.Therearestillopportunitiesherebuttheyare VentureCapital121tendingnowtobebasedaroundtheemail,chatandcontactmanage-mentspaces.Thereweregreathopesforenterprisesoftware(i.e.,softwarespe-ciallytailoredtotheneedsofaparticularindustry)inyearsgoneby,butthesehavebeenlargelyunfulÞlled,despitesomeindividualsuccessstories.Oneoftheproblemsherehasbeenindustryconsolidation,withthenumberofpotentialcustomersinsomeareas(insurancecompanies,banks,etc.)shrinkingrapidly.Attheotherendofthescale,whereanindustryhasanalmostinÞnitenumberofcustomers,thenventurecom-panieshaveseemedunabletohandlethescaleinvolved,resultingintheenterprisesoftwarespacebecominghighlyfragmented,withalargenumberofsmallplayers(perhapsaroll-upopportunityforabuyoutgroup?),andcopyrightpiracyhasalsobeenasigniÞcantproblem,particularlyincountriessuchasChina.Wheresoftwareisbeingcreated,particularproblemsarefacedbyventurecapitalists.Theprocessitselfmustberigorouslycontrolled,butabalancemustbestrucksoasnottoalienatetheindividualdevelopers;asamatteroftemperament,softwareengineerstendnottorespondwelltodiscipline.Attheveryleast,adailydevelopmentlogmustbemain-tained(anditisworthconsideringhiringoneindividualtodonothingelse)sothatintheeventofthelossofanyonedeveloperorbatchofcodeeverythingcanberecreated.TheotherchallengeliesinsuccessfullymarryingÒabunchofguys2writingcodeÓwithpeoplewhocanselltheproduct,andpeoplewhocanrunthebusiness.Toooften,oneormoreofthesoftwareengineerswillbelievethattheycanÞlltheserolesthemselves,andmaybeallowedtodosobyinexperiencedorirresoluteventurecapitalists.TelecomsThishasprobablybeenthemostexcitingsectorinrecentyearsgivenÞrstthebirthoftheinternetandthenitsrapidgrowth,fuelledinpartbytheotherbigfactor:fast,affordablebroadband.Overthelastdecadeorsowehaveseensomemajortechnologicalchanges.Analoguecom-municationhasgivenwaytodigital.Faxhasgivenwaytoemail.TraditionalcablingsystemshaveinmanycasesgivenwaytoÞbreoptics,whileevenold-fashionedcoppercancarryADSL.Data2AsIonceheardsoftwarecompaniesdescribedataventureÞrmÕsannualmeeting. 122PrivateEquityasanAssetClasscommunicationshaveovertakenvoiceconversationsonbothnationalandinternationalnetworks.Thenofcoursethereisthewholemobileworld,whichwaspartoftheanaloguetodigitalprogressionnotedaboveandhasnowspawnedboth3G,properlyso-called(UMTS)andalsoGPRS,whichiscolloquiallyreferredtoasthirdgenerationbutisinreality2½G.Wenowroutinelyusemobiledevicestoaccessemailandtheinternet,whilewirelesstechnologysuchasBluetoothenablesmachinestotalktoeachother,andwi-Þcreateswirelessnetworksthatallowustouselaptopcomputerstoaccesstheinternetnomatterwhereweare.Yes,thereareproblemswhichhavenotyetbeensolved,butforthemostpartthesearenowpractical,commercial,problemssuchastheunwillingnessofincumbenttelcoseithertoprovidefast,affordablebroadbandthemselvesortoallowotherstodosoovertheirnetworks,orthestubbornnessofoperators(includingmanyofthenewerentrants)topricewirelessbroadbandasthecommoditythatitis,ratherthanasaluxuryproduct.Thetechnicalproblemshavebeenlargelyovercome,thoughmuchremainstobedoneintheÞeldofUMTS.Theseareallfertilegroundforentrepreneursandthusalsofortheventurecapitalcommunity.Oneparticularlypopularareaofinterest(somuchsothatitbecameabubble)wasthewholeoftheopticaltechnol-ogyÞeld.Thereweresomeexcitingsuccessesearlyoninthisarea:Chromatis,ametroopticalnetworkingcompanywhichstartedlifeinIsraelwasboughtbyLucentinMay2000for$4.5billioninstock,whileinthesamemonthAltitun,aSwedishtuneablelasercompanywasboughtbyADCfornearly$900M,representingamultipleofover80timestheinvestedcapitalofitslocalventurebackers.Incidentally,IhavedeliberatelychosenthesetwoexamplesratherthantheirmanyUScounterpartssincetheabilityofventurecapitalistsoutsidetheUSAtocreatehomeruncompanieshasbeenlargelyoverlooked.Wewilllookatthisinmoredetaillater.ParticularproblemstowhichengineershaveturnedtheirattentionintheopticalÞeldhaveincludedtheabilitytosplitanopticalbeamintomanydifferentsignalswithoutanyleakagefromonetoanother,andtheneedtoboostthesignalatregularintervalstopreventitdegrading.Thenthereisthewholeareaoftheopticalroutersandswitcheswhichareneededtotransformanopticalsignalintoawire-carriedone,andviceversa.Intheearlydays,manycompaniessoughttodeveloptheindividualitems(tuneablelasersbeingagoodexample)whichwent VentureCapital123intothesedevices;thisbecameknownasthesubcomponentsÞeld.Today,however,companiesthatlooktoprovidethewholedevicecanbecalledcomponentscompaniesbywayofdistinction.ImentionthisspeciÞcallysinceitisnotanobvioususeoftheterminologyÐitwouldseemmorelogicaltocallthemcomponentanddevicecompanies,respectively.Theopticalbubblewasasdevastatinginitswayasthedot.combubble,thoughbecauseithappenedinaspecialistareawithwhichconsumershadnodealing,andwhichwasofinterestonlytoengineersandventurecapitalists,itreceivedrelativelylittlepublicity.Infairness,theproblemwasnotjusttoomanyventurecapitalistsputtingtoomuchmoneyintotoomanyopticalcompanies(thoughthiscertainlyhap-penedÒinspadesÓ,astheAmericanssay).MoreperniciouswastheconductoftheincumbenttelcosinbothEuropeandtheUSAindenyingnewoperatorsaccesstotheirexchanges.Thispreventedthenewentrantsfromrollingoutthehighspeednetworksforwhichtheywerepurchas-ingtechnologyfromtheventure-backedstart-ups,withtheresultthatmostofthemsimplyranoutofmoneyandwentoutofbusiness.Sincethetelcosthemselveswereveryresistanttotheideaofusingthenewtechnology(sincetheycouldenjoythepositionofbeingabletosellobsoletetechnologytotheirexistingcustomersonamonopolybasisatahighprice),theventurecompanieswerefacedwithanightmaresitu-ationofadramaticfallinthenumberofcarriers,whowerethenaturalcustomersfortheirproduct.Somewereabletoselltoequipmentmanu-facturers,andthisinturnpromptedawaveofcorporateacquisitionssuchastheLucent/Chromatictransaction,butthisprovedshort-livedasthefullpotentialdownsideofthemarketcrashbecameevidentandlargecorporationstheworldoverslashedtheirbudgetsforR&Dorthepurchaseofnewtechnology.Asthislastwindowclosed,theopticalsectorenteredanuclearwinterfromwhichitisonlyslowlyemerging.Anotherareaofinterestismobiletelephony,wheretheNordicarea,andparticularlyFinlandhastraditionallyledtheway.Mobileapplica-tionshavefeaturedinmanyventurecapitalportfoliosandthereissomegeographicvariationhere;forexample,SMSmessaginghasbeenrampantinEuropeforyears,particularlyamongyoungerpeople,buttooksometimetocatchoninAmerica.OneshowingconsiderablenoveltyvaluewasacomputerdatingapplicationthatwasbetatestedamongthegaycommunityinLosAngeles.Havingfedyourpreferences(historydoesnotrecordwhatcategoriestheremighthavebeen)into 124PrivateEquityasanAssetClassthesystem,theapplicationwouldtrackyourlocationandifyouwerefoundtobewithinacertainnumberoffeetofsomeonewhoseprefer-encesmatchedyourownthenbothmobileswouldringsimultaneously.AlthoughthetraditionalsetofmobiletechnologyhasbeentheNordicarea,manyinnovativeapplicationshaveoriginatedinIsrael.Duringtheperiodleadinguptothecollapseofthedot.combubblesomeventureÞrmsalsobackedlargesystemscompanies,includingbusinesseswhichwereactuallyinstallingandoperatinghighspeedmetronetworksforbusinesscustomers.Howevertheseprovedpoorinvestments,asthelargeamountsofcapitalrequiredtofundtheirroll-outcouldnotbejustiÞedintermsoftheultimatevaluationofthebusi-ness,soIdoubtwhetherweshallseecompaniesofthistypeinventureportfoliosinfuture.LifeScienceLifeSciencehastraditionallybeendividedintotwobroadareas,althoughthisclassiÞcationisnolongerexhaustive.TheÞrstisthedrugdiscoveryarea,whichasthenamesuggestsinvolvesbackingresearchteamswhowishtospinoutofuniversitylaboratoriesortheR&Ddepartmentsoflargedrugcompanies.Thisisprobablyverymuchthestereotypeviewofwhatventurecapitalisallaboutonthepartofthosewithnoactualknowledgeofthearea.Infact,aswehavealreadyseen,thereisverylittletruthinsuchanimageatall.TheothermainareaofspecialtyisusuallyjustcalledÒdevicesÓ,andasthenamesuggestsdwellsonthevarioussortsofdeviceswhichareusedinthemedicalprofession,rangingfromstents(thetinytubesinsertedintobloodvesselsduringsurgery),throughdiagnostictestingequipmenttolarge,expensivescanners.Perhapsthemostexoticvari-antsIhaveencounteredwereapumpplumbedintothepenistofacilitateerections(thiswasinthedaysbeforeViagra),andwhatwasenthusi-asticallydescribedasÒaßightsimulatorfordentistsÓÐanartiÞcialreplicaofthehumanmouthonwhichdentistscouldpractisetheirgentlearts.AsIsaid,thesetwoareasarenolongerexhaustive.Themajorchangehasbeenbroughtaboutbythesuccessofthehumangenomeprojectwhich,asoneleadingventurecapitalisttoldmeÒmeansthateveryoneissuddenlyplayingwithanewdeckofcardsÓ.InadditiontopureresearchprojectsinthegeneticÞeld(usuallyinvolvingidentifyingtheexactgeneticcombinationwhichcausesaparticularcondition,and VentureCapital125whetherthisbecomesdefectiveinsomewaywhichcanbereversed,thusforestallingtheonsetofthecondition),thereisnowspecialistgeneticsoftwarewhichcangreatlyspeedupthisprocess,aswellasassistingdrugdevelopmentbysuggestingcompoundswhichareknowntohaveworked(orareclosetocompoundswhichhaveworked)before,andanticipatingpossibleside-effectsintimeforalineofresearchtobediscontinuedearly,withconsequentsavingsintimeandmoney.Anotherareawhichhasgrownupisthatofspecialistservicesinthehealthcarearena,particularlyintheÞeldoftesting,analysisanddiag-nostics.Interestingly,thisareahasalsobeenofinteresttobuyoutÞrms,driveninpartbythetrendforbothhospitalsandlargecompaniestooutsourceserviceprovisiontospecialistthirdparties.LifeScienceinvestinghasincreasinglybecomeataleoftwocontin-ents.Whilethereislittlepubliclyavailabledatatobackthisup,apoc-ryphalevidenceandmyownpersonalexperiencestronglysuggestthatLifeScienceventuredealshaveperformedbetterinEuropethantheyhaveintheUSA,bothinabsoluteterms(i.e.,thatEuropeanLifeSciencedealshaveachievedbettermultiplesonaveragethantheirAmericancounterparts)andalsoinrelativeterms(i.e.,thatLifeSciencehasgenerallyperformedbetterthantechnologydealsinEurope,withtheoppositebeingthecaseinAmerica).InfairnesstotheAmericanventurecommunity,however,itmustbeadmittedthatthislatterpointlosesmuchofitsforcewhenoneconsidersthattechnologyventurereturnsinEurope(atleastasrecordedintheavailableindustrydata-3bases)havebeenextremelydisappointingforthemostpart.Whateverthecase,thishasledtoanumberofdevelopments.ItusedtobethecasethatventureÞrmswouldroutinelypractisebothTechnologyandLifeSciencewithinthesamefund(thiswaslessuni-versalinAmerica,butstillafrequentoccurrence).IntheUSA,however,thispracticehasbeenalmostentirelydiscontinued.Publicly,thestatedreasonforthisisusuallyadesireforfocus,andthedesirabilityofallpartnerswithintheventureÞrmtobeabletounderstandanddiscusseveryoneelseÕsdeals.Privately,thereasonisclear.Rightlyorwrongly,LifeScienceisseenashavingunder-performed,andthetechnology-focusedGPswanttobefreetopursuetheirbusinesswithoutthisper-ceiveddragontheirfundreturns.Consequently,mostventureÞrms,andthatincludesjustaboutalltheleadingones,haveeitherhivedoff3Wewillseelaterthattheseconsistentlyunder-stateEuropeanventurereturns,butthisdoesnotchangethepointIammakinghere,onlylessensitsextentalittle. 126PrivateEquityasanAssetClasstheirLifeScienceteamstobecomeseparateÞrms,orclosedthemdownentirely.IcanrememberbeingattheannualmeetingofaventuregroupinCaliforniasometimearoundmid-2001,whentherehadbeenasuddenßurryofinterestinLifeScienceventuresbymanyLPs,andtheGPwhowasonthepodiumatthetimedescribingthecurrentsituationsaidÒyouknowthingsmustbebadwhenLifeSciencestartstolookattrac-tiveÓ.ImentionthisonlytoillustratetheattitudetowardsLifeSciencethatissincerelyfeltbymanyintheAmericanventurecommunity.Whileitmayseemaverysweeping(nottomentionsomewhatjaun-diced)statement,thereareanumberofveryvalidreasonsbehindthisattitude,anditmaybeworthtakingalittletimetoconsidersomeofthem.ChiefamongstthemisthewholequestionoftheapprovalprocessformanyLifeScienceproducts.TheFDAapprovalprocessfornewdrugsandothertherapeuticproducts,forexample,canbeverylengthyandinvolveclinicaltrialslastingyearsratherthanmonths.Giventhatanewdrughasalimitedpatentperiodduringwhichtoearnroyalties,thishasbeenamajorstumblingblocktoachievingventure-typereturns,particularlywhencoupledwiththeverylargeamountsofmoneywhichsuchaventurecompanytypicallyrequires.Thecombinationofalongholdingperiod,highcapitalrequirementandlimitedincomeperiodmakeitverydifÞculttojustifythisasalegitimateventurecapitalactiv-ity,particularlygiventheextremeproductriskinvolved(ithasbeenestimatedthatasfewasoneineveryhundredthousandpharmaceuticalresearchprojectseverresultinacommerciallyavailabledrug).Intruth,ÒpharmaÓitselfmirrorscloselytheearlystageUSventuremodel,wheretheoccasionalhomerunsuchasViagraorZantacjustiÞestheverymanyfailuresandalso-rans.However,heremuchcompetingactivityiscarriedonbythebigpharmacompaniesthemselves,andsothereistheaddedcomplicationthatasaventureÞrmyoudonotevenhaveaccesstoallthepotentialhomerunsfromwhichtomakeyourselection.Thislatterpointisoftenoverlooked.TheargumentsagainstotherformsofLifeScienceactivityarelessclear-cut.Thereseemsnoobviousreason,forexample,whymedicaldevices,particularlyoftheexternaland/ordiagnosticvariety,whichrequireaverylighttouchonthelicensingtiller,shouldnothavethepotentialtobesuccessfulonasimilarscaletootherformsoftechnol-ogyprojects.Whilethedataisnotavailabletosupportthis,itwouldbemyinstinctthatwhatislackinghereiswidespreadgenuinehome VentureCapital127runpotential.AnapplicationsuchasGoogle,AmazonoreBaycanmeetneedsandchangebehaviourpatternsacrosstheglobe.Intheearlydaysofchipdevelopmentarelativelysmalladvanceinmicrochiptechnologycouldincreasethepowerandspeedofacomputerbytwo,orevententimes.ShortofanartiÞcialbrainorafunctionalsuspendedanimationmachine,itisdifÞculttoconceiveofamedicaldevicethatcouldhaveasimilarimpact.Since,aswewillsee,itishomerunsthatdriveventurereturns,thenitmaywellbethatthisisamajorreasonwhyUSventureÞrmshaveshunnedthissectorinrecentyears.Thereisanotherpossiblereasonwhichismorenebulous,butIthinkstillvalid.Americahasledtheworldintechnologicaladvancementininformationtechnology,particularlyinsoftware,applicationsandhard-warebundling(notnecessarilychiptechnology,muchofwhichwasdevelopedintheFarEast,andcertainlynotinTelecoms,wheremuchpioneeringworkwasdoneinEurope).Thus,ifonewasabletoestablishaleadingpositionacrosstheUSAasaproviderof,say,aninternetsearchengine(Google,Yahoo),oroperatingsoftware(Microsoft)orbundledhardware(Dell),thenapositionofgloballeadershipfollowedmoreorlessautomatically.Inotherwords,theamountofproactivemarketingindifferentpartsoftheworldthatwasrequiredintheveryearlystagesofthecompanyÕslifeisprobablynegligible.Thatisnottotakeanythingawayfromtheachievementsofsuchcompanies,whichhavebeenimpressiveonatrulystaggeringscale;Iamsimplyseekingtodrawadistinction.Compareandcontrastthiswiththepositionofayoungmedicaldevicescompany,perhapstheoneIreferredtoabovewhichdevelopedaßightsimulatorfordentists.Almostfromthedaywhentheyhadtestproductavailable,theyneededdedicatedsalespeoplearoundtheglobetryingtosellsometimesindividualmachinestoteachinghospitals,wrestlingwithdifferentlanguages,buyingpracticesandregulations.ThatsameteachinghospitalwouldprobablyhaveboughtWindowssoftwareforeachnewcomputerwithoutevenstoppingtothinkaboutit,andwithoutMicrosofthavingtomakethatsalespeciÞcallytothem.Thus,companieswhereitispossibletoestablishapositionofgloballeadershipwithouthavingtostepoutsidetheirhomemarketintheirearlydaysclearlyenjoyasigniÞcantadvantage,andthecompaniesIhavementionedabovehavedoneagreatjobofexploitingthatadvantagetoitsmaximumpotential.So,yes,therearesomevalidreasonswhyLifeSciencehaslostfavourintheUSA(althoughitstillhasadedicatedfollowingamongstmany 128PrivateEquityasanAssetClassLPs),butIwouldposetwoquestionstowhichIdonotknowtheanswers,butcouldguessatthelikelyoutcomes.First,ifUStechnologyventurehadnotbeensodramaticallysuccessfulduringthemid-1990s,wouldthebifurcationinUSventureandtherelegationofLifeSciencestoperceivedsecondplacenecessarilyhavehappened?Second,ifoneacceptsforthesakeofargumentthatitisnolongerpossibleforanyLPnewtotheassetclasstoaccessanyoftheleadingtechnologyventurefunds,thenwhichispreferable(inUSterms):toinvestinupperquartileLifeScience,ortoinvestinsecondorthirdquartileTechnology?InEurope,thepatternhasbeendifferent.LifeSciencestillroutinelyformshalfoftheactivitiesofmanyleadingventureÞrms(InnovationsKapitalinSwedenandSoÞnnovainFrancebeingtwoobviousex-amples)andinadditiontherearesomeveryrespectedÞrmswhospe-cialiseinnothingbutLifeScienceinvesting(HealthCapinSweden,currentlyinvestingFundV,isoneoftherecognisedleadersinthisÞeld,thoughmulti-stageratherthanjustearlystage).Asmentionedabove,thisislargelybecausethesectorÕsperformancehasbeenviewedinamuchmorefriendlylight.ItmayalsohavesomethingtodowiththefactthatmostoftheworldÕsleadingpharmacompaniesarebasedinEurope,andthatperhapstherearethusmorespin-outopportunitiesavailable;indeed,Actelion,oneofEuropeÕsmostlucrativeventuredealstodate(ahugesuccessforJoelBesseandtheLifeScienceteamatAtlas4Venture)wasjustsuchatransaction.However,notwithstandingtheseapparentdifferencesitisfairtosaythatdrugdiscoverydealshavebeendeclininginEuropetoo.Intruth,itwasprobablyalwaysdifÞcultforEuropeanventureÞrms,withtheirsmallfundsizes,toÞnancethesesortsofundertakingsandthereisinanyeventagrowingfeelingthattheseprojectsareprobablybestlefttolargepharmacompaniesoruniversityresearchlabs,atleastintheirearlystages.CLASSIFICATIONBYSTAGEWehavejustlookedatoneofthetwomainwaysofclassifyingventuredeals,namelybysector.Theotherisbystage,andthisislessclear-cutthantheformer,sincethereisconsiderableloosenessofterminology.4ActelionwentpublicontheSwissstockmarketinApril2000,just2yearsafteritsÞrstventureÞnancinground(therewereonlyevertwo)atavaluationinexcessof$800M,reputedlygainingitsventurebackersamoneymultipleinexcessof200×. VentureCapital129Table6.1TheventureuniversebysectorandstageLifeSciencesTelecomsITSeedSeedSeedEarlyEarlyEarlyMidMidMidLateLateLateVenturedeals,unlikebuyoutdealsforthemostpart,willenjoysucces-siveroundsofÞnancing,andthepointinthecompanyÕsdevelopmentwheneachoftheseroundsoccurswilldeterminewhethersucharoundis,forexample,ÒearlyÓorÒmidÓ.CertainventureÞrmsspecialiseindifferentstages;thusalatestageÞrmmightonlyinvestfortheÞrsttimeinthefourthorÞfthround,whileaseedÞrmwilltendtoinvestheavilyatthebeginningandthenseeksubsequentlytoinvestthebareminimumnecessarytomaintainasigniÞcantequityposition(atleastinEurope,wheretheavailabilityofseedcapitalisseverelylimited).Attheriskofstatingtheobvious,thevaluationofthecompanywilltypicallyrisewitheachsuccessiveroundasitsperceivedriskdecreases,andthusintheorythegainsavailabletotheventurecapitalistsinvolvedwillcorrespondinglydiminish.Itisaclassicexampleoftherelationshipbetweenriskandreward.Broadly,theventureworlddividesbystageintoseed,earlystage,mid-stageandlatestage.Thus,theventureuniversemightbethoughtofasagrid(Table6.1).Letustakealookateachstageinturn,andweneedtobequiteclearwhatwemeanbytherelevanttermineachcase.SeedThistermisparticularlycorruptedinEurope,wherealotofventurecapitalistsclaimtobeÒseedÓinvestorswhoarereallynothingofthekind.ThewordÒseedÓcarriesverystrongimplicationsofatotalstart-up,andinmyviewthatshouldbethesenseofthewordadoptedbytheindustryasawholetoavoidconfusion.However,whilethisisbroadlytrue,industrypracticealsorecognisesasaÒseedÓroundonewhichoccursveryearlyinthelifeofacompanybutnotquiteattheoutsetiftherehasbeenanÒangelÓroundtofundtheactualstart-up. 130PrivateEquityasanAssetClassAnangelroundisoneputtogetherbyangelinvestors,i.e.,investorswhoarenotprofessionalventurecapitalists,andthereareimportantdifferencesinpracticeandpossibleconsequencesbetweentheUSAandEuroperelatingtoangelroundswhichmeritaseparatesectiononthisbelow.Imustapologisefortheconfusionthatthisintroducesintoproceed-ings,notleastbecauseitcanhaveaknock-oneffectsofarastheclassi-Þcationofsubsequentroundsisconcerned.However,thisconfusionisnotofmymakingandIamsimplytryingtoclarifyasbestIcantheobfuscationthatindustrypracticehascreated.TherearemanyventureÞrmswhoclaimthataÒseedÓroundistheÞrstoneinwhichatleastoneprofessionalventureÞrmparticipates,evenifthishappensayearortwointothelifeofthecompany.Whileeverysituationisdifferent,anditishardtolaydownuniversalrules,IhaveproblemswiththisdeÞnition.IagreethatingeneraltheÞrstroundinwhichaventureÞrmpartici-pateswillbeaseedround(particularlyinAmerica).However,wheretherehasbeenalongperiodbetweenthestart-upofacompanyandtheÞrstinstitutionalround(asisfrequentlythecaseinEurope)thenIdonotbelievethatthisisaproperuseoftheterm,andIwouldmuchpreferthephraseÒARoundÓtobeemployed.Howlongistoolong?Well,deÞnitelyifacompanyisgeneratingrevenuesandprobablyeveniftheyhavetestproductoutwithalphaorbetacustomers.ThewordÒseedÓimpliestheveryearlystagesofacompanyÕsexistenceandwemustnotlosesightofthis.SoIwouldsuggestthefollowingasananswertothequestionÒwasthisaseedround?Ó.Inanyparticularcase:¥Wherethecompanyisagenuinestart-up:deÞnitely.¥Wherethecompanyhasyettoproduceitsproductorserviceinevenalphatestingform:probably.¥Whereacompanyhasproductintest:probablynot.¥Whereacompanyisgeneratingrevenues,nomatterhowsmall:deÞ-nitelynot.Asthestoryofseedfundingunfolds,differencesbetweenEuropeanandUSpracticebecomeverystark.ItisprobablynotgoingtoofartosaythatwithaveryfewhonourableexceptionsthereareactuallynoEuropeanventureÞrmswhoarepursuinggenuineseedstageopportu-nities.Tounderstandwhythisis,IamafraidweneedtotakequitealengthyexcursionintotheUSventuremodel. VentureCapital131THEUSMODELAswewillseeinalaterchapter,sofarashistoricreturnsareconcernedthenventureisthemirrorimageofbuyout;notonlyhaveAmericanreturnsbeenbetter,theyhavebeenquitedramaticallybetter.ThishasgivenrisetoanimpassioneddebateaboutwhetherthereissomethingintrinsicallysuperioraboutthewayinwhichUSventureÞrmsdobusi-ness,orwhetherenvironmentalfactorsproducedaÒhappyhuntingtimeÓinUSventureinthesamewaythattheymaywellhavedoneinEuropeanbuyout.Wewillbeexaminingthisdebatelater,butsufÞcetosayforthemomentthattheanswer,asusual,isÒsomeofbothÓ,butwemustatthispointexaminetheformerofthesepoints,sincewecannotsensiblydiscussseedfundingunlessweunderstandwhattheUSmodelis.ThereareanumberofcomponentstotheUSventuremodel,andalthoughtheyinteracttothepointthattheyformacohesivewhole,wewilllookateachoftheseinturnforeaseofdiscussion.Theyare(1)afocusontheseedstage,(2)ahomerunmentalityand(3)ÒvalueaddÓ.SeedStageFocusAswewillseeshortly,twoofthethingswhichUSventurecapitalistslooktodoistoachieveashighamoneymultipleaspossibleandtoaddvalueinactuallybuildingacompanyalongsideanentrepreneur.Bothsuchthingsarefacilitatedbytryingtoinvestwhereverpossibleattheseedstage.Thisbooststhechanceofbeingabletoachieveahighmoneymultiple(becauseoneisgettingintothecompanyatthelowestpossiblevaluation)andalsoallowstheventurecapitaliststobuildthecompanyfromdayoneinthewaytheybelieveitshouldbebuilt,ratherthangettinginvolvedatalaterstageandpossiblyhavingtounscrambleunsatisfactoryarrangementsthatmayalreadyhavebeenputinplace.Inordertoincreasethepossibilityofsourcingqualityseedstagedealßow,andalsotoincreasethechancesofbeingabletoworkwithexperiencedcompanybuildersinthatseedstagedealßow,manyUSventureÞrmsadoptanÒEIRprogrammeÓ.ThisisanintriguingandexcitingprocesswhichhasnotasyetbeenwidelycopiedinEurope.ItconsistsofÞndingthreeorfourexperiencedentrepreneurs(whohavepreferablybeenbackedpreviouslybytheÞrminsuccessfulventures 132PrivateEquityasanAssetClassandarenowÒgoingroundagainÓ)anddesignatingthemasÒentrepre-neursinresidenceÓ(EIRs).TheyareencouragedtospendtimeintheÞrmÕsofÞcestalkingtostart-upteamsabouttheirideas.Theaimispartlythattheymightbeabletojoinoneoftheseteams(probablytoleadit)iftheyliketheideasufÞciently,butthisismoretheprovinceofso-calledÒventurepartnersÓ.TherealobjectivewithanEIRisthatheshouldbepersuadedactuallytostarthisnextcompanyrightthereintheventureÞrmÕsofÞces,usingtheirfacilitiesandinfulldiscussionwiththeGPsandwitheveryexpectationofbeingfundedbythem.ThisprocessiscalledÒincubationÓandisverydifferentfromthewayinwhichthetermisusedinEurope,wherefrequentlyallthatisprovidedisagloriÞedbusinesscentre,withlittlehands-onsupport.WhileitisdifÞculttobecertain,sincenoperformanceÞguresforindividualfundsarepubliclyavailablebrokendownbystage,thereisageneralbeliefthatitisseedstagefundswhichhaveconsistentlyscoredthebestreturnsintheUSA.ThisisborneoutbytheavailableindustryÞgures.Wewillbelookingatthisinmoredetailinalaterchapter,butletusglancequicklyinpassingattheTVPIÞguresforUSventuresinceinceptionbrokendownbystage(Table6.2).Youwillseethatthisshowsroughlywhatonewouldexpect,withthefundÕsmoneymultipledecliningslightlythelaterthestageatwhichitsinvestmentfocuslies.Iappreciatethatthesedifferencesmayseemslightinviewofthepossibledifferenceintheperceivedriskofeachstage,buttheytellonlypartofthestory,sincetherealexcitementofventurereturnsliesattheuppermargins.ThebesteverearlystagefundrecordedbyVentureXperthadafundmultipleofover28×,whilethemostsuccessfullatestageoneenjoyedamultipleof14.6×;thebestbalanced,i.e.,multi-stagefundwasinthemiddleasonemightexpectatjustover16×,andIthinkthattheseÞgurespresentamuchmorepotentviewofwhatmightbeexpected.Table6.2USventurereturnsbystage;TVPIsinceinception,1969to2005inclusiveStageCapitalWeightedAverageUpperQuartileEarly/Seed1.572.56Early1.582.29Balanced1.472.23Late1.422.09Source:ThomsonFinancialÕsVentureXpert.Note:ÒBalancedÓreferstofundswhichinvestatallstages. VentureCapital133HomeRunMentalityThisphraseisbandiedaboutcontinuallywhendiscussionturnstoAmericanventurepractice,butoftenwithlittlerealunderstandingofwhatliesbehindit.Brießy,asweshallbediscussinginmoredetailinthenextchapter,USventurereturnshavebeendominatedbyasmallnumberofverybigwinnersÐthehomeruns.Publiclyavailableevi-denceissketchy,butleadingUSventurecapitalFundofFundsmanagerHorsleyBridgereleasedintothepublicdomainsomeyearsagotheiranalysisoftheirowndatabase(whichisgenerallyrecognisedasbeingthebestintheindustry),whichwasthatslightlylessthan5%ofallcompaniesbycostproduced80%ofreturnsbyvalue,andastheseconclusionshavebeenwidelyquotedandneverchallengedIthinkwemaysafelyadoptthem.AdifferencewhichhasoftenbeenclaimedtoexistbetweenUSandEuropeanventurecapitalists(withmuchjustiÞcation,inmyview)wasthatAmericanGPsrecognisedthisandadaptedtheirapproachaccord-ingly,whereasEuropeanGPsdidnot.Idonotwanttogetdrawnintothisdiscussiontoodeeplyatthisstage,asitisoneweshallbehavinginthenextchapter,butletusnoteforourpresentpurposesthatthisinvolvestryingtogroweverycompanyinwhichtheyinvestintoaverylargecompany,insteadofjustamedium-sizedcompany,andnotcon-sideringforinvestmentintheÞrstplaceanycompanywhichdoesnotappeartohavethispotential.Italsofollowsthat,unlesstheyhavelostconÞdenceinacompany,theywillresistthetemptationofanearlyexit,preferringtoÒswingforthefenceÓ.“ValueAdd”ThisisanAmericanphrasethatwouldperhapsbemoreelegantlyexpressedasÒaddedvalueÓ.ItdescribesthatabilityofAmericanventurecapitaliststogetcloselyinvolvedwithacompanyÕsdevelopmentonahands-onbasis,usingtheirownpersonalknowledgeandcontactsgainedinmanycaseswhentheythemselveswereanentrepreneurwhohadfoundedastart-upcompany.ItiskeytotheUSventuremodel,andistheoneelementofitwhichhasingeneralbeenundeniablylargelyabsentfromEuropeanventureactivity.WhenanAmericanentrepre-neurtriestoattracttheattentionofaventureÞrmheisnotgoingthereprimarilyformoney,butfortheÞrst-handoperatingexperienceofitsGPs.AEuropeanentrepreneur,bycontrast,willbedesperateformoney 134PrivateEquityasanAssetClassfromanysource,sincethereismuchlessofitavailableforearlystagecompaniesinEurope,andwillnotexpectoperatingexperiencetobeonoffer.THEUSMODELCOMESTOEUROPESincewearedealingwiththeUSmodelatthispoint,itisonlyfairtopointout,sinceitdoesactuallyimpactonthequestionofstageprefer-ence,thatwhiletheabovedistinctionsbetweenUSandEuropeanventurewerelargelyvalidonahistoricalbasis,theyarebecominglesssowitheverypassingyear.ThereareanincreasingnumberofEuropeanventureÞrmswhorecognisethemeritsoftheUSmodelandaremakinggreateffortstoapplyitinEurope.Thiswillbeofpar-ticularrelevancewhenwecometoconsiderventurereturnsinlaterchapters.WhyEuropeanVentureCapitalFirmshaveAvoidedtheSeedStageIfyoudonothavetheÞrst-handoperatingexperiencetobringvalueaddtothepartythenthepicturechangesdramatically.FrombeingviewedasanareaofopportunityintheUSA[becauseyoucan(1)getinatalowvaluationand(2)buildthecompanyasyouwouldlikeittobefromdayone],itisviewedasanareaofriskinEuropeandthusanareatobeavoided,ratherthansoughtout.ÒComebackwhenyouÕvegotsomecustomersÓisacommonlyheardrefrain,accordingtotheÞrst-handaccountswhichIhearfromentrepreneurs.Incidentally,itisherethatalotoftheconfusionoverterminologyarises.TherearesomeEuropeanÞrmswhoarehonestenoughtosayÒwedonÕtdoseedÓ,buttherearemanyotherswhoseektoportraytheimageofbeingveryearlystageinvestorswithouthavingeithertheskillsortheinclinationtodoso,andtheydothisbycallingwhatareessentiallyARoundsÒseedÓ.Icanonlyrepeatmyownbelief,whichisdrawnfrommanyyearsofpracticalexperience,andletmephraseitverycarefully:inmyexperiencetherearealmostnoindependent,professionalventureÞrmsinEuropewhooffergenuineseedroundfunding.Thereareaveryfewwhodo,andIhappilyacknowledgethefact,buttheyarevery,veryfewinthecontextoftheindustryasawhole. VentureCapital135CLASSIFICATIONBYSTAGE,CONTINUEDEarlyStageInvestingWediscussedabovethedifferencebetweenÒseedÓandÒearlyÓ.ItakeÒearlyÓasmeaningagenuineARoundtogetherwithapossibleBRoundiftheARoundwasverysmalland/orveryearlyinacompanyÕslife,and/ortheBRoundquicklyfollowedtheARound.Aswithsomanyaspectsofprivateequitythisisanartnotascience,andinstinctandexperienceareprobablymoreimportantthanscientiÞcanalysis.ItisatearlystagethatthebulkofEuropeanÞrmsenterthefray.Infairness,itmakescomparativelylittledifferenceinvaluationterms,asshortageofcapitalensuresthatthereisusuallylittledifferencebetweenthepre-moneyvaluationofacompanyintheearlystagesofitslifeandthepost-moneyvaluationoftheprecedinground,butintheUSAitcanmakeadramaticdifference.Mid-andLateStageInvestingTheskillsrequiredforalaterstageventureinvestoraredifferentfromthoseneededatearlystage,andstarttoapproachthosethatonemightÞndinabuyoutÞrm.Financialanalysisbecomesincreasinglyimpor-tant,andtechnologyskillsandsectorknowledgelessso.Debtcanalsoenterthepicture,eitherbywayofworkingcapitalfacilities(ifthecompanyhasthecashßowtojustifyit)orbywayofequipmentÞnanc-ing(whichmightactuallybepresentfromaveryearlystageofthecompanyÕsexistenceinsomecircumstances).PleaserememberthatthetermÒmezzanineÓisoftenusedtodescribeverylatestage(typicallypre-IPO)ventureinvestingintheUSA,whereasinEuropethistermisusedexclusivelytodescribeconvertibledebt,almostexclusivelyforbuyouttransactions.SUMMARY¥ThemaindifferencesbetweenbuyoutandventurearesetoutinChapter1.¥VenturecanbeclassiÞedbysectorandbystage.¥ThethreemainsectorsareLifeSciences,InformationTechnology(ÒITÓ)andTelecommunications(ÒTelecomsÓ).Thelattertwoare 136PrivateEquityasanAssetClassfrequentlyreferredtotogetherasÒTechnologyÓtodistinguishthemfromLifeSciencesandthedistinctionbetweenthemisbecomingincreasinglyblurred.¥Themainstagesofinvestmentareseed,early,midandlate.Again,thedistinctionbetweenthemisfrequentlyblurredandtheycanmeandifferentthingstodifferentindividuals.Inparticular,theusageofÒseedÓandÒearlyÓisoftenconfused,especiallyinEurope.¥HistoricreturnsintheUSAhavebeendrivenbyasmallnumberofverylargewinners,whicharereferredtoashomeruns.Strictlyspeakingahomerunisanyinvestmentthatreturnstheentirecom-mittedcapitalofthefundwhichinvestsinitatleastonce,butinpracticeithascometomeananyinvestmentthatreturnsover25timesitscapital(Ò25×Ó).¥ItisbelievedthatamongsttheleadingUSventureÞrms,about5%ofcompaniesbycostgenerateabout80%ofreturnsbyvalue.¥ThetraditionalUSventuremodelrecognisesthisandpreaches(1)afocusoninvestingasearlyaspossible,preferablyattheseedstage,(2)afocusonproducinghomeruns,notmedium-sizecom-paniesand(3)valueadd,whichmeanstheabilitytocontributepersonalcompanybuildingskillsonahands-onbasis.¥TheUSmodelhasnothistoricallybeenpractisedinEurope,butvariousEuropeanÞrmsarenowseekingtoimplementit,andhaveinfactbeendoingsoforsomeyears.¥EuropeanÞrmshaveingeneralavoidedtheseedstage,whichhasbeenseeninEuropeasanareaofriskratherthanasanareaofopportunity.¥TheskillsrequiredforlaterstageventureinvestingstarttoapproachthoserelevantforbuyoutÞrms,withÞnancialskillsbecomingmoreimportantandtechnologyandsectorexperiencebecominglessso. 7HowtoAnalyseVentureWehaveseenthattherearethreemaindriversofbuyoutreturns:earn-ings,earningsmultiplesandtheuseofdebt(usuallyknownaseitherleverageorgearing,dependingonwhatsideoftheAtlanticyouinhabit).Thesedriversarisenaturallyfromthewayinwhichbuyoutsaretrans-acted,andinparticulartheyreﬂecttheunderlyingﬁnancialengineeringthatcanmakethedifferencebetweenanindifferentbuyoutandareallyexceptionalone.Aswesawintheopeningchapter,venturecapitaltransactionshavedifferentcharacteristics,andoperateinadifferentway(debt,forexample,israrelypresent,atleastinearlystagedeals).Sincethewayinwhichtheirreturnsaregeneratedisdifferent,itfollowsthatthedriversofthosereturnsmustalsobedifferent.So,whatdowehavetoconsiderwhenlookingatventureﬁrmsandtheirtransactions?THEFUNDAMENTALSMoneyMultiplesLetmesayatoncethatremovingthedebtfactorrendersthebasicarithmeticofventurereturnsconsiderablymoresimple.Inverybasicterms,aventurecapitalistbuyssharesinacompany,hopingtobeablelatertosellthosesharesatahigherprice,thusgeneratingaproﬁt.Itistherelationshipofthelatterﬁguretotheformer(thepriceoriginallyinvestedinthecompanyinreturnfortheshareholding)thatgeneratesthebasicmoneymultiplewhichliesattheheartofanalysingventurereturns.Rememberthatwelookedearlieratthevariouswaysinwhichthemoneymultiplesoffundscouldbeexpressed?Therearetwoveryimportantpointstobearinmindaswestarttoconsiderhowactuallytousetheseinpractice.Theﬁrstisthatwhatevermoneymultiplewedecidetouseatthefundlevel,itcanonlyhavebeengeneratedingrosstermsbythemoneymultiplesachievedonthefund’sunderlyingport-foliocompanies.NotethatIsay“ingrossterms”becauseofcourse 138PrivateEquityasanAssetClassbeforebeingmadeavailabletoLPstherewillbepaymentsofmanage-mentfeeand(ifandwhenappropriate)carriedinteresttobedeductedﬁrst.Thebasicprinciplewillalwaysholdtrue,however.Aventurefund,justlikeabuyoutfund,canonlyeverbeacompositeofitsindi-vidualtransactions,andthisiswhywemodelthemona“bottomup”basis.Thesecondpointisthatthereistypicallyonlyonewayofcalculatingthemoneymultiplewhichisearnedonacompanyandthatisbylookingattheactualamountpaidoutandtheactualamountreceived.Distinc-tionssuchasTotalValue,etc.,havetraditionallybeenaccordedlittlesigniﬁcanceatthecompanylevel.Forthepurposesofsimplicity,andalsowithaviewtokeepingdiscussionwithintheproperscopeofthisbook,Iproposetoacceptthisview,butallowmetodigressverybrieﬂytopointoutwhythismightbeaslightlydangerousassumptiontomake.Isayabovethatthewayinwhichventurereturnsaremadeisbybuyingsharesandsellingthemataproﬁt.Thusthemoneymultipleisessentiallytheratiobetweenthosetwonumbers.Allthisistrue.However,letusconsideracoupleofdifferentsituationswheresuchameasureiseitherunavailableorpotentiallymisleading.Theﬁrstonewillbecomeobviousifyoustopandthinkaboutthewayinwhichaventurefundoperates,andaboutthedifferentwaysinwhichwelookedatfundlevelmultiples.Whatdowedoaboutcom-panieswhicharecurrentinvestmentswithinthefund’sportfolio,butwhichhavenotyetbeensold?Idonotwanttogetdrawnintoadis-cussionatthisstageabouthowtheywillbevalued,becausewearegoingtolookatthisindetailalittlelater,butletusjustnoteforthemomentthatweassumethemtobeworthwhattheventurecapitalistsaystheyareworth.Sinceattheendofthedaytheyaregoingtobeeitherwrittenofforsoldforsomeamountofmoney,thenlittleharmisdone,sincesoonerorlaterwewillknowtherealﬁgureandbeabletouseit.Thuseverythingcomesoutinthewashattheendoftheday,butitdoesmeanthatbothatthefundandthecompanylevelwecanneverbesureofexactlywhattheﬁnalmultiplewillbeuntiltheverylastinvestmentisfullyexited.Thesecondonearisesfromthewayinwhichcompaniesareexited,particularlyintheUSA.Whereacompanyissoldtoalargecorpor-ation,thenallorpartoftheconsiderationforthesaleisfrequentlyinshares(stock)oftheacquiringcompany.Wherethesearereadilysale-ableanddonotrepresenttoolargeaproportionofthetotalﬂoat,then HowtoAnalyseVenture139thiswillnotraiseanysigniﬁcantissue;theindividualvendorscansimplysellthosesharesandpockettheresultingcash.However,theremaybelegalrestraints,eitheragreedatthetimeorarisingthereafterwhichcandelaythingssigniﬁcantly.Forexample,theacquirermaydecideinthecomingweeksormonthstoissuenewshares,andthiscancauseregulatoryheadachesifaventureﬁrmGPhasbeenwelcomedontotheboard.Similarlythey(and,byextension,theirﬁrm)maybebarredfromdealinginthecompany’ssharesatcertaintimes,suchasbeforepublicationofﬁnancialresults.IftheportfoliocompanyisexitedbywayofanIPO,thensimilarproblemscanoccurwithlock-upprovisions,particularlyintheUSAwherethesemaywellberegulatory,ratherthancontractual,inorigin.Whateverthecase,theremaywellbeaperiodofconsiderableuncer-taintybeforealltheventurefund’ssharescanbesoldandtheﬁnalpriceestablished.Duringtherampantequitymarketconditionsofthelate1990sthiscouldactuallyworktotheventureﬁrm’sadvantage,sincetheshareswouldusuallybesoldforconsiderablymorethantheirori-ginalexitvaluation.However,thereversecouldalsobetrue;Iwaspersonallyinvolvedinoneventuretransactionwherethepriceﬁnallyachievedbysomeinvestorswasonlyjustover10%ofwhathadori-ginallybeenanticipated.So,Iamhappytoacceptthesimplisticapproachbutsubjecttothesereservations.Certainlyanyonewhowishestoanalyseventurefundsonasophisticatedbasiswillbealivetothesepossibilities.Attheendoftheday,allthatmattersistherealnumberactuallyachieved,buttherewillalwaysbethosewhoeitherdonothavetheperceptiontorealisethis,orthepatiencetowaitforit.Infairness,therewillofcoursealwaysbesituationswhereLPsfeelthattheyareforcedtosellanexistinginterest(a“secondary”)forsomereasonorother,andthenofcoursethisbecomesaverymajorissue.Wewillexaminethisinmoredetailwhenwelookspeciﬁcallyatthesecondarymarket.So,beforewemoveon,letusbequiteclearaboutwhatthemoneymultipleisatthecompanylevel.Itissimplytheratiobetweenthetotalcashinvestedinacompanyandthetotalcashrealisedbydisposingofthatinterest,nomatterhowmanyindividualcashﬂowsmaybeinvolved.Forexample,ifwepayatotalof$2.5Mintoaportfoliocompanyandweeventuallyreceiveback$5Mthenthemoneymultiplewillbe2×.Itisirrelevantforthesepurposeshowmanyindividualcashﬂowsareinvolved,oroverwhatperiodtheytakeplace,thoughthiswillbecomeofgreatrelevancewhenwemoveontolookattransactionIRRs. 140PrivateEquityasanAssetClassValuationHavingtouchedonthisabove,letusnowturnourfullattentiontothevexedquestionofvaluation.“Vexed”partlybecausethisisoneofthemajorreservationsvoicedaboutventurereturns,partlybecauseverydifferentissuesapplyinEuropecomparedwiththeUSA,andﬁnallybecauseitisanissuewhichis(particularlyintheUSA)opentomuchabuseanduncertaintyeventhoughthisisusuallyinnocentlyarrivedat.ValuationasanElementofStatedReturnsOnehearsmanyreasons(excuses?)fornotinvestinginprivateequityfunds.OneofthemisthatprivateequityreturnscontainalargeelementofilliquidandthereforeunrealisablecapitalgainwhichisrepresentedsolelybyaportfoliocompanyhavingbeenwrittenupbytheGP.Similaraccusationsarelevelledatassetclassessuchasproperty(realestate).Whilethisisundeniablytrue,particularlyinthecaseofventureandparticularlyintheUSA(asweshallseeinaminute,differentconsiderationsapplyinEurope),itcompletelyfailstograspthetruenatureofventurereturns,whattheyrepresentandhowtheyshouldbeused.1AsIhavepointedoutmanytimesbefore,annualreturnsareirrele-vantwhenconsideringhowtomeasureprivateequityfundperform-ance,notleastbecauseoneisahostagetocircumstancessofarastheJ-curveisconcerned.Allthatmattersarelong-termcompoundreturnsovertimeand,aswehaveseen,theseareconventionallyexpressedinvintageyearterms.IRRsmeasurecashﬂows;thatiswhattheyaredesignedforandtheycannotoperateinanyotherway.Yes,whileafundisnotyetfullydivesteditisnecessarytoassumethatthecurrentvaluationoftheexistinginvestmentswillautomaticallyoccurasacashﬂowattheendoftheperiodinquestion,butinwhatotherwaycouldthisbehandled?Propertyreturnscustomarilyadoptanannualreturnapproachandbreakdownthereturnintocapitalgainandrentalyield.Therearetwoproblemswithadoptingthisapproach,however.First,withprivateequity,unlikeproperty,aninvestmentisnevermadewiththeobjective1SeeMultiAssetClassInvestmentStrategy,alreadyreferenced. HowtoAnalyseVenture1412ofcreatinganincomestream,butforgeneratingacapitalgain.Second,whereverweareconcernedwithaclosed-endfund(andthisappliestopropertyfundsjustasmuchastoprivateequityfunds)thenanynotionalbutunrealisedcapitalgainisessentiallyirrelevantasitwillsoonerorlaterberealisedandbecomeacashﬂowbacktotheinvestor.SoitisentirelyappropriatetoadoptacashﬂowmeasuresuchasanIRRtoanalysetheoverallreturntotheinvestor.Privateequityfundscompriseastreamofcashﬂowsandthetruereturnofafundcanonlybemeasuredinretrospect,onceallcashﬂowshavebeenmappedandanalysed.Anytrueprivateequityprofessionalknowsthis.Attemptstoimposemensuraldisciplinesonafundwhichhasnotyetrunitsfullcoursemaybenecessaryforperiodicaccountingpurposes,buttheywillrarelygiveatruepictureofwhatmayactuallytranspire;certainlytheywillgivelittlecluetothetimingoflikelycashﬂowsanditisofcoursethistimingthatwillhaveacrucialeffectontheﬁnalIRR.Itisinpreciselythisareaofuncertaintythatsecond-aryplayersseekoutvalue.Thustocriticisethestatedreturnsofhalf-runfundsascontaininganelementofunrealisedvaluationisanalogoustocriticisingalongdistancelorrydriverforbeingunabletogiveapreciseETAforajourneyofseveralhundredmiles.Allhecandoistoprovideanestimatebasedonthetimehehastakentocoveracertaindistancetodateandhisownexperienceofwhatsortofroadandtrafﬁccon-ditionsheislikelytoencounterontherestofhisjourney.Ofcourse,thecloserhegetstohisdestinationintermsoftimeanddistance,themoreaccuratehisestimateswillbecome,anditispreciselythesamewithprivateequityfunds.Aswewillseebelow,thisisinanyeventmuchlessofanissueinEuropethanitisintheUSA,andtherearemeasuresthatonecantaketoaddressunrealisticvaluationsinindividualcases.DifferencesinValuationApproachbetweenEuropeandtheUSAItisgenerallybelievedthattheventureindustryintheUSAisaheadofEuropeintermsofitsdevelopmentandthisisundeniablytrueinmostareas.Whenitcomestotheﬁeldofvaluation,however,Europehasledtheway.2Exceptforcertaintypesofmezzanineinvestmentandevenherethisrarelytellsthewholestory. 142PrivateEquityasanAssetClassFromtheveryearlydaysofprivateequityintheUK,theBVCAoperatedvaluationguidelineswhichhadbeenpreparedinconsultationwithaccountingbodies,andsimilarguidelineswereadoptedbyEVCA;thecurrentversionisnowpublishedjointlybytheBVCA,EVCAandAFIC.Sadly,thedevelopmentofsubsequentversionshasledtoless,ratherthanmorecertainty.Brieﬂy,theoriginalguidelinesseverelylimitedtheabilityofaGPtowriteupaninvestment,butprovidedvariouscircumstancesinwhichitmustbewrittendownbyanarbitrary25%.Notethattherewastypic-allynooptionhere;ithadtobewrittendownby25%if,forexample,itmisseditsannualbudgetorothertargetsbyasigniﬁcantamount,andbyfurther25%tranchesifsimilarcircumstancesreoccurred.Thenewguidelineshavereplacedbrevityandclaritywithverbosityandobfusca-tion.Evidentlydraftedbycommittee(aphrasewhichIhavecometothinkofasalmostanoxymoron)theytalkatgreatlengthaboutthenebulousconceptof“fairvalue”,andwhiletheylistagreatnumberofthingswhich“should”beconsideredorwhich“mayindicateadecreaseorincreaseinvalue”,theyprovidefewoftheobligatoryadmonitionsthatwereahallmarkofearlierversions.Therearetwoparticularironieshere.TheﬁrstisthatthesenewguidelineswereapparentlypreparedatthebehestoftheLPcom-3munity,whichinmyhumbleopinionbeggarsbelief.WhyshouldanyrationalLPwhomaybeconcernedaboutthelevelofventurevaluationswantguidelineswhichprovideless,ratherthanmore,certaintyandmore,ratherthanless,roomforsubjectivemanoeuvringbytheGP?ItmaybesigniﬁcantthattheworkingpartywhichpreparedthenewguidelinesdidnotincludeasingleLP.Forexample,itwouldhaveseemedlogicaltoincludeatleastacoupleofthelargeFundofFundsmanagers,buttheseareconspicuousbytheirabsence.Thesecondisthat,itseemstome,particularlyfromreadingthecommentsaboutfundingrounds,whattheEuropeanshavedoneislargelytoadoptandreﬂectprevailingpracticeintheUSA.Yetthedif-ferencebetweenUSAandEuropeanvaluationmethodologywasoneofthefewgenuinestrategicadvantageswhichtheEuropeanventureindustryenjoyed,sowhythrowitawayfornogoodreason?Bethatasitmay,itiscertainlythecasethathistoricallyEuropeanventurehasbeensubjecttoamorerestrictivevaluationenvironmentthanitsUSAcounterpart,andinmostquartersisperceivedasstill3Atleast,thatiswhatIwastoldbyaformerchairmanoftheBVCA. HowtoAnalyseVenture143beingso.Itremainstobeseenwhatwillhappeninthefuture,butthenewEuropeanguidelinescertainlyloosentheshacklesofanyGPwhowantstoexercisealittlecreativity(sorry,subjectivejudgement).IntheUSAguidelinesexisttoo,butthedifferenceisthattheseareofapurelyadvisorynatureandmanyprivateequityﬁrmsdonotadoptthem.AtleastinEuropethereisnowalmostuniversalacceptancethatallprivateequityfundaccountswillbepreparedinaccordancewiththeguidelines(andindeedthisisusuallyalegalrequirementimposedbytheLPsthroughthemediumoftheLPA–itismostunlikelythatanyinstitutionalinvestorwouldconsideranyfundwhichdidnotsoundertake).TheUSguidelinesarepreparedbyabodycalledthePrivate4EquityIndustryGuidelinesGroupandpublishedinassociationwiththeNVCA.ManyoftheirrecommendationsaresimilartowhatnowappearsintheEuropeanguidelines,butastheseareneithermandatorynorwidelyadopted,Iproposenottodevoteanyfurtherdiscussiontothem.VariabilityofVentureValuationsVariabilityofvaluationhasbeenaparticularproblemintheUSA,thoughtobefairthisbecameonlypronouncedlysoduringthetechnol-ogybubbleandinitsimmediateaftermath.Togiveyouareallifeexample,IwasapartnerinanAmericanFundofFundsmanagerduringthisperiodandatonepointthreeventurefundswhichhadparticipatedinthesamefundingroundinthesamecompanyhaditvaluedintheirauditedyearendaccountsat$960M,$480Mandzero,respectively.Evenmorealarmingly,twoofthethreeventuregroupsinvolvedhadthesameauditﬁrm(so,aresoundingraspberryherefortheaccount-ancyprofession,Iamafraid).Thisisofcourseanextremeexample,butitdoesillustratejusthowsevereaproblemthiscanbe.Howcanthesamecompanybevaluedatthesametimebyoneventureﬁrmat$960Mandbyanotheratzero?AndwhatisanLPtodowhencon-frontedbysuchwildlydifferingassessments?Speciﬁcally,whatﬁgureistheLPtoadoptforinclusioninitsownaccounts(particularlyas“asktheauditors”doesnotseemtobeagoodapproach)?ItwasbecauseofcaseslikethisthatmanyAmericanLPsyearnedforsemi-compulsoryvaluationguidelinessuchasEuropealreadyenjoyed,butIthinkitwillbeclearfromtheexamplegivenabovethat4www.peigg.org. 144PrivateEquityasanAssetClassithardlyhelpedmattersthattheauditcommunitywasfoundwanting.Insituationslikethissurelyitistheywhoshouldtakethelead.Sadly,farfromdoingsotheyseemedtogotoextraordinarylengthstoavoidtakinganyresponsibilitywhatever,helpedinmanycasesbythetermsoftherelevantLPA.Iservedononeadvisorycommittee,forexample,wheretheGPsandtheauditorstriedtothrowtheburdenofvaluationontothemembersoftheadvisorycommittee,whohadnoﬁrst-handknowledgeoftheportfolioatall.Hopefullythisisanareawherepro-gresswillbemadeinthefuture.AllitreallyneedsistohaveaprovisionintheLPAwhichsayssomethingtotheeffect:“intheeventofanydisputeordisagreementastothevaluationofanyportfoliocompany,theauditors’viewshallprevail”andthengoontodetailwhattheyshouldorshouldnottakeintoaccount.Infairness,Ishouldpointoutthattheremaybeperfectlygenuinecom-mercialreasonsforaGPnottowanttowritedownthevalueofacompany.Theymay,forexample,beinthethroesofnegotiatinganewfundinground,orevenadisposalofthebusiness.However,whenitcomestoaquestionofwhatvalueshouldbeplacedinasetofauditedaccountsIwouldsuggestthatonemaybestrayingintofairlydangerousterritory.YoumightbeforgivenforwonderingwhyIhavefocusedonthisissuewhenwritingaboutventure,butnotaboutbuyout.Theansweristhatitisrarelyanythinglikesodifﬁcultanissue.Foronething,therewillalmostalwaysbeapubliclyavailableearningsmultiple(orrangeofmultiples)againstwhichtocompareabuyouttransaction.Thisapproachisobviouslyirrelevantforaventurecompanywhichisnotyetmakinganyproﬁts;therehavebeenattemptstoargueforturnover(revenue)multiplessuchasusedtobepopularinGermanybeforecashﬂow-basedvaluationscaughton,butIwouldbeverynervousofascribinganyscientiﬁcbasistothis.Second,therangeofvaluationswithinwhichacompanycanﬂuctu-ateisobviouslyvastlydifferent,andthusthescopeoftheproblemisdramaticallybiggerwithventuredeals.Inanextremecase,aventurefundmightinvestinacompanyataninitialpost-moneyvaluationof,say,$20Mandseeitgrowtoseveralbilliondollars.Therangewithinwhichabuyoutcompanywillﬂuctuateismuchnarrower,unlessitisaturnaround,orperhapsunlesssomethingdramaticandunexpected5happensinitsbusinessenvironment.Thusitprobablydoesnotmatter5Thiscanhappen.Forinstance,CVCboughtabusinessinSpainwhichhadalimitedtermcontractforconductingtheSpanishequivalentoftheannualMOTcheckonmotorvehicles.Unexpectedly,theSpanishgovernmentextendedthetermofthecontract,thussigniﬁcantlyincreasingthevalueofthecompany.TheGreatTrainRobberiesareanotherobviousexample. HowtoAnalyseVenture145toomuch(atleastduringthelifeoftheinvestment)ifabuyouttrans-actionhasanearningsmultipleof17attachedtoitasopposedto18.Itdoesmatterifaventurecompanyisvaluedat$960Masopposedtozero.Finally,aswesawwhenwelookedattheanalysisofbuyoutfundsandtransactions,debtmakesakeycontributiontobuyoutreturnsandinmanycasestheenterprisevalueofabusinessmaynotactuallychangeverymuchwhiletheequityvaluecouldchangeconsiderably(duetoacquisitiondebtbeingrepaid).Withventurecapital,theenter-prisevalueistheonlyvaluewhichmatters(sincedebtisnormallyabsent).Pre-moneyandPost-moneyValuationsBeforewemoveontodiscussthenutsandboltsofhowventurereturnsareactuallygenerated,itisimportantthatweunderstandthedifferencebetweenpre-moneyandpost-moneyvaluations,sincethisisaconstantsourceofsomeconfusiontothosenewtotheassetclass.Thedistinctionisbestconsideredinthecontextofasingleroundoffundingforaventurecompany,andforthesakeofargumentletusassumethatitistheBRound,andthattherehasalreadybeenoneroundofﬁnancing(theARound).Thepre-moneyvaluationwillbethevalu-ationofthecompanyuponwhichtheBRoundisbased,whilethepost-moneyvaluationwillsimplybethatﬁgureplusthetotalamountcontributedbytheBRoundinvestors.Perhapsasimpleexamplewouldbehelpful.Supposethattheventurecompanyislookingforanadditional$5Moffunding,andthattheyagreeduringthenegotiationswiththeventurecapitaliststhattheyhaveidentiﬁedapre-moneyvaluationof$8M.Theycannowcalculatehowmuchofthecompany’sequitythenewinvestorswillrequire:5×100%=38.5%13Thusinprinciplethenewinvestorswilltake38.5%oftheequityinthenewlyenlargedcapitalstructure.Theﬁgureof$13Misthepost-moneyvaluation(thepre-moneyvaluationof$8Mplustheamountofnewmoneybeingintroducedof$5M).Therearethreeimportantpointstonotehere.First,Ihavedeliber-atelygivenaverysimpliﬁedexample.Inreality,thingswouldbemuch 146PrivateEquityasanAssetClassmorecomplicatedthanthis.Certaininvestors,suchastheentrepreneurswhocomprisethekeyexecutivesofthecompany,maywellhaveanti-dilutionrightswhichpreventtheirshareholdingfromeverfallingbelowacertainpercentageofthetotal.Others,typicallythosewhocomeintolaterrounds,willhaveliquidationpreferences(Iwilldiscusstheseindetailbelow).Theremayalsobeoptionsattachedtosomeoftheshares(particularlythoseofthefounders)andthesewillalsobepotentiallydilutive.Second,itisimportanttounderstandthatthesameinvestorsdonotparticipateprorataineachroundofthecompany.Inparticular,thosewhoparticipateintheveryearlyrounds,whetherasentrepreneurs,angelsorseedstageventurecapitalfunds,willrarelyhavethelargeamountsofmoneyavailablewhichmayberequiredtofueltherapidgrowthofapotentiallyverylargecompany.Inanyevent,seedstagefundswillwanttokeeptheirmoneyavailabletoparticipateinotherearlystagesituations,notDandERounds.Thismeansthatsomedilu-tionisinevitable(aswewilldiscussbelow)andwillbebuiltintotheirplansfromtheoutset.Third,itisnotnecessarilythecasethatthepre-moneyvaluationofoneroundwillbethesameasthepost-moneyvaluationofthepreviousone;farfromit,infact.Thisupliftinvaluationisoneofthewaysinwhichearlystageinvestorsmaketheirmoneyand,indeed,themainﬁnancialargumentforinvestingatanearlystageintheﬁrstplace.IntheexampleIgaveabove,forexample,itisquitepossiblethattheAstagewasa$2Mdollarroundatapre-moneyvaluationof$3M.Thustherehasbeenanupliftfromthatpost-moneyvaluation($5M)of$3Mtothenewpre-moneyvaluationof$8M.ThustherehasalreadybeenanincreaseinthevalueoftheARoundinvestors’investment:2×$5M=$2M52×$8M=$3.2M5Thus,beforethepossiblydilutingeffectsoftheBRoundcomeintoplay,theARoundinvestorshavealreadymadeanunrealisedpotentialgainof$1.2M,or60%oftheiroriginalinvestment. HowtoAnalyseVenture147ShareClassesTogiveexpressiontothevariousanti-dilutionandliquidationprefer-enceprovisionsreferredtoabove,adifferentclassofsharesinthecompanyistypicallycreatedfortheparticipantsofeachfundinground,withtherelevantprotectionbeinggiveneffectaswhatlawyerstermclassrights(rightsattachedtoaparticularclassofshareswhichcannotbevariedexceptwiththeconsentoftheholdersofthatclassofshares).Sinceanyoneinvestormayparticipateindifferentfundingrounds,itisquitepossibleforthemtoendupwithsharesofseveraldifferentclassesinthesamecompany.Bytradition,thesharesissuedfortheARoundarecalledAshares,thesharesissuedfortheBRoundarecalledBshares,andsoon.CostandValueHavinghadfairlycomplicateddiscussionsaboutthenatureofbuyoutreturnsitmaycomeassomethingofarelieftohearthatwhenitcomestoventureweareconcernedwithsuchbasictopicsascostandvalue.Thisinitialviewmightwellbemistaken,however.Onceyoucanignorethedebtfactorthenbuyoutreturnstoocomedowntolittlemorethanthis,whilethewayinwhichcostandvaluearebuiltupisactuallymuchmorecomplexinaventuretransaction,largelybecause,unlikethetypicalbuyout,aventurecompanymaygothroughseveralfundingrounds,allatdifferentvaluesandondifferentterms.Costisofcourseafairlystraightforwardconcept.Thecostofaninvestmentiswhatwepayforit,andsowecananddocalculatethissimplybyaddingtogetherallthevariousamountswhichhavebeencontributedbyanyonefundinthevariousfundingroundsofthatonecompany.However,itisimportantforustobeabletoseehowthatcostﬁgurehasbeenbuiltup,otherwisewewillnotbeabletoconductanymeaningfulduediligence.Thus,the“cost”sideofyourmodelmaywelllooksomethinglikeFigure7.1.Letusjustbeclearwhatwearelookingat.Wearemodel-linganindividualventurefund,andwithinthatwearemodellinganindividualventurecompany.Thispartofthemodelisshowingusessentiallyhowmuchwehaveinvestedtodateinthatcompany(ourcost),whatpercentageofthecompanywecurrentlyowninreturnforthatcost,andwhatpercentageofthefundasawholethisinvestmentrepresents. 148PrivateEquityasanAssetClassFundName:AllstarVenturesIIIFundSize($M):220CompanyName:CrazyNewVentureInc.Sector:TelecomsBusinessDescription:HighspeedopticalroutersformetronetworkingRoundPreAmountPost%*CostCo-investors($000)($000)($000)($000)A30002000500020.01000BabySeedIIB8000500013000800CaliforniaWarriorsIV.BabySeedIITotalCost:1800Fund%:0.82*Thiscolumnisdesignedtoshowthecurrentpercentageofthecompany’stotalissuedsharesownedbythefund.Itwillthereforeneedtohavesomethinglikethefollowingsittingbehinditinthemodel:Round#Shares#Shares#Shares#Shares#Shares%Pre(000)Round(000)Post(000)Taken(000)ToDate(000)CurrentA3000200050001000100020.0B5000500010000800180018.0Figure7.1The“cost”sideofaventurefundanalysismodelWecaninturnusethepercentageweownofthecompanytocalcu-lateourcurrentvalue.AssumingthatthevaluationofthecompanyhasnotincreasedsincethetimeoftheBRound,wecurrentlyown18%ofacompanywhichisvaluedat$13M.Thisvaluesourholdingat$2.34,whichinturnrepresentsamoneymultipleof1.3×onourcurrentcostof$1.8M.Isitreallyaseasyasthis?Well,no,actuallyitisn’t.Wearehappilyignoringforillustrativepurposesthepotentiallydilutiveeffectsofanyanti-dilutionrights,liquidationpreferencesandoptionsinthehandsofeitherthirdpartiesorindeedofthefundwhichweareanalysing.Thustherewouldhavetobeyetanotherlevelsittingbehindourmodelwhichcalculatedthepossibleeffectofthesebasedonthecurrentvalueofthecompany.However,werunveryquicklyintothreemajorproblemshere.First,thefulleffectofthemoftencannotbeproperlyappreciateduntiloneknowstheﬁnalexitvalueofthecompany.Itmaybeadvanta-geoustoexerciseoptionsatonevaluebutnotatanother,forexample.Second,thisisanextremelycomplicatedprocessandmanyinvestorsmaywelltaketheviewthatitreallydoesn’tmatterthatmuch,sincetheywillknowattheendofthedayexactlywhatcashmultipleresultsandinthemeantimetheyhavearoughlyaccurateﬁgurewhichisﬁnefortheireverydaymonitoringandreportingpurposes.Third,theinfor-mationwhichyouneedwillfrequentlysimplynotbeavailable.The HowtoAnalyseVenture149exacttermsoffundingroundsareusuallynotdisclosedsavetothosewhohavesignedtherelevantdocumentation,andagainthevastmajor-ityofLPswillneitherneednorwanttheinformation,norwouldtheyprobablyknowwhattodowithitiftheyhadit.ThusasamatterofpracticemostLPssimplyignorethisaspectofthingsandadjusttheirﬁguresonexitasnecessary.Indeed,inmyexperience,manyLPsdonotundertakeeventhelevelofanalysiswhichyouseesetoutinFigure7.1(thoughitisdifﬁculttoseehowtheycanconductanymeaningfulmonitoringorduediligencewithoutit).Wealsoneedtorememberthatjustasaventurecompanymayhaveseveralroundsoffunding,sotheexitrarelycomprisesonesinglecash-ﬂow.Eitherthecompanywillbeﬂoated(IPO’d)andquotedsharesmaybeheldwithinthefund(ordistributedinspecietoLPs)andsoldintranchesoveraperiodoftime,orthecompanymaybeboughtforstockbyapubliccompanyandasimilarprocesswillensue.Itisrelativelyrareforaventurecompanytobeboughtforasinglecashpayment.ThusourmodelwillhavetodistinguishbetweenmoneythathasalreadybeendistributedtoLPsor,toputitanotherway,valuethattheyhavealreadyrealised,andunrealisedvaluethatisstillsittingwithinthefundaspotentialdistributionsthathavenotyetoccurred.Justastheperformanceofafundcannotbeproperlymeasureduntiltheendofitslife,soanindividualinvestmentinaportfoliocompanycanonlybeproperlyanalysedoncethereisnoremainingvalue(inotherwords,oncethecompanyhasbeeneitherfullyexitedorwrittenoff).IRRSANDMULTIPLESDiscussionastothetimingofcashﬂowsbringsusratherneatlytothequestionofIRRs.YoumaybewonderingwhywehavebeentalkingaboutmoneymultipleswhenanalysingventuretransactionsratherthanIRRs.Well,theansweristhatwelookatboth,butsophisticatedin-vestorshavealwaysrealisedthatwithventure(andwithbuyouttoo,intruth,butthatismoredifﬁcultasbuyoutLPsandGPsalikeseemobsessedwithIRRs)themultipleiswhatmatters.Ifyoucangetthemultipleright,thentheIRRwilltakecareofitself.Thesameisnotnecessarilytrueviceversa.ConsiderwhatmayhappenifaprivateequitytransactiongeneratesanIRRof60%overa6-monthperiod.Thisisallverywell,butIammostunlikelytobeablethentoredeploythatmoneystraightawayinanotherprivateequitytransactionofferingasimilarrateofreturn.Onthecontrary,themostlikelyoutcomeisthatitwillendupinvestedatamoneymarketrateofreturnwhilesome 150PrivateEquityasanAssetClassalternativeuseisfoundforit.Wewillcomebacktothispointinalaterchapter.Theothersideofthisparticularcoin,asIhavementionedbefore,isthatifgiventhechoiceIwouldratherhavethemoneyinvestedat,say,20%for10yearsthan60%for6months.TosaythatwhatIamconcernedaboutisthemoneymultipleratherthantheIRRissimplyanotherwayofputtingthis.Asaroughruleofthumb,aventurefundwillalwaysbedeemedasuccessifitgeneratesamoneymultipleof3×,butwillusuallynotbeifitdoesnot.Theabilitytogenerate3×onpre-viousfundsisthereforeoneofthemainthingsyoushouldbelookingforwhenperformingduediligenceonaventuregroup,andthosewhoslavishlyrankfundspurelybyIRRwillmissthispointentirely.However,IRRisobviouslyanothervaluabledialonthedashboardandourmodelshouldbecalculatingthisbothattheindividualtrans-actionlevelandalsoatthefundlevel(whichwillofcoursebelowerbecauseoftheimpactoffeesandcarriedinterest).Pleaseremember,though,thatwhilethecloseronecomestotheendofthefundthemoreaccurateIRRislikelytobeasameasureofﬁnalperformance,theearlystagesofthefund’slifewhenitisstillundertheundueinﬂuenceoftheJ-curvewilltendtobemuchlongerforaventurefundrelativetoabuyoutfundbecauseofthelongeraverageholdingperiods.Thismeasureshouldthereforebetreatedwithextremecautionduringtheﬁrst6yearsorsoofafund’sexistence.Letuslookbrieﬂyatoneortwoindividualcomponentsofourmodelandthenturntoconsideringhowthepatternofventurereturnsismadeup.GoinginEquity(GI%)Thisisoneofthetwofactorswhichmakeupthecostofanyoneroundandthevalueofanytotalinvestmentinaventurecompany.Sur-prisingly,manyLPspaylittleattentiontoit,givenitsvitalnature.Thereislittlepointinhavinganinvestmentinasuccessfulcompanyunlessoneisgoingtobeabletoclaimamajorpartofthespoils,andindeed,experienceshowsthatlevelsofequityownershipareamajordriverofventurefundreturns.Thisisparticularlyimportantgiventhatearlystageinvestorswillnotbeabletoinvestproratainlaterrounds(andsometimesnotatall)andmustthereforeplanboththeleveloftheirinitialinvestmentandalsotheirstrategyfordealingwiththecapitalstructurethereafterwiththisinmind.Traditionally,theverybestUS HowtoAnalyseVenture151ventureﬁrmsaimtoendupwithnolessthan20%ofacompanyifatallpossibleandwilltypicallylooktostartataround40%forthisreason.WewillbelookingatthisfurtherinChapter9,butconsistentlylowlevelsofequityownershipareindicativeofaﬁrmwhichiseither(1)piggy-backingonotherpeople’sdealsratherthansourcingtheirown,(2)attemptingtolimittheirdownsidebyinvestingintoomanycom-paniesratherthanlookingtomaximisetheirupsidebyconcentratingonfewerandfewerpotentiallysuccessfulcompaniesasthefundpro-gresses,or(3)whosefundsizeistoosmalltoallowthemtoholdontoadecentequitypositiononceother,larger,investorsbecomeinvolved.NoneofthesearedesirablequalitiessofarasanLPisconcerned.PercentageoftheHoldingwithintheFundThisisanotherkeyindicatorwhichmanyLPsignore.Aswewillseeinaminute,venturereturnsaredrivenbyaverysmallnumberofverybigwinners,andthereislittlepointinhavingabigwinnerwhichisnotabletomakeasigniﬁcantcontributiontotheoverallfundreturn.Asaroughruleofthumb,anyoneofthesebigwinners(homeruns)shouldbeabletoreturntheentirecapitalofthefundatleastonce,andsince25×isgenerallyregardedasthehurdlemultipleforahomerunthenthissuggestsatargetofabout5%ofthefund,inordertoallowfortheimpactoffeesandcarriedinterest.Aswewillseewhenwelookatduediligence,oneofthekeyindi-catorswhenlookingataventureﬁrmisthecorrelationbetweentheirbiggestbetsandtheirbiggestwinners.Puttingalotofmoneyintopoorlyperformingcompaniesisindicativeofbadjudgement.Evenworse,puttingasmallamountofmoneyintoverysuccessfulcompaniessmacksofalackofhomerunmentality.Puttingagoodproportionofyourcapitalintosuccessfulcompanies,ontheotherhand,speaksnotonlyofbeingabletochoosetherightcompaniesbehindwhichtothrowthemainthrustofyoureffortsbutalsoofknowingwhichcompaniestokill,anddoingsoasearlyaspossible.THEIMPACTOFHOMERUNSThisistheoneissuewhichisfundamentaltoaproperunderstandingofventurecapital;indeed,itisprobablythesinglemostimportantissuetounderstandinthewholeﬁeldofprivateequityandsowouldprobably 152PrivateEquityasanAssetClassjustifyawholechapter(ifnotabook!)toitself.Itisalsotheoneissuewhichhasmostdividedtheprivateequityindustry;therearemanyEuropeanLPs,forexample,whoﬁndthewholeconceptjusttoomuchtostomach.Wehavealreadylookedbrieﬂyatthe“USventuremodel”andsoyouwillalreadyhaveanunderstandingofwhatahomerunis.Itisaninvestmentwhichcanreturnthewholecapitalofthefundatleastonce,anda25×multipleisusuallyacceptedasaproxyforthatlevelofperformance.Wealsolookedinthelastchapteratwhatitmeanstohaveahomerunmentality,andIdonotproposetorepeatanyofthat.Whatweneedtolookathereistheimpactwhichhomerunshaveonventurereturns.Thereisanimmediatedifﬁcultyhereinthatdataonindividualventurecompaniesisnotaswidelyavailableasitisforventurefunds,andwhatdatathereistendstoberelativelyrecentinorigin.However,theindus-tryowesahugedebtofgratitudetoleadingUSFundofFundsmanagerHorsleyBridge,whoseUSfundsspecialiseinalmostnothingbutearlystageventure,andwhosein-housedatabaseisthereforealmostcer-tainlythebestrepositoryofventurecompanyinformationintheworld.Whileofcoursetheycannotdoanythingthatmightidentifyindividualfundsorcompanies,theydooccasionallyreleaseintothepublicdomainsummariesoftheirdataona“blind”basis,andFigure7.2hasbeenwidelyseenanddiscussed.Letusbeclearwhatwearelookingat.Ontheleft-handsideofthegraphic,IhaveinsertedwhatIbelievetobetheroughlytypicalproﬁleofabuyoutfund.Atmost(Ihavebeenconservative)10%ofcompaniesbycostwillfail,i.e.,failtoreturntheircapital.Anotherwayoflooking100%80%HomeRuns60%SuccessesFailures40%20%0%BuyoutCostBuyoutValueVentureCostVentureValueFigure7.2Impactofhomerunsonventurefundreturns HowtoAnalyseVenture153atthisistosaythatitislefttotheremaining90%tocontributeallthefund’svalueorreturn.Imustemphasisethatthisbreakdownisnotbaseduponanyharddata(which,sofarasIamaware,isnotavailableanyway)butonmyownmanyyearsofexperienceofbuyoutfunds.Theright-handsideofthegraphictellsaverydifferentstory.Notethatthereisanextracategoryhere:thehomeruns,deﬁnedforthesepurposesasanyinvestmentthatmakesatleast25×.Theﬁrstthingtonoteisthatroughly50%ofallventurecompanieswillfail.OneofthehardestthingswithwhichventureGPsandLPsalikestruggletocometotermsisthatthisisnoreﬂectiononanyone’sabilitiesasaventurecapitalist;itisjustthewaytheventuremodelworks.Evenifyouarethebestventurecapitalﬁrmintheworldthereisachancethat50%ofyourcompaniesbycostwillfailtoreturntheircapital.However,thisdoesn’tmatter,andifyoutakealookatthehomerunscategoryyouwillseeinstantlywhyitdoesn’tmatter.Thehomerunsrepresentabout5%ofcompaniesbycost.Yetthis5%bycostcreatesnearly80%ofthevalue.Thestarkrealityisthatitisalmostcompletelyirrelevantwhathappenstotheother95%oftheportfoliobycost.Yes,theremaining95%orsomakesomecontribu-tion,butonlyabout20%ofthetotal.Itisthehomeruns,andthehomerunsalmostalone,whichdriveventurereturns.Forexample,KleinerPerkins,perhapsthebestknownoftheleadingUSventureﬁrms,isrumouredtohavebought25%ofNetscapeatapost-moneyvaluationofabout$20M,toseethecompanylateracquired(havingﬁrstgonepublic)byAOLfor$4billion.Therearemanyotherexamples,andKleinerPerkinsarefarfromtheonlyﬁrmtohaveachievedthesesortsofmultiplesonindividualdeals,butitwillgiveyousomeideaofthescaleofwhatcanbeachieved.Thisiswhyhomerunmentalityissoimportant,andthisiswhytheonlythingyoureallyneedtolookforinaventureﬁrm(ifyouareanLP)istheabilitytoscorehomeruns.Almostnothingelsematters.Everysuccessfulventurefundinhistoryhasincludedatleastonehomerun.Onewillfrequentlyhearduringindustrydiscussionscommentssuchas“ohyes,thatwastheirCienafund”;inotherwords,thefundwilloftenbeassociatedinpeople’smindswith,andthusidentiﬁedby,theparticularhomeruncompanywhichitfeatured.Wetalkedinthelastchapter,forexample,aboutthewayinwhichmanyUSventureﬁrmshavewithdrawnfromLifeScienceactivity.Oneofthemainreasonsforthiswasthatitwasperceivedasmuchmoredifﬁcult(certainlythisiswhatexperiencesuggested,anyway)toscore 154PrivateEquityasanAssetClassahomeruninthatareacomparedwithITorTelecoms.TheEuropeanexperience,aswenoted,hasbeenratherdifferent.Wealsoneedtobeawarethatthereisinsomepartsoftheworldconsiderablescepticismastowhetherthehomerunmodelconstitutesasustainablemodelofventureinvestment.Inthemoretraditionalcor-ridorsofEuropeanventureinvesting,forexample,thereisdeepuneasewithsuchafundamentallybinaryapproach,andacontraryviewthatreturnscanandshouldbeearnedmoreevenlyacrossthewholeportfolio.Inpart,thisstemsfromadifferentculturalbackgroundinsomecountries,particularlyamongst,say,theover-50s.Inthesemoreenlight-enedtimesitmaycomeasashocktosomeyoungerEuropeanstoknowthatonlyafewyearsagothegeneralruleinmanyEuropeancountries,includingtheUK,wasthatifyouhadbeenadirectorofacompanywhichhadgoneintoliquidationorreceivershipthenitcouldbeextremelydifﬁculttobecomeadirectorofanothercompany;therewasverycon-siderablestigmaattachedtoinsolvencyandcorporatefailure.Fortu-nately,amuchhealthierviewpointhasspreadfromtheUSA,whichseesafailedbusinessventureasworthwhileexperience,acampaignmedaltobewornwithsomepride.Iremember,forexample,astudyinabout1999whichshowedthattheCEOsofmostNASDAQﬂotationshadpreviouslybeentheCEOoftwofailedcompanies.However,oldhabitsdiehardandthetraditionalEuropeanmindsetledtoanundoubtedreluctancetokillstrugglingcompaniesandthis,combinedwithalackofvalueaddskillscomparedwiththeUSA,contributedtoawidespreadfailurebytheEuropeanindustrytogener-atethenumber(andscale)ofhomerunswhichitneededtoestablisharecordofhealthyhistoricreturns.Wewilllookatthisareainmuchmoredetailinthenextchapter.Onesmallpersonalrecollectionmayperhapsservetoillustratethispoint.IusedtobeinapositionwhereIwasmonitoringtheperformanceofventurefundsbothintheUSAandinEurope.IfoundthatthequarteroftheyearinwhichcompanieswerewrittenoffwasfairlyrandomintheUSA,whereasinEuropetherewasaheavyconcentrationinthefourthquarter.ThissuggestsverystronglythatinEuropetheimpera-tivetokillacompanywaslargelybeingdrivenbyaccountingcon-siderations(i.e.,theneedtoagreethenecessaryﬁguresfortheauditedaccounts)ratherthanstrategicissuesofportfoliomanagement.Attheendoftheday,though,thehistoricﬁguresareallwehavetogoon,andtheyseemtoshowveryclearlythattheEuropeanssimply HowtoAnalyseVenture155gotitwrong,andthattryingtodrawintellectualdistinctionsaboutthebasicconceptsislargelyirrelevant.TheUSexperienceshowsover-whelminglythatthehomerunmodelisvalid,andindeed,willultim-atelyimposeitselfuponanyventuremarketgiventherightGPskillsandenoughcapital.Ihavenodoubtpersonallythatitcanand,indeed,doesworkinEurope,andthatwewillwitnesssomethingofarevolutioninEuropeanventureincomingyearsassomeﬁrms(generallythesmallerandthenewer)embraceitenthusiasticallywhileothers(gener-allythelargerandthelonger-established)attempttosoldieronmuchasbefore.Thereason,incidentally,thatIdrawthesedistinctionsisthatitseemstomeonthebasisofmypersonalobservationsthatittendstobethesmallerandnewerEuropeanﬁrmsthatareattractingpeoplewithgenuineentrepreneurialexperienceasformercompanyfounders,andthatitistheseoperatingskills(previouslylargelyabsentfromEuropeanventureﬁrms)whicharerequiredtoprovidethesortofvalueaddwhichwillallowthehomerunmodeltowork.SUMMARY•Venturedeals,unlikebuyouttransactions,typicallydonotinvolvedebtandsotheanalysisprocessisatﬁrstsightmuchsimpler,atleastatthemostbasiclevel.•However,themechanicsofventurereturnsareinfactverycomplex,sinceseveralfundingroundswillusuallybeinvolved,andeachondifferentterms.Theabilitytomodelthis,though,isusuallyrestrictedbythelevelofavailableinformation.•Thebasicdriversarethepost-moneyvaluationoftheroundcon-cerned(withtheﬁrstroundinwhichthefundparticipatesobvi-ouslyhavingthemostimpact)andthepercentageofthecompany’sequitywhichafundholds.•Byfarthemostimportantmeasureofventureperformanceisthemoneymultiple,i.e.,theratioofthetotalamountofcashgeneratedbyaninvestmenttothetotalamountofcashinvested.IRRisalsoimportant,notleastforchartingtheprogressoftheJ-curve,butislargelymeaninglessintheearlytomid-stagesofafund–evenmoresothanforbuyout,giventhelongeraverageholdingperiodsofventurefunds.•Valuationofcurrentinvestmentsismuchmoreofanissueforventurefundsthanforbuyoutandtherehavebeensomeextreme 156PrivateEquityasanAssetClassvariationsofapproachandprocedure,particularlyintheUSA,whichhavegivenriseforconcern.•Historically,EuropeanventurewassubjecttostrictperemptoryvaluationguidelineswhileUSventurewasnot.Withthepublica-tionofnewguidelinesinEurope,thesituationappearslessclear-cutgoingforward.•Homerunsdriveventurereturns.WithinthebestUSportfolios,companiesdeliveringamultipleofatleast25×accountforlessthan5%ofcompaniesbycostbutgeneratenearly80%ofﬁnalfundvalue.Whathappenstotheother95%islargelyirrelevant.About50%ofallventurecompanieswillfailtoreturntheircapital.Thusanalysisofventurefundsshouldconcentrateonillu-minatingtheability(orotherwise)oftherelevantventurecapitalteamtoscorehomeruns.•Aswellasexaminingwhatpercentageofacompany’sequityisheldbyafund,oneneedsalsotolookatwhatpercentageofthefunditselfisrepresentedbyanyoneinvestment.Thereislittlepointinhavingacompanywhichreturns25×ifitisonly1%ofthefund. 8VentureReturnsJustasweexaminedthehistoricreturnsthathaveactuallybeenearnedbybuyoutfunds,sowewillnowdothesameforventure.Someoftheissueswhichwewillbeexaminingwillbesimilar,butsomewillberatherdifferent.Howcanweexplainthedifferentreturnsthathavebeenearnedindifferentgeographicareas,speciﬁcallyEuropeandtheUSA?AretheEuropeanﬁguresreallyasbadastheyappeartobe?Isthereanycorrelationbetweenreturnsandfundsize?Canwedigalittlemoredeeplyintohowreturnsareinﬂuencedbythestageatwhichoneinvests?Arethehistoricﬁguresagoodguidetofutureperformance?USOUT-PERFORMANCEVERSUSEUROPEThereallybigissuehere,though,istheradicaldifferencebetweenthehistoricreturnsofventurefundsinEuropeandtheUSA,respectively.TakealookatFigure8.1,whichshowsthehistoricreturnsofthe1990smeasuredbyCapitalWeightedIRR.LookatthehugeextenttowhichUSventureout-performedEuropeanventureduringthedecade.Itlooksasthoughthe“EuropeanbuyoutandUSventure”mantrareallywasjustiﬁedthroughoutthe1990s.Remem-ber,too,thatweareherelookingattheCapitalWeightedAverageratherthantheUpperQuartilefund,whichmostpeopleintheindustrywouldconsideramorerealisticmeasure.Figure8.2showsthatthisdifferenceisevenmoredramatic.Theconclusionisinescapable.NotonlyhasUSventureasawholeout-performedEuropeanventuresigniﬁcantlythroughoutthedecade,butthebestUSfundsout-performedtheirEuropeancounterpartsquitedramatically.Weneedtoconsidernotonlytheseﬁguresbutalsotheimplicationsandissueswhichliebehindthemtoseeiftheycanhelpusunderstandjusthowandwhythisshouldhavehappened.IamafraidthatinthisoneareawearegoingtohavetodigintotheVentureXpertﬁguresrathermoredeeplythanwehavehitherto,becauseoneoftheissueshereistheextenttowhichthedatapopulationisrep-resentativeandstatisticallysigniﬁcant.Wewillsee,whenwedo,that 158PrivateEquityasanAssetClass70.0060.0050.0040.0030.0020.00IRR(%)10.000.00-10.001990199119921993199419951996199719981999-20.00EuroCWAIRRUSCWAIRRFigure8.1USandEuropeanventure–relativeperformance(1);CapitalWeightedAverageIRR,byvintageyear1990–1999140.00120.00100.0080.0060.00IRR(%)40.0020.000.001990199119921993199419951996199719981999-20.00EuroUQIRRUSUQIRRFigure8.2USandEuropeanventure–relativeperformance(1);UpperQuartileIRR,byvintageyear1990–1999thecontrastbetweenEuropeanandUSventurereturnsisnotactuallyasstarkasitmightatﬁrstappear.However,letusleavethistoonesideforthemoment.Nobodycandenythattherehasbeenadramaticout-performancebyUSventure,andweneedtoanalysethissowecanbetterunderstandit. VentureReturns159MoneyMultiplesDriveIRRsItisusuallymoneymultipleswhichdriveIRRs.Letusseeifthisissointhiscase.Figure8.3clearlysuggestsadirectconnectionbetweenhighermoneymultiplesandhigherIRRs.Infact,wemeasurethecorrelationforthisperiodbetweentheCapitalWeightedAverageTVPIandtheCapitalWeightedAverageIRR;itis81%forbothEuropeandtheUSA.Inotherwords,theabilitytoscorehighmoneymultiplesappearstodrivehighIRRs,justaswesuspected,andthisseemstobe(exactly!)equallysoinbothregions.Aswehaveobservedmanytimesinthisbookalready,itismultipleswhichdriveIRRs,andnottheotherwayround,atleastnotdirectly.ThedesiretochaseahighIRRcanresultinGPsbalingoutofaninvestmentbeforetheyshould,whichmayofcourseresultinalowermultiplethanmightotherwisebethecase.(Remembermyearlierexampleofaskingyoutoconsiderwhichyouwouldprefer:60%IRRfor6monthsor25%IRRfor6years.ThesophisticatedLPwillofcoursechoosethelatter,butaGPwhoisabouttogooutfundraisingmightbetemptedtooptfortheformer.Thisisanextremeexample,butdeliberatelychosensothatthedifferenceisobvious.Moreusuallyinpracticeitwillbeamoresubtlequestionofdegree.)Thisexampleisstrictlyirrelevant,though,sinceitrequiressomeformofconscioushumanintervention.TheprinciplewhichIam5.004.504.003.503.002.50TVPI(x)2.001.501.000.500.001990199119921993199419951996199719981999EuroCWATVPIUSCWATVPIFigure8.3EuropeanversusUSCWAmoneymultiple;TVPIbyvintageyear 160PrivateEquityasanAssetClassexpoundingisthatintheabsenceofanyintentionalalterationofeventsthenitisthemultiplewhichwilldrivetheIRR,ratherthanviceversa.Figure8.3supportsthisview.Ithinkwecanaccordinglysafelyadvancethehypothesisthattheout-performanceachievedbyUSventureduringthe1990swasactuallyamanifestationofanabilitytoachievehighmoneymultiples.Further,ifwerememberwhatwesaidabouthomeruns,itmustspeciﬁcallyhavebeenamanifestationoftheabilitytoscorehomeruns.Sadly,thatdegreeofdataisnotpubliclyavailableatthecompanylevel,butwemaybeabletoﬁndechoesofitinthedatawhichwedohaveavailableatthefundlevel.HomeRunsandtheGoldenCircleFirst,though,alittlebackground:USventurereturnshavenotonlybeendrivenbyarelativelyverysmallnumberofbigwinnersatthecompanylevel,butalsobyarelativelysmallnumberofbigwinnersatthefundlevel(whichhavebeenessentiallythosefundsinwhichthebigwinnersatthecompanylevelhavebeenpresent).Thesefundshaveinturnbeenmanagedbyarelativelysmallnumberofventureﬁrms,towhichsomeyearsagoIgavethenameofthe“goldencircle”.Whilenotwoventureindustryprofessionalswillagreeonpreciselythesamelistofnamestoinclude,thereisgeneralconsensusonwhoisorisnotlikelytoﬁgureonthelist,anditmaybeasfewasadozennames,andcertainlynomorethanacoupleofdozen.Iamnotsuggestingthatthefundsmanagedbytheseﬁrmsconsistentlyout-performtimeaftertime;onthecontrary,whatresearchhasbeendonesuggeststhatitisextremelydifﬁcultforanytwoconsecutivefundsmanagedbythesameventureﬁrmbothtoout-perform.Itismoreageneralpatternofout-performance,probablyabouttwofundsoutofeveryﬁve.Ibasetheseobservationsonmypersonalexperienceoftheindustryratherthanonanyhard,publiclyavailabledatabuttheyarebroadlycorrectandIaskthereadertotrustmeonthispoint.Inotherwords,ifyouhadbeenableconsistentlytoselect(andaccess,whichisanotherpointentirely)fundsmanagedbythegoldencirclethenyouwouldhavescoredverydramaticreturnsfromyourventurefundportfolio,whereasifyouhadnotbeenabletoselectoraccessthesefundsthenyourreturnswouldhavebeensigniﬁcantlylower,evenifmostofyourfundpickshadbeenintheupperquartile.AsPhilHorsley,thefounderofHorsleyBridge,memorablyremarked:“ventureisanupperdecilegame”.Indeed,itismycontentionthatitistheabsenceofthisannualcluster VentureReturns161ofgoldencircletypereturnsthathasbeenthemajorfactorinthedif-ferentialbetweenhistoricUSandEuropeanreturns.Whatweneedtotrytodo,therefore,issomehowtoisolateandcon-siderthetrackrecordofthe(few)verybestUSventurefundsineachvintageyear,sinceitisherethatthehomerunsaremostlikelytohavebeenscored.Unfortunately,lackoftransparencyagainarisestothwartourefforts,sincethepubliclyavailabledataintheVentureXpertsystemdoesnotallowonetoidentifytheperformanceofindividualnamedfunds.However,wedoknowwhichindividualfundsmakeupthesamplepopulationineachvintageyear,whichallowsafeweducatedguessestobemade,andwedoknowtheperformanceofboththebestandtheupperquartilefunds:inotherswords,weknowthespreadoftheupperquartilesinceweknowbothitstopanditsbottom.Table8.1showsthetopandbottomoftheupperquartilebyTVPIforeachofthevintageyearswehavebeenconsidering,anda“shortlist”ofgoldencirclecandidatesfromwithinthatyear,anyoneofwhichmaywellberepresentedbythe“maximum”ﬁgure.FiguresareforUSventurefunds,withthedatabeingdrawnasusualfromThomsonFinancial’sVentureXpertsystem.YouwillseethatinsevenoutoftheninevintageyearsunderreviewtherewasatleastoneUSventurefundthatreturnedaverysubstantialdouble-digitmultiple.Infact,giventheverylargegapbetweenthetopandthebottomoftheupperquartile,itisreasonabletoassumethatineachofthosevintageyearstherewereinfactthreeorfourthatout-performedinthisway.ItisthesefundsthatoneneededtocapturetoachievethesortofreturnsthatwereinfactachievedbyasmallnumberofprivateequityfundinvestorsintheUSAduringthe1990s.YouwillseealsothatalthoughforthesakeofcompletenessIhaveincludedgoldencirclecandidatesfor1991and1999,thescaleoftheirsuccessatthefundlevelisnotinthesameleagueasforthevintageyearscomprisingtherestofthedecade.Ithinktherearedifferentreasonsforthis.1999wasofcoursethelastvintageyearunderreviewcompletelytoencapsulatethetechnologyandinternetbubble.Onewouldthereforeexpectperformancetobedisappointing,giventhatmanyinvestmentswouldhavebeenmadeathighvaluationsandtheneitherwrittenofforsoldaconsiderabletimelateratwritten-downvalues.TakealookattheUpperQuartileTVPIandyouwillseethestarkreality:anyGPwhoreturnscommittedcapitalona1999vintageyearventurefundwillbedoingwell.Tomakeanysigniﬁcantreturnwouldbeheroicindeed. 162PrivateEquityasanAssetClassTable8.1UpperQuartileUSventureanalysisbyTVPI(×)VintageyearMaximum(Bottomof)Goldencircle(topofUQ)UQshortlist19915.73.6AustinVenturesIII,IVPV,SierraIV,SutterHillVentures199214.13.6HighlandII,KleinerPerkinsVI,Matrix,MayﬁeldVII,MohrDavidowIII,OakV,SevinRosenIV199328.02.9AccelIV,HummerWinbladII,NEAVI,SequoiaVI199413.74.3ARCHII,BatteryIII,IVPVI,KleinerPerkinsVII,MohrDavidowIV199521.94.5BenchmarkI,CharlesRiverVII,DollI,FoundationI,MatrixIV,MayﬁeldVIII,MohrDavidowV,SevinRosenV199619.66.0AccelV,GeocapitalIV,HighlandIII,IVPVII,KleinerPerkinsVIII,MayﬁeldIII(?),SequoiaVII,USVPV,WorldviewI199715.82.7BenchmarkII,CharlesRiverVIII,GreylockIX,MayﬁeldIX,MenloVII199817.71.5AccelVI,BenchmarkIII,FoundationII,HighlandIV,IVPVIII,MatrixV,MayﬁeldIV(?),SequoiaVIII,SevinRosenVI19995.61.0AccelVII,BatteryV,BenchmarkIV,CharlesRiverIXandX,DollII,KleinerPerkinsIX,MayﬁeldX,MohrDavidowVI,SequoiaIX,SevinRosenVII,WPGV1991isadifferentmatter.Isuspectthatthetruthhereispartlythat1991vintageyearfundsweretooearlytocapitaliseonthehugerampincompanyvalueswhichoccurredduringthe1990s.ItisalsopartlythatatthistimealotofventureﬁrmsintheUSAwerestilltransactingamixofLifeScienceandTechnologydeals,andwehavealreadyheardthattheformerperformeddisappointinglyingeneral.Indeed,itwasthefearthattheseweredraggingdownoverallfundreturnsthatledmanyAmericanGPstowithdrawfromtheﬁeldand/ortohiveofftheirLifeScienceteamsasseparateﬁrms.Theﬁnalreasonisapurelysta-tisticalone.VentureXpert’ssamplepopulationforthe1991vintageyear VentureReturns163isonly41funds,comparedwithanadmittedlyextreme525forfundyear2000.Inpartthisreﬂectstheexplosioninventureactivitywhichtookplaceduringthelate1990s,butIthinkitmayalsobeasymptomofthefactthatcollectingfunddatawasstillinitscomparativeinfancyin1991andtherewasconsiderableresistancetotheideaofmakingperformancedatapublic,evenonablindedbasisasThomsonFinan-cialdo.Attheendoftheday,though,1991isprobablyaverygoodexampleoftheprincipleIhavebeenexpounding.Thefactisthatnotasinglefundwasclosedin1991byaclear-cutgoldencirclecandidate,saveforaverysmall($5.4M)expansionfundbySevinRosen.Itmaywellbe,therefore,thatthisprovidesyetmoreevidencetosuggestthatwithoutthepresenceofthegoldencircle,venturereturnswillindeedstruggletoﬁndbreak-outperformance.Perhapssigniﬁcantly,themaximumTVPIforboththepreviousvintageyears(whenthereweregoldencircleﬁrmsclosingfunds)ishigher,thoughtheUpperQuartileTVPIislower,suggestingsigniﬁcantout-performancebyoneortwofundswithintheupperquartile.MarketConditionsItistemptingtoseektoexplainUSout-performanceduringthe1990ssolelybyreferencetotheamazingmarketconditionswhichﬂourishedduringthesecondhalfofthedecade.Wehavealreadyseenwhathap-penedtoPEratiosduringthisperiod:theS&PPEratiopeakedatnearly35in1999.WhileitisnotstrictlyrelevanttotalkaboutPEratiosinthecontextofventurecompanies,sincefewhaveanyearnings,thisisnonethelessindicativeofwhathappenedtoequitymarketsgenerally.Attheendof1990theNASDAQindexstoodatalowly374,whilebytheendof1999ithadrisento4069.Thatiswhyitistemptingtoseektodismisssuchout-performanceonthegroundsthat“arisingtideliftsallships”.Iftheequitymarketwhichprovidesyourmainexitrouteandyourmainexitvaluationbenchmarkrisesmorethentenfoldinadecadethen,theargumentruns,youwouldhavetohavebeenprettystupidnottoscoregoodreturnsevenifonlybyaccident.KleinerPerkins,forexample,werereputedtohaveearnedatransactionIRRinexcessof50000%ontheirinvestmentinAmazon.combasedon1999stockprices.However,thisargumentissimplisticandpayslittleregard(orrespect)totheveryrealskill-basewhichexistsamongthebestUSventure 164PrivateEquityasanAssetClasscapitalists.Yes,bytheendofthedecadevaluationshadrisentoridicu-louslevelsforcompanieswhichhadabsorbedinsomecaseshundredsofmillionsoffundingandhadyettoturnaproﬁt(andinmanycases,werebasedonabusinessplanthatwasunlikelyevertoproduceanysigniﬁcantproﬁts).Yes,thiswasagenuinebubbleand,yes,experiencedandskilfulventurecapitalistswhoshouldhaveknownbetterfellforitssirencallinmuchthesamewayasothersdid,butmuchwasachievedthatwasgenuineandcannotbeexplainedbythissimplisticanalysis.Genuinecompanieswerecreatedwhicharetodayacknowledgedgloballeaders,manyofwhicharesolidtechnologybusinesses,suchasCisco,Sun,IntuitandLotus,inadditiontointernetsuccessstoriessuchasGoogle,AOL,eBayandAmazon.Thesearehighqualitycompanieswhichwouldhavesucceededinanyequitymarketenvironmentbecausetheywerebasedonsoundbusinessprinciplesandrunbyhighlytalentedindividuals.Yetthe“valueadd”whichtheirventurecapitalbackersprovidedalsoplayedanessentialroleintheirsuccess.Thus,whileitisundeniablethatmarketconditionsboostedUSventurereturnsduringthisperiod,highqualitycompanies,andthehighqualityventurecapitalistswhobackedthem,wouldhavethrivedinanyconditions,andstillproducedgood(thoughnotsoexaggerated)returns.Itisworthstatingforthesakeofbalance,though,thattheargumentdoeshavesomerelevanceintwospeciﬁcareas.First,thespectreofalmostunbelievableventurereturnsdrewalargenumberofnewinvestorsintothemarketplace.In1991$1.9billionwasraisedbyUSventurefunds.By1999thishadrisento$60billion,andinfactpeakedatnearlydoublethatamountin2000–a60-foldincreaseinjust10years.Therewereonlytwowaysinwhichthismuchmoneycouldbeaccommodated.Existingﬁrmsincreasedtheirfundsizes(insomecasesto$1.5billion–moreorlessthewholeamountthathadbeenraisedby40fundsin1991)andmanynewentrantscameintothemarket(contrastthose42fundsin1992with525in2000).Thismassiveinﬂuxofnewcapital,muchofitinunskilledhands,actedlikeairbeingsuckedintothebottomofafurnaceandfuelledthemassivebubblewhichgrosslyinﬂatedventurevaluations.ItisfairtosaythatwhilethishappenedinEuropetosomeextent,itwasnotonanythinglikethesamescale.ValuationsneverreachedthepeakstheyhadscaledintheUSA,andmoreimportantly,everythingwasayearortwolater,whichmeantthatthescopeformakinghighreturnsbygettingintobubble-typecompaniesandoutofthemagainintimebeforethemarketcol-lapsedwasmorelimited. VentureReturns165Second,thereisnodoubtthattheabsenceofanythinglikeNASDAQwasaseveredrawbackforEuropeanventurecapitalﬁrms,andhadadeﬁnitenegativeimpactontheirreturns.Inretrospect,Europeansshouldhaveinvited(evenimplored)NASDAQtocometoEuropewithaviewtocreatingaglobalexitmarketforventure-backedcompanies.Awelcomecorollarytothiswouldhavebeenthatontheircoat-tailswouldprobablyhavecomemostoftheleadingUSventureﬁrms,settingupofﬁcesinEurope(asitis,onlyaveryfewhavedoneso–seebelow).Instead,theEuropeansdecidedtotrytocreatetheirownversionofNASDAQ.NamedEASDAQ,itwasasadfailurewhichonlyeverattractedahandfulofcompaniesand,likeallsuchpan-Europeanproj-ects,becameahighlypoliticalaffair,withnobodybeingpreparedtoadmitdefeat.Ironically,NASDAQwereinvitedtotakeacontrollinginterestinitin2001,bywhichtimethedamagehadbeendoneandEuropeanventureﬁrmshadbeendenied(inpractice–intheorytheycouldhaverelocatedtheircompaniestotheUSAasIsraeliventureﬁrmsdidinordertotakeadvantageofNASDAQ)accesstoNASDAQexactlywhentheycouldmosthaveproﬁtedfromit.NordoestheLondonStockExchangeemergeparticularlywellfromthestory.Twoattemptsatprovidingjuniormarkets,theThirdMarketandtheUnlistedSecuritiesMarket,bothtookholdbutwerethenabruptlycloseddownbytheLSEfornogoodapparentreason,leadingtogreatscepticismabouttheLSE’scommitmenttothisarea.Ironically,AIM,theLSE’slatestoffering,hasnowbecomewhatEASDAQwasintendedtobeandisattractingIPOcandidatesfromallovertheworld,includingtheUSA.ItisasadindicationofjustwhatanopportunitymighthavebeenmissedasaresultoftheLSE’sarbitraryactionsinthepast.EUROPEANVENTURE–ISITASBADASITSEEMS?Theanswertothisis“no”,butunderstandingwhyitis“no”requiresmetoexplainafewthings.Wehavealreadydiscussedacoupleoffactors(NASDAQandthebubble)whichartiﬁciallyboostedUSventurereturns,thusmakingEuropeanreturnslookworseinrelativeterms.Wehavealsodiscussedtheverydifferentskill-setswhichwouldhaveensuredthatinanyeventUSventurewouldhaveout-performedEuropeanventureduringthe1990s.Noneofthisisanissue.USventurecapitalﬁrms(particularlythegoldencircle)achievedsomeamazingthingsduringthe1990sand 166PrivateEquityasanAssetClassdeserveeverycongratulationforhavingdoneso.Wewillprobablyneverseethelikeofthosereturnsagain.However,whenwecometolookathowEuropeanventureperformedinabsolutetermswehitanimmediateproblemandIamafraidthatitisaproblemwiththeavailabledata.Sincethisislikelytoproveacon-troversialtopic,letmechoosemywordsextremelycarefully.TheVen-tureXpertﬁguresforEuropeanventureincludealotoffundsthatsimplyshouldnotbethere,andtheydothistosuchanextentthattheresultingﬁgurescannotbetakenasanyvalidmeasurementofEuropeanventurereturns.Letmesayatoncethatalotofthisisnottheirfault,andhasindeedresultedfromexcesszealratherthanlackofit.Manyverysmallseedanddevelopmentfunds,usuallyoperatingonaverylocalisedbasis,andfrequentlyeithergovernmental(localornational)orattachedtoanacademicinstitution,havebeenrightlyanxiousthattheyshouldbelistedintheVentureXpertdatabase.Arguablythesearenotevenprac-tising“venturecapital”inthetruesenseanyway,butwhateverthecasevirtuallynoneofthemwouldbeeligibleforinvestmentbyinstitutionalLPsinanyeventbecauseoftheirsizeortheirnature.InamarketthesizeoftheUSA,forexample,thiswouldnotmatterverymuch,thoughitwouldintroducesomestatistical“noise”intothesystem,butwithinamuchsmallersamplepopulationitmattersverymuch.TheaveragenumberofEuropeanventurefundstrackedintheﬁvevintageyearsfrom1992to1996,forexample,isonly18;withinsuchasmallsample,anysamplingerrorcanpotentiallyhaveaverysigniﬁcanteffect.Inadditiontotheseverysmallquasi-developmentaltypefunds,therearefundsrunbyentitiessuchasbanks,mediacompaniesandindustrialgroupswhicheveniftheyaretechnicallyopentooutsideinvestorswouldnotgenerallybeconsidered(sophisticatedLPsinvestonlywithindependentprofessionalﬁrms,totheextentthatthemerestpossibilityofanyoutsiderbeingabletoexertinﬂuence,eitherininvestmentde-cisionsorotherwise,willusuallybestowthekissofdeath).Therearealsofundswhichwouldbeineligiblebecauseoftheirlegalnature;VCTs,forexample,aretax-friendlyvehiclesaimedatBritishretailinvestors.Finally,therearesomefundswhicheitherdonotﬁtcomfortablywithinthegeographicrange(therearemanyRussianandEastEuro-peanfundswhichshouldreallybeseparatelyclassiﬁed)andmanyfundswhichhavejustbeenwronglyclassiﬁedintheﬁrstplace.ThereareAsianandAfricanfunds,forexample,andbuyout,mezzanine, VentureReturns167Table8.2AnalysisofVentureXpertdataforEuropeanventurefunds,vintageyears1990–1999YearStatedtotalRealtotal*%bynumber1990154271991201519928225199317424199421210199522523199622627199743153519984517381999682232Source:ThomsonFinancial’sVentureXpert.*(1)Independentﬁrms,(2)conductinggenuineventuretransactions,(3)withafundstructureopentoinstitutionalLPsand(4)fundsize>$20M.FundsofFunds,etc.So,letusseewhathappensifwenotionallystripalltheseinappropriatefundsoutoftheuniversetoleaveonlythosewhichareinstitutionalgradeEuropeanventurefunds(Table8.2).Thedifferencereallyisverydramatic.Youwillseethateveninthebestyear(1997)only15outofthestated43fundswereeligible,whiletheaveragenumberofeligiblefundsforanyoneofthevintageyearsunderconsiderationisonly27%.Putthistheotherwayround,andwecanstatethatintheaveragevintageyeartheﬁguresare73%inaccuratebynumberoffunds.Needlesstosay,thisisaprettystaggeringresultandunderlinesthefactthatinthisoneareathenormallyexcellentVentureXpertsystembreaksdown,andthatitsnumberscaninnowaybeseenasrepresentativeofreal-lifeEuropeanventureperformance.So,wheredoesthisleaveus?IfwecannotrelyontheVentureXpertﬁgures,whatcanwedoinstead?Well,thereareafewpointers.First,lookattheﬁguresachievedbythe“maximum”fundineachvintageyear(Table8.3).Clearly,theremusthavebeenatleastoneEuropeanventurefundineachvintageyearthatachievedstand-outperformance.TheﬁguresshowninTable8.3wouldbecompletelyacceptableastheperformancemeasuresofanyqualityUSventurefund,andinsomeyears(e.g.,1996and1997)arethesortofﬁguresthatcouldbeachievedbyoneofthegoldencircleﬁrmsintheUSA.Thus,itisfaciletosuggest,asmanydo,thatitissimplynotpossibletoearndecentventurereturnsinEurope.Notonlyisitpossible,butpeoplehaveactuallydoneit. 168PrivateEquityasanAssetClassTable8.3PerformanceofthebestrecordedEuropeanventurefund,vintageyears1990–1999YearTVPI(×)IRR(%)199011.255.119913.336.219923.026.219936.655.519946.227.419956.4200.8199614.7103.9199710.0262.019988.2180.519992.8125.3Source:ThomsonFinancial’sVentureXpert.Thequestion,ofcourse,is“who?”Unfortunatelytheﬁguresdonothelpusverymuchhereastheyareofcourseblinded.Itcouldbesug-gestedthatasweareforthemostpartconcernedonlywithaboutaquarterofthedatathenweshouldtaketheupperquartileﬁgureasessentiallythebottomoftherange,butthissuggestionisnotstrictlylogicalastherecanbenoguaranteethatthequarterwithwhichweareconcernedisindeedallclusteredwithintheupperquartile.Justasthereisundoubtedlyatleastonefundineachvintageyearwhichhasout-performed,theremustsurelybeotherswhichhaveunder-performed.However,experiencesuggestsverystronglythatifoneiscomparinginstitutionalqualityfundsagainstnon-institutionalqualityfundsthentheformeraremorelikelytohaveover-performedthanunder-performed.Thusitisveryprobableindeedthatmostofthemwillbeintheupperquartile,atleasthalfofthemanyway.So,ifyouwereapproachingtheproblemwithaverybroadbrush,itisalmostcertainthatthestatedupperquartileisinfactmoreofamedian,andprobablyevenbelowthat.Letusseewhathappens,forexample,ifwecomparethestatedEuropeanUpperQuartileTVPIwiththestatedUSmedian(Figure8.4).Roughandreadythoughsuchanapproachmaybe,itmaywellbethatthepositionitsuggestsisnotunrealistic.Yes,USventurestillout-performedduringthemiddleofthedecadebutperhapsthescaleofitwasnotquitesodramaticasmayappearatﬁrstblush.Fortherestofthedecade,Europeanventureseemstohavebeenverycompetitiveintermsofthemoneymultipleswhichithasgenerated. VentureReturns1693.503.002.502.001.50TVPI(x)1.000.500.001990199119921993199419951996199719981999EuroUQTVPIUSMedianTVPISource:ThomsonFinancial’sVentureXpert.Figure8.4StatedEuropeanUpperQuartileTVPIversusstatedUSmedianTVPI,byvintageyear1990–1999Wearestrayingintodangerousterritoryhere,sincewearenowlargelyintherealmofsupposition,yetwhentheofﬁcialﬁguresfailuswehavelittlealternativeanditseemspreferabletomeatleasttomakesomeattemptatindependentthoughtratherthan,asmanyintheindus-trydo,simplytoaccepttheﬁguresatfacevalueandneverevenwonderaboutwhatmayliebehindthem.IfreelyacceptthatmyapproachmayﬂatteractualEuropeanventurereturns.However,iftheydo,thentheyprobablydonotdosobyverymuch,andcertainlynotbyasmuchastheofﬁcialﬁguresseemtounder-estimatethem.OneotherpointtobearinmindbeforeweleavethisissueandmoveonisthatthereisundoubtedlymuchgreatervariationinEuropeanventurereturnsthaninAmerican,andinEuropethisisconcentratedwithinamuchsmallersample.Inotherwords,IamsureitmustbetruethatinEuropethereisamuchgreaterproportionoffundswhichmaketrulyawfulreturnsthanintheUSA.IntheVentureXpertﬁguresforUSventure,forexample,thereisonlyonevintageyearinwhichafundhasmade−100%sincerecordsbegan,whereastheEuropeanﬁguresshowﬁve,andthiswithinamuchsmallersample.Whatdoesthismean?SimplythatinEuropemanagerselectionisevenmoreimportantthanintheUSA.ThishasunderstandablyledtoEuropeanventuregainingareputationasbyfarthemostdifﬁcultofthevariousprivateequity 170PrivateEquityasanAssetClassclasses,andtomanyLPsdecidingthattheysimplydonotwanttobeinvolvedwithit.RETURNSANDFUNDSIZELetusnowrepeattheexercisewhichwecarriedoutforbuyoutfundsbylookingattherelationshipbetweenhistoricventurereturnsandaveragefundsize.LetuslookﬁrstatEurope.Figure8.5showstheCapitalWeightedAverageTVPIachievedineachvintageyearbetween1990and1999againsttheaveragefundsizeofthesamevintageyear.Thisseemstosuggestadeﬁnitesweetspotintermsoffundsizeatabout$150M,bothbelowandabovewhichreturnswillsuffer.Sofarasverysmallfundsareconcerned,experiencedoesindeedsuggestthattheytendtofarebadly.Theyareunabletofollowonwhenother,bigger,sourcesoffundinggetinvolvedatlaterstagesandtendtogetexces-sivelydiluted.Also,theyarelesslikelytobetryingtogrowreallylargecompanies,inpartbecausethatisoftennottheirraisond’être(theymay,forexample,beauniversityseedfund)andinpartbecausetheyrightlyidentifyinsucheffortsahighchanceof(astheyseeit)unneces-sarydilution.IcanthereforehappilyacceptthatthereisanefﬁcientfundsizeinEuropebelowwhichreturnswillsuffer;indeed,thisis3.002.502.001.501.00CWATVPI(x)0.500.00050100150200250300350400AverageFundSize($M)Source:OwnworkingsfromThomsonFinancial’sVentureXpert.Figure8.5AnalysisofEuropeanventurereturnsversusaveragefundsize;TVPIbyaveragefundsize,vintageyears1990–1999 VentureReturns171currentlyaveryrealissue,withevenhighqualityEuropeanventureﬁrmsstrugglingtoraisemoney.Attheotherendofthescale,though,Ithinkoneneedstobealittlemorecarefulaboutacceptingtheﬁguresatfacevalue.Wehavetorememberthattheseﬁguresarehighlyquestionable,particularlywhenwestarttalkingaboutaveragefundsize.Thereare,forexample,anumberoffundswithinthedatabasewherethefundsizeisstatedaszero,whichmustinevitablyskewtheresultingaverages.Myownper-sonalinstinctisthattheidealventurefundsize,certainlyforthoseoperatingattheseedandearlystages,isprobablyabout$250M,sothattheseﬁguresprobablyallneedshiftingnotionallytotherightasyoulookatthegraph.WewilltalkalittlemoreaboutlargefundsizesinamomentwhenweexaminetheUSﬁgures,sincetheissueismuchmorerelevantthere,butcertainlythereisapointbeyondwhichreturnswillsuffer,ifonlybecausealargefundsizewillinevitablypushone’sinvestmentfocustowardsthelaterstages.Becausetheseﬁguresseemtobesomewhatskewedbyfalse“zero”fundsizesIthinkitmaybemoreusefultolookatreturnsversustotalcapitalraisedinanyonevintageyear.Again,Iamconsciousthatsuchanapproachisfarfromperfect.Itignores,obviously,thenumberoffundsthatwereraisedandthesectorsandstagesforwhichthecapitalwasintended.However,ifwedonothavethedatawhichweneedthenwehavetomakethebestofwhatwedohave,anditstrikesmethatthiswillatleastgiveussomeindicationofpossibleover-capacityinthesystem(Figure8.6).Wehavetobecarefulaboutwhatconclusionswedrawhere,sincewecannotignorethetimelineofthe1990s.Yes,commitmentstoEuro-peanventurefundsrosequicklytowardstheendofthedecade,butthiswasonthebackofthebubbleandwecannotjustignorethefactthatthebubblehappened.However,verycautiouslyIwouldsuggestthattheseﬁguresdoseemtosupportthecommon-sensehypothesisthatthelessmoneythereisavailableinthesystemthenthebetterreturnsarelikelytobe.Evenhere,though,wemustbecareful.Itmaywellbethatoncetheamountofavailablecapitaldipsbelowacertainpointthenthistrendwillreverseitselfasitbecomesdifﬁcultorevenimpossibletoraisefurtherﬁnancingroundsforcompanies,ortogetfundedintheﬁrstplace.Itcouldalsodriveﬁrmstoinvestinfewercompaniesineachfund,thuslesseningtheirchancesofcatchingthatoneall-importanthomerun.Theyears2002–2005,forexample,sawverylowlevelsoffundraisinginEurope.Figure8.6wouldsuggestthattheyshouldbe 172PrivateEquityasanAssetClass3.002.502.001.501.00CWATVPI(x)0.500.000200040006000800010000120001400016000TotalFundCapitalRaised($B)Source:OwnworkingsfromThomsonFinancialVentureXpert.Figure8.6Europeanventureperformanceversustotalfundcapitalraised;TVPI(×)byvintageyear1990–19995.004.003.002.001.00CWATVPI(x)0.00020,00040,00060,00080,000100,000120,000-1.00-2.00TotalFundCapitalRaised($B)Source:OwnworkingsfromThomsonFinancialVentureXpert.Figure8.7USventurereturnsversustotalfundcapitalraised;TVPI(×)byvintageyear1990–1999verysuccessfulvintageyearsintermsofreturns,butthereistheveryrealdangerthatlevelsmayhavebeensolowthatsomeofthephenom-enaImentionabovemayapply.LetusnowlookatthesamemeasureappliedtoUSventurefunds(Figure8.7). VentureReturns173Wow!Thisseemstobesendingaveryclearpictureofadirectinversecorrelationbetweencapitalraisedandvintageyearperform-ance.ImustsayrightattheoutsetthatIbelievethispicturetobebroadlytrue,butthereareanumberofimportantcaveatstostate.First,thereisthetimelineeffectjustaswithEuropeanfunds.Second,thisisprobablyexacerbatedbythefactthatthefundsfromthelastcoupleofyears(whichwerethereallybigones)maynotyethavehadachancetodevelopanyrealisticindicationoftheiractuallifetimereturn.However,theseﬁguresagainseemtosquarewiththecommon-sensehypothesisthatanexcessofmoneyinthesystemwillleadtoadiminu-tionofreturns.Thisarisesinanumberofways.First,AmericanGPshavealwaysdrawnadistinctionbetweenwhattheycall“smartmoney”and“dumbmoney”.WhatmadethefundingbubbleparticularlyharmfulintheUSA(and,bytheway,itwasevenworsethantheseﬁguressuggest–theoriginaltotalraisedfor2000wasover$120billionbeforefundsizereductionsstartedtokickin)wasthatmostofthenewinﬂuxwas“dumbmoney”fromLPswhoweredeterminedtocommittoUSventurefundscomewhatmay,anddidnotparticularlymindthatitmightfallintoinexperiencedorinexperthands;525fundswereraisedin2000,ofwhichaverylargeproportionmusthavebeenﬁrsttimefunds.Inotherwords,LPswerepreparedtocommittofundswhichwerelikelytoendupinthethirdorfourthquartilesofUSventureperformanceratherthantofundswhichhadeverychanceofendingupintheupperquartileof,say,Europeanbuyout.Giventhatevenintheglorydaysof1995and1996thetopofthelowerquartileonlyreturned3.5%and1.7%,whereastheupperquartileEuropeanbuyoutfundreturned20.3%and22.9%,respectively,thenitcanreadilybeappreci-atedjusthowtragicallymistakenthisapproachwas.So,qualitywasundoubtedlyanewproblemwhichwasforcedupontheUSventureindustrybyLPbehaviour,butsowasquantity.Asmoreandmoremoneycameintothesystem,companyvaluationsrosedramatically,andfundsizesspiralledupwardstotrytokeepupwiththem.By2000,ﬁrmswhichjustafewyearspreviouslyhadbeenraisingfundsof$300Mweresuddenlyraising$1.5billionfunds.Whileofﬁciallydeniedatthetime,therecanbelittledoubtinretrospectthattheselargerfundsizesinturnplayedtheirpartinacontinuedincreaseincompanyvaluations,eventhoughthesewerealreadyinmanycasesalreadyatsustainablelevels.Iwouldarguethatoncethelevelofavailablefundingreachesacertainlevelwithinanyventureenviron-mentthenthissortofoutcomeisinevitable,whichiswhyIamcomfortablewiththegeneraltrendwhichFigure8.7identiﬁes,even 174PrivateEquityasanAssetClassthoughIacknowledgethattherewerespeciﬁcfactorsthroughoutthebubbleperiodandthebuild-uptoitwhichallmadetheirindividualcontributions.Infact,whatweareseeinghereisprobablyanaturalcycleinwhichperceivedout-performanceinanassetclasssucksmoremoneyintoituntiltheexcessavailabilityofmoneypushesdownreturnssufﬁcientlytomaketheassetclassunattractiveinrelativeterms,atwhichpointallocationlevelsdropoff,returnsriseandthewholecyclestartsalloveragain.WeseethisclearlyintheUSA,where3or4yearsofbumperfundraisingfollowed2or3yearsofbumperperformance.Ithinkwhatmadethispossiblewasthatwhereasnormallyitwouldtakeseveralyearsforfundperformancetobecomeapparent,theprevailingclimateofrapidlyrisingequitymarketsandfairlyquickventurecompanyexitsintoaboomingIPOenvironmentmadeclearveryquicklythesortofreturnsthatLPsinthetopUSventurefundsofthateracouldreason-ablyexpect.InmorenormalcircumstancesIwouldexpectthecycletodevelopmoreslowly.Initialhopesthatthiscyclemayhavereverseditselfveryquicklywereinitiallyraisedbytheﬁguresfor,say,2002and2003.Inboththoseyearsroughly$11billionwasraisedbyroughly100fundsevenatatimewhenfundsizereductionsweretakingplaceandsoLPsshouldlogicallyhavehadsurpluscapitaltoallocate;compareandcontrastthiswith2000,when525fundsraisedinitiallyovertentimesthatamount.Itistooearlytosaywhetherthisreductionwillhavehadanylong-termbeneﬁcialeffectofsqueezingexcesscapitaloutofthesystem,butprob-ablynot,sincemanyLPsseemtobereturningquicklytotheirformerways.2005sawUSventurefundraisingreturntoverynearly19981levels,whilepreliminaryﬁguressuggestthatover$18billionhasbeenraisedintheﬁrst6monthsof2006alone.RecentevidenceemergedthatconcernatfundraisinglevelswassharedevenwithintheGoldenCirclewhenventureﬁrmSevinRosenannouncedthattheywereabandoningfundraisingfortheirFundXonthegroundsthat“thetraditionalUSventuremodelwasbroken”(theirwords,notmine).“Whilegoodreturnsfromanygivenﬁrm’sportfolioarecertainlyapossibility,”theﬁrmwrotetoitsLPs,“thestatisticshaveclearlyshiftedinanunfavourabledirection.Theventureenvironmenthaschangedso1$27billionisreportedtohavebeenraisedin2005.Notonlywasthisnearlyasmuchaswasraisedin1998,butitismorethanwasraisedforthethreeyears1994,1995and1996combined. VentureReturns175thatoverallreturnsfortheentireindustryarewaytoolowandeventheupperquartilereturnshavedroppedtoinsufﬁcientlevels.”VENTURERETURNSBYSTAGEAcceptedwisdomhasitthattheearliertheinvestmentstageatwhichaventurefundfocusesthenthehigherthereturnstheycanrealisticallyexpect,andviceversa.Wehavealreadytouchedonthisbrieﬂy,andIhavetosaythatitaccordswithmyownexperiencegainedlargelyfromUSventurefunds.Letusseehowitworksoutinpractice.IthinkTable8.4showsbroadlywhatonemightexpect.ObservethatforbothIRRandTVPIthereisaslowbutsteadyfallingoffasoneprogressesfromearlytolaterstagesofinvestment.Bytheway,theseﬁguresshowthefund’smaininvestmentfocus,andwillthereforebebluntedsomewhatsincethereisnothingtostopalaterstagefundmakingafewearlystageinvestmentsaswell,orviceversa.Theseedﬁgures,though,areabitstrangeandweneedtodigalittledeepertoseewhathashappenedhere.Wespokeearlieraboutthedifﬁcultywhichverysmallventurefundshaveinavoidingdilution,andthisiswhatIthinkweareseeingatworkhere.ThisproblemismoreacuteintheUSAthanitisinEurope.InEurope,thereisafeelingthatacontinuinggoodrelationshipwiththeotherventureﬁrminquestionismoreimportantthanpressingwhatmightbeseenasacruellyhardbargainonanyonefundinground.IntheUSA,theoppositeisthecase,andtheprevailingmaximis“ifyoucan’tpay,youcan’tplay”,orinotherwordsifyoucannotparticipatemeaningfullyinafundingroundthenyoumustexpecttobeseriouslydiluted.Inciden-tally,thiscausedquiteafewrufﬂedfeatherswhenUSﬁrmsﬁrststarteddoingdealsinEuropeintheheadydaysof1998and1999.Table8.4AnalysisofUSventurefundperformancebystage;allfundsfromincep-tiontoend2005StageUQCWAUQCWATVPI(×)TVPI(×)IRR(%)IRR(%)Seed2.121.3013.30.2Early2.251.5816.313.2Balanced2.221.5215.46.9Late2.091.4414.85.8Source:ThomsonFinancialVentureXpert. 176PrivateEquityasanAssetClassAcrossbusinessasawhole,andventureisnoexception,USpartici-pantstendtobetransaction-orientedwhereastheirEuropeancounter-partstendtoberelationship-oriented,andIfeelthateachsideneedstotrytounderstandtheothermuchmoreinthisregardorfurtherbadfeelingisinevitable.AsthebubblestartedtoburstIlostcountofthenumberofEuropeanGPswhocomplainedbitterlytomethattheyhadbeenbadlytreatedbyaUSGP“whoIthoughtwehadarelationshipwith”,usuallyfollowedbyanexpresseddeterminationnevertohaveanythingtodowiththatﬁrmagain.Naïve,perhaps,butonecouldarguethattheAmericanattitudewasjustasmistaken,initsshort-sightedness.WhatwillhappenwhenthatUSﬁrmtriestore-enterEurope?Peoplehavelongmemorieswhentheythinktheyhavebeenill-used.IsuspectthattheﬁguresforUSseedfundsareaclearexampleofthisinabilitytoavoiddilution.ThevastmajorityoftheUSseedstagefundslistedbyVentureXpertarelessthan$25Minfundsize,certainlywaytoosmallto“playwiththebigboys”asIhavehearditexpressedbyUSGPs.Theabsoluteminimumeffectivesizeforaseedfund,bearinginmindtheneedtobeabletofollowinlaterroundsallthewaythroughtoexit,isprobablyabout$100M,andsomewouldprob-ablyargueforanevenhigherﬁgure.Infact,only34outof525seedfundsinthedatabase,orabout6%bynumber,arebiggerthan$100M.ThisalsohelpstoexplainwhytheCapitalWeightedAverageIRRissolow.JustaboutallthelargerfundswereraisedattheheightofthebubbleandtheirpredictablylowIRRswillbeundulydepressingtheresult–hencetheverylargedifferencebetweentheCWAandtheUpperQuartile.Ingeneral,though,IthinkTable8.4doesindeedsupportthegeneralviewthatlaterstagefundsarelikelytoseelowerreturnsthanearlyones.Ascepticmightobjectthatthedifferencesaresosmallthattheymightsafelybeignored,howevertheyaredrawnfromalargesampleandthetrendwhichtheydisplay,thoughsmall,isstatisticallysigniﬁ-cant.Moreimportantly,thereisonekeyfactthattheydonotshow.Rememberthatventurereturnsaredrivenbythestand-outfundslargelymanagedbythegoldencircleﬁrms?Well,youarenolessthan15timesmorelikelytoachieveatleasta10×returnbyinvestinginanearly2stageUSventurefundthanyouarebyinvestinginalatestageone.Foranyonewhoreallyunderstandsventurereturns,thisisakillerpoint.2FiguresfromThomsonFinancial’sVentureXpertsystem. VentureReturns177YoucannotachievethesortofreturnswehaveheardtalkedaboutbythelikesofHorsleyBridge,theYaleEndowmentandotherswithoutcapturingagoodnumberofthesestand-outfundswithinyourportfolio;youhaveonlyalimitednumberofbulletstoﬁreatthatparticulartarget,sowhywasteanyofthemonsuchaverylongshot(nopunintended)?ItisnocoincidencethatHorsleyBridgespecialisealmostexclusivelyinearlystageUSventure–theyworkedthisoutalongtimeago.WHATOFTHEFUTURE?Itisalwaysadifﬁcultbusinessmakingpredictionsaboutwhatwillhappentoprivateequityinthefuture.Ifeltreasonablyconﬁdentindoingsowhentalkingaboutbuyoutreturnssincetheprevailingtrendsseemtobesuggestedsostronglybytheavailabledata.Here,weareobviouslyindifferentterritory.Firstthereistheeffectofthebubbletoconsider.Thishadinﬁnitelymoredirectimpactonventurereturnsthanitdidonbuyout.Buyoutsufferedindirectlythroughtheassociatedrampinequityvaluationsfollowedbywhatwasalmostanuclearwinterforsomeyearsasfarasexitswereconcerned,butventurecaughtthefullblastofit.Thiswashopefullya“onceinageneration”eventandsoitseemshardtotakethepossibilityofanothersuchcataclysmicperiodintoaccount,buthumannaturebeingwhatitisonetremblestothinkwhatmighthappentoinvestorsentimentshouldthingssuchasstemcelltherapy,fuelcelltechnologyorcoldfusioneverreallytakeoff;thereistheevenmorelikelyprospectthatsomethingasyetcompletelyuncontemplatedcouldsuddenlybehailedas“thenextbigthing”.Sofaddism,orirrationalexuberance,orcyclicalityorwhateveryoumightliketocallitisprob-ablysomethingthatmustbefactoredintoourexpectationsofventurereturnsinthefuture.Myconcernsinthisdirectionareheightenedbythefactthatventurefundraisingdoesnotappeartohavefallenback,asonemighthavehopedwhenlookingattheﬁguresafewyearsago,tothemorerationallevelsof,say,1994or1995.Onthecontrary,fundraisingalreadyseemstohaveregainedthelevelsitenjoyedatthebeginningofthebubbleperiodandmyinstinctisthatitwillgohigheryet.Therearelikelytobeagoodnumberofinvestorswishingtoentertheprivateequityspaceoverthenextfewyears,andtheadvicetheywillprobablyreceiveisthattheyshouldbelookingtoputtheirmoneytoworkinUSventurefunds.Sinceaccesstothegoldencirclewillbeeffectivelyimpossible, 178PrivateEquityasanAssetClassthismeansthatwewillseetheirrationalintentionofinvestingwithpotentialthirdorfourthquartilefundsperpetuated.Thisinturnwillenablesomeﬁrmswhoshouldprobablynotbeabletoraiseanewfundinnormalcircumstancestoremaininbusiness.Aswesawafewpagesearlier,myconcernsaresharedevenwithintheGoldenCircleitself;SevinRosenwereraisingtheirtenthfundwhentheywithdrewfromtheMarket.Interestingly,anotherfactorwhichSevinRosenmighthavementionedbutdidn’tisthattheUSventuremarketisonceagainseeinglargenumbersofnewentrants(justasin2001justbeforethebubbleburst):52newUSventureﬁrmsintheﬁrstthreequartersof2006aloneaccordingtotheNVCA.ThenthereistheproblemofcomingtoanysortofaccurateviewonwhatEuropeanventurehasactuallyachievedintermsofhistoricper-formance,andinanyeventishistoricEuropeanperformanceneces-sarilyagoodguidetofuturereturns?WehavedemonstratedthatcomingtoanysortofaccurateviewofhowEuropeanventurehasreallyperformedisvirtuallyimpossible.ThereisevidencethatatleastonefundineachvintageyearhasusuallyproducedperformancethatwouldmeasureagainstthegoldencircleintheUSA,althoughthegoldencircleeffectassuchisabsent.How-ever,therecanbenodoubtthatEuropeanventurehasbadlyunder-performed,thoughitisimpossibletosaybyexactlyhowmuch.Thisisduepartlytotheabsenceofthegoldencircle,butthisonlytellspartofthestory.TheabsenceoftheUSmodelofearlystageinvest-ing,andskills,expertiseandmind-setthatthisrequires,havemeantthatwiththeexceptionofthatoddoneortwofundsayear,Europeanventurehasunder-performedacrosstheboard.Thereallyinterestingquestion,ofcourse,iswhatwillhappenastheUSmodelstartstobewidelyemployedinEurope.IsthereanygoodreasonwhyitshouldnotgenerateatleastasgoodreturnsasithasdoneinAmerica?Myinstinctsays“no”.However,Iaminadelicatepositionhere.IamwellknownasanadvocateofEuropeanventureanddonotwanttobeaccusedofmakingfancifulclaimswithlittleharddatatobackitup.Itmay,Ifreelyadmit,beseenashighlyconvenientthatthehistoricdatawhichseemstodamnhistoricEuropeanventurereturnsturnsouttobeunreliable.Verywell,hereissomeharddata.AccordingtodataproviderVentureOne,therehaveonlybeeneightventureexitsintheworldsincethebeginningof2002withanexitvalueinexcessof$1billion.ItmaysurprisemanythatnotonlyhavefourofthesebeenEuropean,butalsothatwiththeexceptionofGoogle,theEuropean VentureReturns179realisedexitmultipleshavebeenhigherthantheothers.Now,oneswallow(orevenfourswallows)dothnotasummermake,butsurelythisisatleastcircumstantialevidencethatEuropeanventurecapitalistsarewatchingwhathashappenedintheUSA,learningfromit,andapplyingitinEuropetogoodeffect?So,thefutureforventuremaybeunpredictablebutcertainly,forthismostexcitingofassetclasses,isnotgoingtobeboring.Certainlythegoldencirclewillcontinueconsistentlytoout-perform.Thequestioniswhathappensoutsidethegoldencircle.Howwillthereturnsoftherun-of-the-millUSﬁrmsholdupinanenvironmentwhichstilllooksover-fundedandover-populated?Willthegapbetweenthegoldencircleandtherestopenupstillfurther?WillthebulkofthegoldencirclecometoruetheirdecisionnottoexpandintoEuropeinthelate1990s?Myinstinctsays“yes”,butIamunsureexactlyhowthismightplayout.IamawareofatleastoneEuropeanventureﬁrmwhichhasbeenapproachedwithaviewtobecomingtheEuropeanoffshootofanAmericanﬁrm,andthisiscertainlyonewayahead,butIamnotsurethatitwillprovewidespreadasanapproach.NorIamsurethatUSﬁrmswillactuallycometoEuropeenmasseinthenearfuture.Euro-peanexpansion,or,atleast,successfulEuropeanexpansionrequiresamind-setwhichIthinksimplydoesnotexistinUSﬁrmsatpresent.Itrequiresawillingnesstoadaptwherenecessarytoslightlydifferentwaysofdoingbusiness,andtoacceptthatcompaniesplantedbeyondyourowngardenfencemightprovejustassuccessfulasyourownhome-grownvariety.ItalsorequiresareadinesstoworkwithEuro-peansasequalpartners.Thereareatleasttwohonourableexceptions3here,butforthemostpartthebestUSventureﬁrmsseemtobelievethatnoneofthisispossiblewithoutinsomewayfatallycompromisingtheUSmodel.Ithinktheywillcometoseethattheyaremistaken,butitwilltaketimeandbythentherealopportunitymaywellhavebeenmissed.InthemeantimetheymaywellhavedecidedtoexpandtoAsiaﬁrst.Whileillogical,sinceEuroperepresentsanalreadyestablishedventurecommunity,andastablebusinessinfrastructureinmarkedcontrastto,say,China,thiswouldbeconsistentwithwhathashappenedinotherareasofinvestmentandalsowitheverythingIhaveheardfromtalkingwithAmericanLPs.TherootsoftheAmericanloveaffairwithAsia,3AccelandBenchmark,alreadymentioned. 180PrivateEquityasanAssetClassandparticularlywithChina,rundeepandwereplantedalongtimeago(atleast70yearsagoandpossiblylonger).AsiaishugelyseductiveanditisaseductionthatUSinvestorsfeelunabletoresist.Oneconstantinhumanaffairsisourapparentinabilitytolearnfromhistory.Thosefewofuswithlongenoughexperienceofprivateequitywillremembertheill-fatedChinafundswhichweresetupalmostexclusivelywithUSmoneyintheearly1990s,amidbravetalkofexpectationsof4×or5×fundreturns(sincenaturallysomethingwhichwashighriskmustalsoproducehighreturns,mustn’tit?).Yetsadlyitseemsthatthisissome-thingthateachsuccessivegenerationofinvestorsmustlearnforthem-selvesalloveragain.PleasedonotrunawaywiththeideathatIamsomehowanti-Asian;Iamnot.VenturecapitalhasbecomeaglobalbusinessandAsiahasavitalroletoplayinglobalexpansionofventurecompanies;Worldview,forexample,hashadbusinessdevelopmentofﬁcesinAsiaformanyyears.YetthereisallthedifferenceintheworldbetweenseeingAsiaasalogicalmarketforportfoliocompaniesandinvestinginfundsdedicatedtoconductingventuretransactionswithinaparticularAsianmarket.Herethereisasigniﬁcantperceivedriskpremiumduetothingslikelackoftransparencyinbusinessaffairsanddifferentattitudestocontractualcommitments.ItisimportantthatinvestorsgointomarketslikeAsiaandSouthAmericawiththeireyesopenandwithrealisticexpectationsofextrareturntocompensateforthisadditionalrisk.SUMMARY•Historically,USventurehasverysigniﬁcantlyout-performedEuropeanventure.However,whiletakingnothingawayfromthesuperbachievementsofUSventureﬁrmsduringthe1990s,thedifferenceisnotperhapsquitesodramaticastheofﬁcialﬁgureswouldhaveusbelieve.•TheofﬁcialﬁguresforEuropeanventurecontainalargenumberoffundswhicheithercannotbeproperlyclassiﬁedasventure,orarenotofinstitutionalinvestmentgrade,eitherbecausetheyareverysmall,orbecausetheyarenotmanagedbyindependentventureﬁrms.Thelevelofaccuracyintheaveragevintageyearsduringthe1990s,measuredbythenumberofsucheligiblefunds,isonlyabout27%.Thus,whileperformancehasbeenundeni-ablydisappointing,itisdifﬁculttobesurejusthowdisappointing. VentureReturns181IndividualEuropeanfundshaveprovedsuccessful,evenachieving10×,butitseemsthatsuchsuccesseshavebeenisolatedandnotreproducedacrossanysigniﬁcantportionoftheindustry.•Instatisticalterms,muchofthedifferenceisduetotheconsistentsuccessofthe“goldencircle”ﬁrmsintheUSAinproducingfundswhichcanreturnmorethan10×.Itissigniﬁcantthatintheonlypre-bubblevintageyearinthe1990stoproducelessthanexcitingreturns(1991),therewasnotasinglesuchfundformed.ThustheabilitytoproduceexcellentreturnsfromaportfolioofUSventurefundsisdependentupontheabilitytosuccessfullyidentifyandaccessthesefunds.•Earlystagefundsseem15timesmorelikelytoproduceatleast10×thanlatestagefunds.•Thereseemstobeadirectinverserelationshipbetweentheamountofcapitalraisedinanyvintageyearandthereturnsofthatvintageyear,particularlyintheUSA.•InpracticaltermsthemainreasonforthedifferingreturnswastheabsenceinEuropeoftheUSmodel,witheverythingthatthisimplies(mind-set,skills,etc.).•However,itshouldberememberedthatnoequivalentofNASDAQexistedinEuropetoprovideexitsanddrivevaluations.Also,thebubblehadmuchmoreopportunity(becauseoftherelativetime-lines)tocreatehighreturnsforabrieftimeintheUSAthanitdidinEurope.•LevelsofventurefundraisingremainaconcernintheUSA.Thereareindicationsthatthesearereturningtoearlybubbleerapro-portions,despiteasigniﬁcantoverhangofcapitalalreadyinthesystem.Thiscouldwellresultinvaluationsremainingatrelativelyhighhistoriclevels,butwillalsoseeLPsbeingpushedinexorablydownthequalitychainintheirfundselection.•Itseemshighlylikelythatthegoldencirclewillcontinuesigniﬁ-cantlytoout-performtherestoftheirUScompetitors.Indeed,itispossiblethatwithhighlevelsofavailablecapitalenablingthirdandfourthquartileﬁrmstostayinbusiness,thisdifferencewillbecomeevenmorepronounced.•ThehugeunknowniswhatwillhappenastheUSmodelbecomesincreasinglywidelypractisedinEurope.Recentbilliondollarexits,thoughsmallinnumber,suggestthatEuropemaywellbeabletoatleastmatchUSreturnsinfuture.Giventhatverysmall 182PrivateEquityasanAssetClassamountsofcapitalarecurrentlybeingallocatedtothisarea,Euro-peanventurecouldbeseenasrepresentingaclassiccontrarianopportunity.•ItispossiblethatthevastmajorityofUSventureﬁrmsmaylivetoregrethavingmissedastrategicwindowforexpansionintoEuropeinthelate1990s.Itisunlikelythatthissituationwillchangeanytimesoon;indeed,itisquitepossiblethatmostUSﬁrmshaveAsiaaheadofEuropeontheagenda.•Whateverthecase,ventureisrapidlybecomingaglobalbusiness,andthekeytestforanyventureﬁrminthefuturemaywellprovetobehowtheyrisetothischallenge.Withoneortwohonourableexceptions,internationalexpansionbyventureﬁrmshasprovedhighlyproblematicinpractice. 9DueDiligenceThemakingofanyprivateequityinvestmentisatwofoldprocess.Firstcomesthedecisioninprincipleastowhetherthislookslikeanattrac-tiveprospect.Ifthisendswithayesvotethenyouwillhavedecidedtomaketheinvestmentsubjecttoduediligenceandthissecondpartoftheprocesswillnowfollow.Inpractice,thedistinctionbetweenthetwoisbecomingincreasinglyblurred,sinceyouwillhaveneededtoinvestigatealotofthefactsverythoroughlyinordertomakeyourdecisioninprincipleintheﬁrstplace,particularlyifthesehavebeenidentiﬁedasspeciﬁcissues.However,foreaseofdiscussionwewillassumethatthesetwopartsoftheprocessareseparateanddiscrete.Duediligenceisahugesubject,particularlysointhiscasesinceweneedtocoverallthedifferenttypesofprivateequityinvestment.However,thereismuchthatiscommonintheapproachtoeachone,andsoIwillbeginbydescribingtheprocessingeneralandthenfocusonwhatyoushouldlookforineachparticularcase.Iwouldrecommendthatduringtheinitialdecisionprocessyoukeepalist(puttingitonaﬂipchartworksverywell)dividedintothreecolumnsheadedpros,consandissues,respectively.Theobjectiveofduediligenceistofocusoneachoftheissuesuntilitispossibletoresolveit,hopefullytransferringittooneoftheothercolumnsintheprocess.Ofcourse,thisisnotalwayspossibleandtherewillbesomeissuesthatremainissuesrightuptothetimetheﬁnaldecisionistaken.Generallyspeakingwithprivateequityyoumakeanydecisiontoinvestdespitetheexistenceofvariousissues.Thisisjustthewayitis(chieﬂybecauseinmanycasesyourdecisionislargelyadecisiontobackcertainindividuals,andhumanbeingsarenotoriouslydifﬁculttounderstandandclassify)andifyouseekaperfectsituationwheretherecanneverbeanypossibledoubtwhattherightdecisionmaybethenIamafraidyouwillnevermakeasingleinvestment.Youmustdoyourbest,exhaustingeveryreasonableavenueofenquiryintheprocess,butyoucannotachievecertainty.Indeed,itisinthisﬁnallayerofuncertaintythattheskillandjudgementwhichdistinguishesatrulygoodprivateequityinvestorfromanalso-ranresides. 184PrivateEquityasanAssetClassThefactthatduediligencecarriesonfromtheinitialstagesoftheinvestmentprocessisinfactagreathelp,sinceyoushouldalreadyhaveidentiﬁedthoseissueswhichyouneedtoexplore.Incidentally,thereisanimportantlessonherewhichisignoredbythevastmajorityofprivateequityinvestors,bothatthefundandatthecompanylevel.Duedili-gencedoesnottakeplaceinavacuum.Ifyouhaveastandardduedili-gencechecklistwhichyoudutifullyandmeticulouslyfollowineachcase(or,evenworse,astandardquestionnairewhichyouexpecttheinvesteetocomplete)thenyouarecompletelymissingthepoint.Yes,ofcoursetherearecertainthingswhichyouwillalwaysneedtocheck,butthemainpurposeofduediligenceistosatisfyyourselfonthosespeciﬁcissueswhichyouhaveidentiﬁedduringyourinitialinvestiga-tionsandanalysis.Sadlymostinvestorsseemtofailtorecognisethattheaimofduediligenceistohelpthemmakebetterdecisions,andprefertoseeitasameansofcoveringtheirbacksinadvanceshouldanythinggowrongwiththeinvestmentinthefuture.Inmanycases,particularlywheretheLPreliesontheinvesteesup-posedlytodotheirworkforthembyﬁllingininterminablequestion-nairesaskingfortheirgrandmothersdateofbirth,duediligenceatthefundlevelmayconsistlargelyofrecalculatingtherelevanthistoriccashﬂowstocheckthatthestatedIRRsareindeedcorrect.Inpassing,Iwouldquerywhetherthisisreallynecessarywhen,forexample,theﬁgureshavealreadybeenspeciﬁcallyauditedbyamajoraccountingﬁrm,orveriﬁedbyareputableplacingagent,butletthatgo.Suchinvestigationmaybeaverygoodwayofpaperingtheduediligenceﬁle,butfailstoaddressthekeyquestions,whicharenotwhatistheIRR?buthowdoesitcomparetotheIRRsofsimilarfundsfromthesamevintageyear?,ifitisdifferent,whyisitdifferent?,howhavethereturnsbeeninﬂuencedbytherelevantdrivers?,whatevidencedotheﬁguresshowofthisﬁrmdoingthingsdifferentlytootherﬁrms,ordifferentlytohowthesameﬁrmusedtodothingsinthepast?,etc.Inotherwords,evenﬁnancialduediligenceneedstobeintelligentandgearedtowardsansweringspeciﬁcquestions,notjustverifyingthedatawhichhasbeenproffered.Atthecompanylevel,ofcourse,particularlyinthecaseofbuyouts,veriﬁcationisvitallyimportantandwillusuallybeaddressedbywayofaninvestigatingaccountantsreport.Yetevenhere,ﬁnancialduediligencewillgowaybeyondveriﬁcationandtheexplorationofcon-tingentliabilities,etc.Thebuyoutﬁrmwillbeﬂexingtheforecastsandmanagementaccountstoseehowmuchextracashﬂowcanbesqueezed DueDiligence185outtoservicedebt,orinvestigatingtheeffectsofpossibleassetorbusi-nessunitsales.However,itisonthesoftissuesthatduediligencebecomethemostdifﬁcult,partlybecausepeoplearealwaysreluctanttospeakfranklyabouttheirassociates,andinparticularreluctanttosayanythingnega-tiveaboutthem.ForsomereasonthisproblemisparticularlyacuteinFrance,whereeffectivepeopleduediligenceisallbutimpossible;evenifyoumaketheefforttohavetheconversationinFrenchallanyonewillusuallysayisthattheobjectofyourenquiriesiswellconnected.Agoodwayofgettingaroundhisproblem,ifyoucan,istotrackdownanyonewhohaslefttheﬁrmrecently;eventheinsightsofquitejuniorstaffonthingsliketeamdynamicscanbeveryhelpful.Thisraisesafurtherimportantpoint,bytheway.Byallmeansmakeafewcallstothenamesyouhavebeengiven,butthisshouldbelargelyamatterofformsincetheyaremostunlikelytotellyouanythingreallyvaluable.Mostofyourcallsshouldbeoffthelist.Inadditiontorecentleavers,trytoﬁndtheCEOsofportfoliocompanieswhichmayhavegotintodifﬁculties,anyotherprivateequityﬁrmswhoco-investedinsuchdeals,andanyLPswhocommittedtopreviousfundsbuthavenowstoppeddoingso.Asamatterofformyoushouldverifythepersonaldetailsyouhavebeengivenbycontactingpreviousemployersandeducationalinstitu-tions.Itisamazinghowmanypeoplelieabouttheirclassofdegree,forexample.Itisapitythatthisisnotdonemoreoftenasamatterofroutinewhencheckingofferingdocumentsandthelike.IhavesofarcomeacrosssomeonewhoclaimedtohaveadegreefromaprestigiousBritishuniversitywheninfacthehadbeenexpelledinhisﬁrstyear,andsomeonewhoputthelettersLLDafterhisnamesomethingwhichwentunnoticedforsometimedespitethefactthatthiscanonlybeawardedasanhonorarydegreetoamajorpublicﬁgure,whereasthisparticulargentlemanturnedouttobeastruck-offsolicitorsclerk.Mycastofcharactersovertheyearshasalsoincludedaphoneybarristerandsomeonewhochangedthespellingofhisnameinanattempttoconcealastringofbankruptcyorders(andwhoalsoturnedouttohavespenttimeatHerMajestyspleasure,describedratherinventivelyasvoluntaryworkoverseas).Allthisshouldberoutine,butoftenisnot.Thescopeofduediligenceisboundedonlybyyourimaginationandtheamountoftimewhichyouhaveavailable,butyoushouldneverlosesightoftherealobjective,whichistoresolveanyoutstandingissueswhichyouhavewiththefund 186PrivateEquityasanAssetClassorcompany.Inthecaseofafund,allyourenquiriesshouldbeleadingyoutowardsonething:exactlyhowdoesthisgroupdoitsdeals,andhowdoesthisdifferfromotherpeopleinthesamespace?Thiswillincludethingssuchasdealﬂow(IanSimpsonofHelixAssociatesoncememorablydrewattentiontoacomputerviruswhichhadinvadedthecomputersofprivateequitypractitionersinsertingthephrasespropri-etarydealﬂowandupperquartileperformanceatrandomintopeoplespresentations),butalsohowtheydeveloptheirportfoliocom-paniesduringthepost-investmentphase.BUYOUTFUNDSWehaveseeninanearlierchapterhowtomodelandanalysebuyoutreturns.Youneedtobeabletoexamineexactlywhatcontributioneachofthebuyoutdrivershasmade,sincethiswillgiveyouagoodideaofhowtheﬁrmcreatesvalueforitsinvestors.Topofyourlistofprefer-encesshouldbeanyﬁrmthatisableconsistentlytoincreasecompanyearningsinrealterms(i.e.,afteradjustingforinﬂation)sincethisisagroupthatwillbeabletomakemoneyinanymarketconditions.However,youshouldalsouseyourdriveranalysistocomparewhattheﬁrmhasbeendoingagainstotherbuyoutﬁrmsovertime;obviouslythiswillonlybecomepossibleasyouaddmorebuyoutﬁrmstoyourportfolioovertheyears,butoncecomparativedataisavailablethenthiscanbecomeaveryrevealingexercise.Isoneﬁrmusingmoreorlessdebtthantheothers,forexample,orpayinghighermultiplesforitscompanies?Thereisoftenasurprisingvariationintheformermeasure,whilethelattercanbeanindicatorofagroupthatisstrugglingfordealﬂow.Incidentally,thisisonereasonwhydoingduediligenceonaﬁrmisneverwasted.Evenifyoudecideattheendofthedaynottoinvest,thenyourduediligencematerialcanbesavedandusedforcomparativepurposeswhenanalysingotherfunds.However,Iamnotsuggestingthatyoushouldembarkuponduediligenceroutinelyjusttoacquiredataforthesepurposes.TherearequiteafewLPswhodoseemtodothis,andtheyrapidlyacquireapoorreputationamongstGPsandplacingagents.Duediligenceshouldonlyfollowadecisioninprincipletoinvest,andifyouarenotcommittingtoatleasttwo-thirdsofthefundsonwhichyouperformduediligencethensomethingiswrong;speciﬁcally,youarestartingafullduediligenceprocesswhenalittlelimitedinformationgatheringcouldprobablyhavekilledtheprojectat DueDiligence187amuchearlierstage.Duediligencetimeisprecious,particularlyifyouaregoingtodothingsproperlybyspeakingtolotsofpeople.Useitwiselytodoreallymeaningfulworkonthosefewfundsyoubelievetobekeyprospects.Dealﬂowiskeyforbuyoutﬁrmsandoneofthethingsyoushouldbeanalysingisexactlywhereeachdealcomesfrom.Forthelargerplayers,justabouteverydealwillnowadaysgothroughsomesortofauctionprocess,sobeverywaryofdealswhicharedescribedaspro-activeorexclusiveinorigin.Similarly,mostwilltodayinvolveaconsortiumofinvestors,possiblywithequitysyndicationoutsidetheconsortiumaswell.Awordofwarninghere:everybuyoutﬁrminvolvedinaconsortiumwillclaimtohaveledit,andthattheirinvolvementwasthereasonwhythedealwasofferedtotheconsortiumintheﬁrstplace(e.g.,wehadbeenchasingthisdealforﬁveyears,weknewthecompanyverywell,wehaverecognisedexpertiseinthesector,etc.).Takesuchclaimswithapinchofsaltandseeifyoucanﬁndindepend-entveriﬁcation(perhapsfromtheinvestmentbankwhichhandledthedeal,fromalendingbank,orfromsomeonewhohasrecentlyleftoneofthebuyoutﬁrmsinvolved)ofexactlywhatreallyhappened.Equallyimportantistotrytoﬁndoutwhichdealstheywerechasingbutdidnotmanagetoclose.Weretheyontheshortlistofpotentialpurchasers?Ifnot,whichoftheircompetitorswerepreferred,andwhy?Iftheywereonthelistbutdidnotclosethedeal,whywasthis?Isitpossibletocheck,forexample,thatthepricetheyofferedwaslowerthanthatofthewinningconsortium,and,ifso,byhowmuch,andwhy?Withsmallerbuyoutﬁrmsduediligencecantakeonamoretrad-itionalﬂavoursincehereitisperfectlypossiblethattheymaybesourcingdealsonanexclusiveand/orproactivebasis,butagaindomaintainahealthyscepticism.Thetentaclesoftheauctionprocessnowreachaverylongwaydownthesizescale.Timeshavechangedsinceamanagementteamusedtohireanaccountancyﬁrmandgotoseetwoorthreebuyoutﬁrms.Thesedaysmostcompanyvendorswillusesomesortofinterme-diarywhowillsolicitoffersfromawidevarietyofpurchasers.Teamdynamicsarekeyandrequirecarefulteasingout.Howmanyoftheexecutivesshareinthecarryandthemanagementfeeproﬁts,andinwhatpercentages?Therecanbesomeverylargesumsofmoneyinvolved,particularlyinthecaseofmegafunds,andhavingtheequityownershipcontainedwithintootightagroupofpeopleisgenerallyanunwelcomesign,asitcanbeanomenofexecutivedeparturesoranunhappyship. 188PrivateEquityasanAssetClassSimilarly,exactlywhotakestheinvestmentdecisions,andhowarethesemade?Isitmajorityvoting?Doesanyonepersonhaveaveto?Doesithavetobeunanimous?Incidentally,dolookoutforsituationswhereanoutsider,i.e.,someonewhoisnotamemberoftheexecutiveteam,playsanypartintheinvestmentdecisionprocess.Thiswillnotnormallybeanissuesinceitwilltypicallyonlyoccurwhereagroupisnotindependentbutispartofalargerorganisation(usuallyabankoraninsurancecompany)andyouwouldnotnormallyconsiderafundmanagedbysuchateamintheﬁrstplace.However,itisstillquitecommonincontinentalEuropeforoneortwoprominentoutsiderstoplayarole.Anotherwayinwhichtheissuecanoccurisifanoutsiderhaspreviouslyplayedarolebuttheteamhasgotthemessagethatthisisbadnewsforinvestorsandhasremovedthepersonfromthatrole.TheproblemhereisthatsometimesallthathappensisthatthenamedisappearsfromtheOfferingMemorandumbuttheindividualcarriesonplayingtheroledefacto;youneedtobeverycareful(butdiscreet)incheckingwhatisgoingonhere.Thegeneralruleisthatifyouhaveanydoubtatallthatdecisionsarenotbeingmadeexclusivelybytheexecutivesthemselves,thendonotproceed.VENTUREFUNDSManyofthepointswhichIhavealreadymadeinrelationtobuyoutfundsarerelevantheretoo,particularlyinsofarastheyrelatetoteamdynamics.Indeed,withinaventureﬁrmthisisevenmoreimportant,astheytendtobemoreofacollegiate,equalpartnershiptypeoforgan-isationratherthanthemorehierarchicalstructureofthetypicalbuyoutﬁrm.Someventureﬁrms,forexample,haveanonlypartnerspolicy,andthustheydoalltheworkthemselvesratherthandelegatingittoprincipals,associates,analysts,seniorvicepresidents,juniorvicepresi-dents,middlingvicepresidents,etc.Insuchasituationtherelationshipofeachpartnertotheothersisall-importantandshouldformalargepartofyourinitialdiscussionsandduediligencework.Again,thebestpeopletoaskarealmostcertainlynotthepartnersthemselvesbutpeoplewhohavedealingswiththeﬁrmandwho,ideally,havebeeninvolvedinoneormoreoftheirtransactions(includingonesthathavenotworkedout).Wehavealreadyseenthatwhatdistinguishesagoodventureﬁrmfromitscompetitorsishomerunmentality,andallyourduediligenceshouldbefocusedonidentifyingthepresenceorotherwiseofthis. DueDiligence189Unfortunately,justaseverybuyoutﬁrmwillclaimtohaveproprietarydealﬂow,soeveryventureﬁrmwillclaimtohaveahomerunmentality,sothisisverymuchanareawhereyouwillhavetorelyonwhatyouseeandhearforyourself,ratherthanonwhatyouaretold.Withanestablishedﬁrmwhichhasbeeninbusinessfor10yearsormorethereisaverysimplelitmustestwhichcantellyoustraightawayifthisisanofferingonwhichyouwishtospendanytimeornot.Iftheyarenowon,say,FundIVandnoneoftheirearlierfundsseemlikelytoreturnatleastthreetimestheirmoneyortoproduceahomerun(andtodoonewithouttheotherisdifﬁcult)thenIthinkyouareentitledtoassumethatthisisagoodindicatorthattheﬁrmisunlikelyevertoachievethis.Remember,wearedeﬁningahomerunassome-thingwhichhasthepotentialtoreturnthewholecapitalofthefundatleastonce,soeveniftherehasbeenabigwinner(25×orbetter)itdoesnotcountasahomerunifitonlymadeup,say,1%ofthefund.Thisraisesanimportantpoint,andsomethingwhichisnotappreci-ated(andcertainlynotcarriedout)bymostLPswhododuediligenceonventureﬁrms.Itiscrucialthatyouanalysethemoneymultiplemadebyeachdealrelativetowhatpercentageofthefunditmadeup.Ideally,ofcourse,whatyouwanttoseeisagoodcorrelationbetweenbigbetsandbigwinners.Thisisaverygoodindicatorofhomerunmentality;aﬁrmthatisidentifyingandkillingoffitslosersquicklyanddevotingitsresourcestothosefewcompanieswhichemergeashavinghomerunpotential.Whileaperfectresult(atrendlinefrombottomlefttotopright)willrarelybepossible,aclusterofcompaniesinthetopleft-handcornerwouldalmostcertainlybeaclearreasonnottoinvestwiththatﬁrm.Thepercentageofacompanysequitywhichisheldbythefundisalsooftenagoodindicatorofhowtheyaredoingbusiness.Theidealisafundwhichcangetintoacompanyearly,secureagoodequitypercentage(anythinguptoabout40%)andprotectthatagainstsubse-quentdilutionasmuchaspossible,endingupwith15%to20%.Ifafundshowsconsistentlylowpercentageholdingstheneither(1)theyarenotdoingagoodjobofprotectingtheirpositionor(2)theyare1predominantlycomingintootherpeoplesdealsatalaterstage.Neitheroftheseapproachesislikelytoresultinthescoringofhomeruns.1IwasoncemakingareferencecalltotheCEOofacompanyinwhichaventurefundhadtakenaverysmallstakelateintheday,andwhenIexplainedthatIwascallingaboutXYZPartnersheaskedwho?. 190PrivateEquityasanAssetClassObviouslythereareexceptionswhenacompanysvaluationreallyexplodes,ashappenedrecentlywithSkype,butIthinkthegeneralprinciplewillbeclear.Itismucheasiertoscoreahomerunifyouhavealargepercentageofacompanysequity,sinceyouwillcapturepro-portionatelymoreofthegain,andifitrepresentsagoodpercentage(atleast4%)ofyourfund,sinceitwillhaveamuchgreatereffectonthefundsmoneymultiple.Wewanttoinvestwithventureﬁrmswhichhavethemaximumchanceofscoringhomeruns,sowewilltendtoavoidthosewhichexhibiteitheroftheabovetendencies.Theotheraspectofahomerunmentalitywhichneedstobethor-oughlytestedistheabilitytocontributevalueadd.ThisisbestdonebyspeakingtootherventurecapitalistswhohaveinvestedalongsidethemandCEOswhosecompanieshavebeenbackedbytheﬁrminthepast,andquizzingthemaboutwhattheindividualGPsactuallydidforthecompany.HeretheremaywellbeadramaticdifferenceintheresponsesdependingonwhetheryouareinEuropeorAmerica.IntheUSAyouwillhearaboutGPshelpingwithproductdevelop-ment,drawingupsalespresentations,makingintroductionstokeycustomers,hiringexecutives,etc.TheCEOislikelytobeveryclued-upaboutventurebestpractice,particularlyifheisanexperiencedentre-preneur,andmaywellbeabletodrawdirectcomparisonswithotherventureﬁrms.WhenconductingduediligenceonatraditionalEuro-peanventureﬁrm,CEOsarelikelytosaywell,hecomestotheboardmeetingonceamonthafterall,thatswhatventurecapitalistsdo,youknow.Happily,thingsarechanginginEuropebutclearlyaresponselikethisisnotlikelytoinspireconﬁdenceinaﬁrmsabilitytoscorehomeruns.Therearelotsofotherthingsthatyoucandowhenlookingataventurefund.Youcanchecktoseehowtheirpre-moneyvaluationscomparewithotherdeals,howtheirperformancemaydifferbysector,andwhethertheirinvestmentfocusismovingearlierorlaterbystage(thismaywellbeafunctionoffundsizelargerventurefundstypicallypushaﬁrmlaterinstagefocus).Attheendoftheday,however,homerunsareallthatmatterinventurecapitalandallyourduediligence,nomatterwhatformittakes,shouldbegearedtowardsansweringthefundamentalquestion:howlikelyisitthatthisfundwillendupwithatleastonehomeruninit?Withventurebecominganincreasinglyglobalbusiness,youalsoneedtolookverycarefullyathowaﬁrmmightbeabletogrowacompanyacrossnationalboundariesiftheyareoperatinginsectors DueDiligence191wherethismightprovenecessary.Forexample,ifaCalifornianﬁrmisdoingdealsinthemobilespace,howisitgoingtoaccessEuropeanmarkets?Similarly,howisaEuropeanﬁrmgoingtorelocateasoftwarecompanytotheUSA?Thisiscurrentlyseen,rightlyIthink,asmuchmoreofanissueforEuropeanﬁrms,whocommonlycomplainthatitisimpossibleforthemtogettheattentionoftheleadingUSventureﬁrmswhentheytrytointeresttheminbecomingaUSco-investorintheirdeals.However,IhavewrittenelsewherethatIthinkthefailureofthebestUSventureﬁrmssuccessfullytocoloniseEurope(withtwohonourableexceptions)maywellprovetobeasourceofmajorstrategicweaknessinthefuture.CO-INVESTORSAsanessentialpartoftheduediligenceonaventurefundyoushouldlookcarefullyattheventureﬁrmswhichco-investedinportfoliocom-panies.Qualityventureﬁrmswanttoinvestinqualitycompaniesalong-sideotherqualityventureﬁrms,andtheidentityofco-investorsisaverygoodindicatoroflevelsofpeerrecognitionandrespect,bothfortheﬁrmgenerallyandforitsportfoliocompanies.Indeed,ifyouwantaquickanddirtyindicatorofﬁrmqualityyoucouldsimplylookattheidentityoftheirco-investorsandthenumberofhomerunstheyhavescored.However,pleasebeawarethatthismeasure,thoughstillvalid,islessjustinEurope,wherecapitalistypicallyinshortsupplyandventureﬁrmsfrequentlyhavetotakeitwheretheycanﬁndit.Incidentally,thisisanissuetooinbuyoutfunds,butfordifferentreasons.Wehavealreadynotedthepracticeofbuyoutfundsgatheringtogetherinconsortiatobidforvariouscompanies.Wearenowalsostartingtoseeevidenceofequitybeingsyndicatedimmediatelyaftercompletiontootherbuyoutfunds,whomayhavebeenmembersofunsuccessfulconsortiabiddingforthesamedeal.Thisneedstobecarefullymonitored,asitthreatenstocommoditisebuyoutreturns.Inparticular,ifyouseeevidenceoftwoorthreebuyoutﬁrmshabituallyactingtogetherthenyouneedtothinkverycarefullyaboutwhetheryoucanvalidlyinvestwithanymorethanoneofthem.Conversely,ifyouseeevidenceofabuyoutﬁrmthatcanactaloneandstillwindeals,orperhapsinvolveotherﬁrmsinfrequentlyandonarandombasis,then2thisoffersgenuinepotentialforauniquepatternofreturns.2Butbewarethiscouldbeuniquelybadaswellasuniquelygood! 192PrivateEquityasanAssetClassCROSS-FUNDINVESTINGWithbothbuyoutandventurefundsyouneedtokeepaverycarefuleyeoninstancesofcross-fundinvesting.Imentionthisherebecausetraditionallyithasbeenmoreofanissuewithventurefunds,althoughtherehavebeenacoupleofhighproﬁlecasesinvolvingbuyoutfundsinrecentyears.Thereasonitismoreofanissuewithventurefundsisthatventurecompanieswillhaveserialfundingrounds,whereastypic-allybuyoutcompanieswillhaveonlyone.Thus,inbuyoutsituationsitnormallyariseseitherwhereacompanyismakinganacquisition,orwhereithasgotintoseveredifﬁcultyandaninjectionofnewequityisproposed,or(andthismaysurpriseyou)whereitisbeingsoldandthebuyoutﬁrminvolveddecidestomakeanewinvestmentintothedealfromitscurrentfundalongsidethepurchaser.Spaceforbidsadetailedexaminationofthesesituations,butsufﬁceittosaythateachofthesebuyoutsituationsinvolvesatleastthepotentialformassiveconﬂictofinterest(sincetheLPmembershipofeachfundwillbedifferent)andtheneedforastronganddisinterestedadvisoryboardofindependentviewsisparamount(butunfortunatelyrarelyrealised).ThebestadviceIcangiveisthatifyoucomeacrosssuchasituationthatseemsapar-ticularlyunfairuseofcurrentfundcapital,thenthisisprobablyaﬁrmbestavoided.Withinaventurefund,otherissuesariseinadditiontotheobviousoneofvaluation.Principallyyouwillneedtoaskwhatwentwrongwiththereservesforfuturefundingroundswithintheﬁrmspriorfund,andquestiontowhatextenttheeffectofsuchfollow-oninvestingmayshifttheinvestmentstagefocusofthenewfundawayfromearlystagetowardslatestage.Thegeneralprincipleshouldbethatanearlystageventurefundshouldnotbeinvestinginacompanyfortheﬁrsttimeatalaterstage,fullstop.Todosoistodiminishitschancesofscoringahomerun,towhichendeverypennyoffundcapitalshouldbeutilised.BUYOUTCOMPANIESBuyoutﬁrmsperformduediligenceonprospectiveportfoliocompaniesinmuchthesamewaythatanyprospectivecorporateacquirerwouldinanyM&Atransactionandthisisonereasonwhybuyoutprofession-alsareoftendrawnfromtherankseitherofinvestmentbankersoraccountants;thedisciplinesofM&Aandbuyoutareverysimilarinthe DueDiligence193investmentandexitmodes,thoughabuyoutﬁrmwillbelookingatacompanywithdifferentobjectivesinmind.So,fullﬁnancialduediligenceistheorderofthedayand,aswehavealreadyseen,thiswillusuallyincludecommissioningareportfromaninvestigatingaccountant.Thisispartlyinthenatureofanauditprocessbutmoreimportantly(sincethemostrecentauditedaccountswillusuallyformthesubjectofrepsandwarrantiesanyway)looksatthingslikethecompanyscurrencyexposure,leasingandborrowingarrange-mentsandworkingcapitalgenerally.Theobjectiveistomakequitesurethatthecashﬂowassumptionswhichthebuyoutﬁrmismakingcaninfactbereliedupon.Thisishugelyimportantsince,aswesawinanearlierchapter,theabilitytoserviceandrepaytheacquisitiondebtisanessentialrequirementforthesuccessofanybuyout.Thebuyoutﬁrmwillalsowanttomakesurethatkeypersonnelwillstayinplaceduringthepost-dealstage.Typically,theywilltrytodothisbypersuadingtheindividualsconcernedtotakeeithersomepartofthesweetequitypersonallyorsomeshareoptions,andatthesametimesignagreementswhichtiethemtothecompanyforacertainlengthoftimeasaconditionsubsequenttotheirequityentitlement.However,insomecasesthebuyoutﬁrmisnotallowedaccesstothemanagementteam,oronlyunderstrictlyregulatedconditions,sothisisverymuchadelicateareaandonewheresomeoftheblackartsofthebuyoutworldcomeintoplay.Youwillalsoneedtoexaminethevarioussupplyanddistributionchannelagreementstowhichthecompanyisparty.Thisshouldbenotonlyinthenatureofalegalaudit(theremayforexamplebeachangeofcontrolprovision)butalsotoinvestigatewhatislikelytohappeninpracticalterms.If,forexample,therelationshipwithakeycustomerhasbeenhandledbyoneindividualforanumberofyearsandthatindividualisleavingthecompany,youmightconsiderinsertingsomesortofearn-outprovisiontoprotectyoushouldturnoverandearningsfallsharply.Iftheyarestayingaspartofthemanagementteam,thenyoumightalsobethinkingaboutwhatyouputinthatindividualscontractaswellasintroducingfurtherpeopleintotherelationshipasapracticalmeasure.Whereaverylargebusinessisconcerned,whichisincreasinglythecasegiventhemuchbiggerfundsizesthatweareseeing,youwillalsoneedtoduediligencethecompetitivesituationforfearoffallingfoulofanti-trust(USA)ormonopolies(Europe)legislation.Thiscanleadtoalengthyandcostlyinvestigationattheendofwhichthedeal 194PrivateEquityasanAssetClassmaybevetoedoronlyallowedundercertainconditions(usuallyofbusinessunitsorrightsbeingrelinquishedartiﬁciallytocreategreatercompetition).PersonallyIhaveneverseenthepointofsuchlegislationinacapitalistsystem.Itseemsratherlikesayingtoatigeritsallrighttohaveteethaslongasyoudontactuallybiteanyone,butthefactremainsthatitisanincreasinglyimportantfactorinthebuyoutworldandyouwouldbewelladvisedtoseekadviceinadvancefromthelawﬁrmsandstrategicconsultancieswhospecialiseinsuchmatters.Anotherareawhichhasbecomeofvitalimportanceinthesedaysofpensiondeﬁcits(atleastintheUK)isthequestionofthecompanyspensionscheme.Thiscanbeaparticularproblemwherethecompanybeingboughtispartofalargergroupandthegroupschemeisindeﬁcit.Here,theacquiringentity(buyoutfund)mayhavetonotonlymakegoodthedeﬁcit(measuredartiﬁciallyforaccountingandregulatorypurposes)butalsobringituptowhatiscalledbuy-outlevel.Confus-ingly,thishasnothingtodowiththeprivateequitymeaningofthetermbutreferstothecostofbuyingannuitiesforalltheschememembers,3whichcanbeupto40%higher.Atthetimeofwritingthisisaverytopicalissue.AccordingtoasurveycarriedoutbyMercers,over20%ofbuyoutﬁrmspolledsaidtheyhadpulledoutofadealsolelyforthis4reason.However,itnowseemsthatintheUKnewInlandRevenueruleswillallowanalternativesolutionwherebythebusinessunitanditsworkerssimplycarryonpayingintothepensionschemeoftheformerparentgroup,butithasyettobeseenhowthiswillworkoutinpractice.Whateverthecase,detailedactuarialanalysisofthecompa-nyspensionpositionwillcontinuetobeanessentialpartofbuyoutduediligence.VENTURECOMPANIESTheissuessurroundingventurecompanieswillbedifferent,andthusduediligenceneedstobeaimedindifferentdirections.Themainconcernwhichanyventureﬁrmwillhaveaboutanewinvestmentwillbewhethertheproductorservicewillbesuccessfulcommercially,andsuccessfulonalargeenoughscaletoprovidethepotentialforgrowingaverylargecompany.Thiscanbeaddressedindifferentways,butmuchwillcomedowntotheparticularsectorknowl-3SeeanarticlebyPhilDavisintheFinancialTimes,11September2006.4Pensionliabilitiesbadforprivateequity,www.globalpension.com,14September2006. DueDiligence195edgeofanindividualGP,andthisiswhypersonalentrepreneurialexperienceissoimportant.Aventurecapitalistwhocanlookatapros-pectfromtheperspectiveofhisownrecentstart-up,andwhoisacquaintedwiththecompanyspotentialkeycustomersclearlyhasahugeadvantage.ThisisavitalpartoftheUSventuremodelwhichhas5untilveryrecentlybeenlargelyabsentinEurope.ThisprocesswillinevitablybelargelysubjectiveandcollegiatetheGPwilldiscusstheprospectonanongoingbasiswiththeotherpartnersintheﬁrm,andventurepartnersandEIRswillalsooftenbeabletoaddtheirpersonalperspective.Theprocesscanbemoreformalised,however.IknowofoneEuropeanventureﬁrm,forexample,whowillnotmakeanewinvestmentuntilaftertheyhavetakentheentrepreneur-ialteamontouraroundanumberofprospectivecustomersworldwideandhavewatchedanddiscussedtheirreactiontotheteamspitch.Shouldtheﬁrmcontinuewiththeinvestmentthenthisprocessofcoursehasamultiplepurposesinceitrepresentsnotonlyvaluableadvancemarketingtopossiblealphaandbetacustomers,butalsoprovidesinputonproductdesignandspeciﬁcation.Atascientiﬁclevel,theventureﬁrmwillneedtoassurethemselvesofthesoundnessofthedesign,i.e.,thattheproductwillactuallywork.ManyofthebestGPshavethesetechnicalskillsthemselves,butmostventureﬁrmsalsomaintainapanelofconsultanttechnicalexperts,manyofwhomwillbesenioracademicsorresearchscientists.Theﬁrmwillalsoneedtosatisfyitselfonownershipoftheintellec-tualpropertyofthetechnologyinvolved.Hereagainusewillbemadeofoutsidespecialists,thistimepatentagentsandlawyers.Ventureinvestingisaquestionofinvestinginpeople,perhapsevenmoresoatthecompanylevelthanatthefundlevel.Afterall,thetypicalventurecompanypropositionis,atleastatseedandearlystage,twoguyswithanidea.Thusmuchtimewillbespentgettingtoknowtheindividualsinvolvedonapersonalbasis(frequentlybyoneormoreGP,VPand/orEIRfromtheﬁrmgoingandworkingwiththeteamforaperiodoftime).Anotherimportantpointwillarisehere.Theteammembersneedtounderstandthattheywillalmostcertainlynotbetherightpeopletoleadthecompanylongterm,andunlesstheventureﬁrmisabsolutelysurethatthisrecognitionisbothclearandgenuine,then5Aninformalsurveyconductedbythewriteracoupleofyearsagoacross10leadingEuropeanventureﬁrmssuggestedthatonlyabout4%oftheirITandTelecomspartnershadthemselvesfoundedastart-upcompany. 196PrivateEquityasanAssetClasstheyshouldnotproceed.TheprospectsofmanyapromisingventurecompanyhavebeendestroyedbytherefusalofanintransigentfoundertostanddowninfavourofaprofessionalCEO,andthishasbeenaparticularprobleminEurope,whereventureﬁrmshavetypicallystrivenheroicallytoavoidanyundueconfrontationinsuchsituations.Ifallthissoundsalittleunstructuredthatisprobablybecauseifbuyoutinvestingisascience,thenventureinvestingisanart,inwhichsoftissuessuchaspeoplequalitiesandmarketinstinctaremoreimport-antthanﬁnancialengineering.However,whilethisisundoubtedlytrue,Iwouldnotwishtoover-playit.Theventureﬁrmwhichneglectedhardcoreduediligenceonthingslikebackgroundchecksandintellec-tualpropertywouldsoonﬁnditselfintrouble,nomatterhowsounditsinstincts.FUNDOFFUNDSTheissuesbeforeaninvestorwhenconsideringinvestmentinaFundofFundswillvaryaccordingtothestructure,timehorizonandinvestmentfocuswhichtheinvestordesires.Sadly,thesubtletyofrealisingthatdifferentFundofFundsmanagerscanofferdifferentthingsisfrequently6lostonLPs,particularlythosewhoresorttothetenderprocess,butthisisnonethelesstheidealatwhichoneshouldaim.Yes,ofcoursetherearelargemultinationalFundofFundsplayerswhosefundsareboth7generalistandglobalinscope,buttherearealsonicheplayerswhomightspecialise,forexample,inUSventureorEuropeanbuyoutandasophisticatedLP,evenifembarkingonaFundofFundsprogramme(whichisnotonlyaperfectlyvalidapproachbutprobablyverysensibleinmanycases)willbeseekingtounderstandexactlywhatcoverageisoffered,notonlysothattheymayﬁne-tunethisasnecessarybutalsotoknowinwhatdirectionstheirduediligenceshouldbeaimed.DuediligenceonaFundofFundsisalmostavicariousexperienceasmuchofitwillconsistofexamininghowtheFundofFundsmanagercarriesoutduediligenceonitsownpotentialinvesteefunds.Havingagoodideanowofthesortofthingstolookforwhenexaminingbothbuyoutandventureﬁnds,youwillinturnhaveanideaofwhattheyshouldbedoingand(importantly)why.6Foranarticleonthetenderingprocess,particularlyasitaffectsEuropeanpensionfunds,seeGottimetokill?,PensionsWorld,Vol.35,No.1,January2006.7Ofﬁcially,atleast.Infact,Europeanventureisusuallyconspicuousbyitsabsence. DueDiligence197Themostimportantareaofduediligence,though,particularlyasregardsanyﬁrmwhichpromisesalargecoverageofUSventure,isthequestionofaccess.TestthelevelofexposurewhichtheyhaveactuallyachievedfortheirinvestorsingoldencircleUSﬁrms(beware,here,thattheymaywelltrytostretchthisdeﬁnitionveryconsiderably).Inmanycasesitwillbe5%orlessoftheirtotalfundcapital(sometimescon-siderablyless).Ifso,thisshouldraisequestionsastowhytheyareraisingsomuchmoney.IftheirtargetforUSventureis,say,30%overall,theneveniftheywantedtomatchtheirgoldencircleexposuredollarfordollarwithotherhopefullyﬁrstquartilefunds,theyshouldstillonlyberaisingaboutone-thirdasmuchtotalfundcapital.Itshouldalsoraisequestionsabouttheirassetallocation.Iftheycanonlyget5%intothegoldencirclethenisitreallysensibletobeputtingﬁvetimesasmuchintootherUSventurefunds?Theymayhaveperfectlygoodanswerstothesequestions,butitisherethatthebulkofyourduedili-genceshouldbefocused,notﬁlingawayvoluminousquestionnairesfulloflargelyirrelevantinformation.Infact,thisissoimportantthatletusmakethispointjustoncemore.Themostimportantfactorinanalysinganyprivateequityfund(andFundsofFundsarenoexception)istheinvestmentmodel.Isitvalid?Cantheﬁrmkeeptoit?Doesitmakesenseinthecontextofcurrentandpossiblychangingmarketconditions?Isitconsistentwiththeamountofmoneywhichtheyareraising?Asyouwillhaveseenfromearlierchapters,itisthislastquestioninparticularwhichmanyﬁrmsmaystruggletoanswerconvincingly.Similarly,letmerepeatoneﬁnaltime:thewaytodothisisbyfullandfrankface-to-facemeet-ings,thecontentofwhichistargetedatspeciﬁcissuesanddiscussedinternallyafterwards,notbypaperingtheﬁlewithquestionnaires.Ifyouwanttomakethetransitionfromasimplefunctionarytoanintel-ligentinvestor,forgoodnesssaketearupyourquestionnaireandthrowitaway.TheﬁnalpointwithaFundofFundsisofcoursepeopleandperformance.ThelattershouldbefullysetoutinwhateverOMisavailable.Ifnot,itisagoodideatoprepareaone-pagesummaryoffundhistory,showingtheage,vintageyear,TVPIandIRRtodateofeachindividualfund.Indeed,agoodOMshouldalreadycontainthisasamatterofcourse.Sofaraspeopleareconcerned,allmyearlierremarksapply.Incidentally,whileconductingduediligence,itisworthremember-ingthefollowingprinciple,sometimesknownasthe3Ps: 198PrivateEquityasanAssetClassPeople+Process=PerformanceIhaveseenthisusedbymanyﬁrmsindifferentdisciplines(mostrecentlybyhedgefunds)andauthorshipisclaimedbymanypeople.However,forwhatitsworthmyinstinctisthat,aswithsomanythingsinprivateequity,itprobablyoriginatedmanyyearsagowithPhilHorsley.MONITORINGPRIVATEEQUITYFUNDSManypeoplefeelthatoncetheyhavedoneallthehardworkoftheinvestmentdecisionprocessandduediligencetheycanrelaxandsitback.Infact,thisiswhatmanyactuallydo,simplyattendingthefundsannualmeetingand,onesuspects,gatheringupallthequarterlyreportsfortheirauditorsonceayear.Thisisnot,however,howasophisticatedinvestorwillapproachthings.Oncemade,theinvestmentmustbemonitored.Youwanttoknowthattheﬁrmisstickingtoitsagreedinvestmentmodel,thatitisinvestingefﬁciently,andthattheteamdynamicsarestillastheywerewhenyoucarriedoutyourduediligence.Inparticular,youwanttoknowatonceifanykeyplayerwithintheteamisthinkingofleaving.Inshort,unlesstheﬁrmisactuallyhidingthings(whichwouldobvi-ouslycarryveryseriousimplications),youshouldneverdiscoverany-thingnewattheannualmeeting,andifyoudothenIwouldsuggestthatyouhaveprobablynotbeendoingyourjobproperly.Ofcourse,ifaﬁrmdoeschoosetohidethingsthereislittleyoucandosavedeter-minenottoinvestwiththatﬁrmagainor,inanextremecase,seektosellyourLPinterestinthesecondarymarketsoastobringyourre-lationshipwiththatﬁrmtoanend.IhavetosaythatthevastmajorityofGPsarehonest,professionalandhighlyreputable,andwillnotonlypracticefulldisclosurebutwillseektobringanyparticularissuestoyourattentionspeciﬁcally,andinmanycasescanvassyourviewsbeforetakinganyaction.Ihaveonlypersonallyexperienceddownrightconcealmentonthreeoccasions,ineachcaseconcerningthedepartureofapartnerorpartners,butwhenitdoesoccurthenlossoftrusttendstobebothrapidandtotal.Formalmonitoringwilltaketwoforms.First,youwillbeenteringthedealdatacontainedinthequarterlyreportsintoyourbuyoutorventuremodelasappropriateandanalysingitonanongoingbasis.You DueDiligence199willﬁndthatmostfundsdonotprovidethelevelofdetailyouneedtobeabletodothis,butmostarehappytoprovidesupplementalinforma-tion,particularlyifyoupromisetoshowthem,onablindbasis,howtheyrankagainstsomeoftheircompetitorsonthekeydrivers.Armedwiththisinformation,thesecondpartofyourmonitoringprocesswillberegularupdatevisitswiththegroup,ideallyatleasttwiceayear.Itmaybeanideatoshowthemyouranalysismaterialinadvanceandtostipulatethoseissuesuponwhichyouwishtofocus.Otherwise,thereisarealdangerthattheﬁrmwillsimplyruntheclockandthemeetingwilldegenerateintoageneralchataboutthemarket.Bytheway,anhourisrarelyadequateforthesemeetingsandyoushouldinsistontwohoursbeingsetaside,particularlyifthereisapotentiallysigniﬁcantissuewhichyouwishtodiscuss(suchaswhyanearlystagefundissuddenlymakinglotsoflatestageinvestments,orwhyabuyoutfundseemstobepayinghigherearningsmultiplesthanitscompetitors).Informalmonitoringconsistsofkeepingoneseartothegroundgenerally.Inadditiontoeverydayconversationswithotherpeopletherearenowanumberofgoodonlinenewssources.Itisnecessarytodis-tinguishbetweentheusefulandthedangerous,however.Intotheformercategorywouldfallhearingfromabankerfriendthatabuyouttrans-actionsdebtisbeingofferedatadiscountinthemarketplace.IntothelatterwouldfallcommentsoftheIspoketo(insertnameasdesired)atanannualmeetingandhedoesntlikethemvariety.Thereareotherthingsthatcangiveyouacluethatallisnotwell.ChiefamongtheseistimelyreportinganditispuzzlingthatsomanyGPsshouldovertheyearshavefailedtorealisethis.Notonlyarecon-sistentlylatereportsandaccountsindicativeofsloppyprocesseswithintheﬁrm,buttheycangivecertainclassesofinvestor,mostnotablyFundsofFunds,veryrealproblemsregardingtheprovisionsintheirownlegalagreementsgoverningtheirreportingtotheirownclients.Itcanbeeasy,andevenappealing,towritethisoffasaminoradminis-trativeirritant,butIdourgeyounottoneglectthiskeyindicator.Itmaybeacoincidence,butIhaveonlyencounteredtwocasesofreallybadandconsistentlatereporting,andoneofthemwasalsooneofthethreeconcealmentﬁrmsalludedtoabove.Remembertoothatwhatyoulearnthroughyourmonitoringofthecurrentfundwillformpartofyourduediligenceforthenextfund,sothebetteryourmonitoring,theeasierandquickeryournextroundofduediligenceislikelytobe.Inparticular,thereportpagesfromyour 200PrivateEquityasanAssetClassventureorbuyoutmodelwillformthestartingpointforyourquantita-tiveduediligence.Finally,dorememberwhatIsaidintheIntroductionaboutthere-lationshipbetweentheGPandtheLP.ThepowerisallwiththeGP,providedyouarecommittingtoqualityfunds.Thereisaccordinglynopointatallintryingtothrowyourweightaroundduringthemonitoringprocess;indeed,thisislikelytoprovecounter-productive.Ignoringforamomentno-faultdivorceprovisions[since(1)adetaileddiscussionoffundtermsfallsoutsidethescopeofthisbookand(2)thisisnotsome-thingthatyoucanusebyyourself,butonlyinassociationwithamajor-ityoftheotherLPs]thenyouroptionsasadisgruntledprivateequityfundinvestoraretwo,andtwoonly.Youmaychoosenottoinvestintheﬁrmsnextfund,andyoumaychoosetosellyourexistinginterestinthesecondarymarket.Themonitoringprocessisdesignedtohelpyouprimarilywiththeﬁrstofthesedecisions.Yourmonitoringactivitiesmayalreadyhavedisclosedbythetimethenextfundraisingcyclecomesaroundthatthisisnotaﬁrmyouwishtobackagain.Iwouldstress,though,thatsuchsituationsarecomparativelyrareandwillusuallyonlyoccurwhereaﬁrmhashadkeyGPdepartures,failedtokeeptotheagreedinvestmentmodel,actedinperceivedconﬂictofinterest,orwhoseinvestmentmetricshavedeterioratedunacceptably.Fortunately,suchsituationsareunusual,andthenormwillbethatwhenyousignupforafundyouareinrealitysigningupforatleastthenextone,andpossiblytwo,aswell(sincetheperformanceoftheﬁrstonemaynothavebecomeapparentevenbythetimethethirdoneisraised).Sinceyouarethuscommittedtoalong-termrelationshipwiththeﬁrmnomatterwhathappens,conductingyourmonitoringinafriendlyandconsideratemannerisnotonlyamatterofpracticalcommonsense,itisalsoyourbestchanceofgettingsomethingyoudontlikechanged.Incidentally,thiscanbeagoodreasonfornotsittingonadvisoryboards(thoughIreadilyacknowledgethattherearedifferentschoolsofthought8onthis).Advisoryboardsgenerallydonotmakeagoodjobofwhat8IthinkmyargumentholdsbroadlytruewithqualityUSandEuropeanventureﬁrms,whotypicallydoaverygoodjobofkeepingtheirinvestorsinformed.Ifreelyadmitthatthesituationwithbuyoutﬁrms,particularlyinEurope,maybedifferentasthereisaregrettabletendencytocultivateaninnercircleofthosefewLPswhositontheadvisoryboardwhilekeepingtherestinrelativeignorance.However,providedthatyouarehavingupdatemeetingsonaregularbasisandconductingthemproperly,thenunlessaﬁrmisactivelyconcealingsomething,notbeingontheadvisoryboardshouldnotbeaproblem. DueDiligence201theyaresupposedtodo(protectLPsagainstconﬂictsofinterest),andopendiscussioninaformalsettingisnotthebestwaytoapproachsensitiveissues.AsanindependentvoicewhohascultivatedagoodpersonalrelationshipwithatleastsomeoftheGPs,youoftenhaveafarbetterchanceofgettingsomethingdonethroughfriendlychatthanbyattemptingtouseabargainingpositionthatitiseffectivelynon-existent.SUMMARYThedecisiontoinvestinaparticularfundorcompanyisusuallyatwofoldprocess,althoughinpracticetheboundariesbetweenthesetwoneatlydeﬁnedareastendtobecomesomewhatblurred.Intheory,adecisiontoinvestinprinciplewillbetakenﬁrst,andthisdecisionwillbesubjecttosatisfactoryduediligencewhichwillthenfollow.Itmaybefoundhelpfultomaintainarunningrecordofpros,consandissues.Duediligenceisaimedatresolvingallout-standingissues,andshouldbespeciﬁcallytargetedinthisway.Itshouldnotberegardedasanunfocusedinformation-gatheringprocess.Stilllessshouldittaketheformofastandardformques-tionnaire.Itisawayoffacilitatingdecision-making,notaprocessofpaperingtheﬁletoprotectindividualsfromtheinternalconse-quencesofmakingbaddecisions.Itisgenerallyfarmorehelpfultoseekoutyourownrefereesthantorelyonthosegiventoyoubythefundorcompany.Inparticular,trytoﬁndindividualswhohavelefttheorganisationrecently,andﬁndoutwhy.Co-investorsandportfoliocompanyCEOscanalsobesourcesofveryusefulinformation,particularlywheretheinvestmentconcernedhasnotperformedwell.Buyoutfundduediligenceshouldbebasedonthebuyouttrans-actionanalysisdiscussedearlier,andonhowwellplacedtheﬁrmmaybeintermsofdealﬂowchannels,andhowexpertitisinitsﬁnancialengineering.Venturefundduediligenceshouldbebasedontheventuretrans-actionanalysisdiscussedearlierandshouldfocusontheﬁrmsabilitytoscorehomeruns.Buyoutcompanyduediligencewillbeverysimilartothestan-dardM&Aduediligenceperformedbyaprospectivecorporate 202PrivateEquityasanAssetClassacquirer.However,particularattentionshouldbepaidtokeymembersoftheexecutiveteamandtheirlevelofcommitmenttotheproposedtransaction.Venturecompanyduediligencewillfocusonthequalitiesoftheindividualsconcerned,andthelevelofmarketriskwhichtheirproductorservicewillneedtoovercome.Alsokeyisthepotentialforthecompany,ifsuccessful,tobesufﬁcientlysuccessfultobecomeahomerun.FundofFundduediligencewillfocusonhistoricperformance(trackrecord)andtheﬁrmsabilitytoaccesstheverybestprivateequityfunds.Duediligenceﬂowsnaturallyintomonitoring.Howeverhere,atthefundlevel,yourfocuswillbeonfacilitatingyourdecisionwhethertoinvestinsuccessorfunds,whileatthecompanylevelitwillbeoncheckingtheﬁnancialperformanceofthecompanyand,inthecaseofventurecompanies,thehealthyandtimelydevelopmentofthecompanysproductorservice. 10PlanningyourInvestmentProgrammeHopefullyhavingreadthisfaryouwillhaveagoodideaofwhatbuyoutandventurecapitalare,whatdrivestheirreturns,andwhattolookforwhenselectingfundsinwhichtoinvest.Youhavealsohadachancetoconsiderthehistoricreturnsofeachassetclass,arrangedbygeography,andtotakealookathowthesemightbeinﬂuencednotjustbytransi-toryoutsidefactorssuchasbubblesandmarketconditionsbutalsotodiscerntheworkingsofmorelastingtrends.Iwouldliketoturnnowtothenutsandboltsofhowactuallytoputmoneytoworkintheprivateequityﬁeld.Itisallverywellhavingaworkingunderstandingofbuyoutandventure,butifyouaresuddenlypresentedwithanallocationof,say,$100Mforprivateequity,howshouldyougoaboutdrawingupanactionplanandimple-mentingit?CASHFLOWPLANNINGLet’sjustremindourselvesofthewayinwhichanyindividualprivateequityfundworksbylookingagainatsomethingwesawearlier.CommitmentsDrawdownsDistributionsYear123456789101112 204PrivateEquityasanAssetClassRemember,thisistheproﬁleofoneindividualfund,whereaswewillbelookingtocommittoquiteanumber(ideallyatleastsixineachvintageyear).Inplanningourprogramme,therefore,wewillhavetooverlaytheproﬁlesofalargenumberoffundsontoanoverallcashﬂowmodel.Thus,atanyonetimewithinourplannedprogramme,wewillhavesomefundsthatareininvestmentmode,somethatmaynotyethavedrawndownanysigniﬁcantamountofcapitalatall,andsomethatwillalreadybeharvest-ingtheirinvestmentsandreturningmoneytoinvestors.Youwillofcourseneedtoassumesomemoneymultiples,sinceonceafundprogrammeismaturethecashthatisﬂowingbacktotheinvestorwillalwaysbegreaterthanthemoneywhichisﬂowingoutbywayofdrawdowns.Iwouldsuggestthatyoustartwithsomeveryconservativedefaultmultiples–say1.7×forabuyoutfundand2.3×foraventurefund–andadjustthesetomatchactualperformanceasyougoalong.RemembertoothatjustastheJ-curvewillbethesamebasicshapeforeachfundbutmaybeeithersquashedorelongatedaccordingtothefundtypeandmarketconditions(andmaymovewithindifferentrangesaccordingtotheamountandtimingofcashﬂows),sotoothepatternwhichyouseesetoutintheﬁgureabovewilloccureithermorequicklyoroveramoreextendedintervaldependingonwhethertheinvestmentfocusofthefundisonearlystageventure(longest/slowest),buyoutorlaterstageventure(roughlyasdepicted)orsecondarytransactions(shortest/quickest).Wearelookingherespeciﬁcallyatprivateequityfunds,butitisofcoursequitepossiblethat,indecidingyouroverallinvestmentpolicy,youmightdecidealsotoparticipatedirectlyinindividualprivateequitytransactions,particularlyinthesecondarymarketwherevariousLPscommonlyoperatealongsidespecialistsecondaryfunds.Wewillbelookingspeciﬁcallyatthisarealaterinthischapter.Thepurposeofthissortofoutlinecashﬂowmodellingisnottoprovideaforecastofincomeandexpenditureforaccountingpurposes.Wearedealingherewithcashﬂowswhichareessentiallyunpredictablebothastotheirtimingandtheiramount,overaperiodwhichstretchesalongwayoutintothefuture.Suchanexercisecannotpossiblyproduceanythingotherthanaguesstimate,atbest.Thechancesofyourcash-ﬂowsinanyoneyearconformingexactlytowhathasbeenpredictedattheoutsetarevirtuallynil.Ifyouareanaccountant,youmightﬁndithardtounderstandwhyinthesecircumstanceswewouldwishtoembarkupontheexerciseatall.Yettocriticiseitinthisway,orlabelitaspointless,isfundamentallytomisunderstandthereasonforem- PlanningyourInvestmentProgramme205barkinguponit.Itisnottohavesomethingavailableasayardstickagainstwhichtojudgejusthowcloselyactualcashﬂowsinfutureyearsmayconformtowhatwepredictedattheoutset(indeed,theveryword“predicted”isinappropriate–itwouldbemuchmorecorrecttosay“projected”).Itissothatweplanourexposurefromtheoutsetinamethodicalmanner;itisalwaysopentoustoﬁne-tunethisaswegoalong,butitisessentialtohaveanoverallplanwithinwhichtooperate(andnottoallowourselvestobeundulydistractedfromitaswegoalongbyshort-termissues).ALLOCATED,COMMITTEDANDINVESTEDCAPITALInChapter1welookedatthedifferencebetweenallocated,committedandinvestedcapital.Itmightbeanideajusttoglanceatthesedeﬁn-itionsintheGlossarytoremindyourselfofthedistinction,sinceanunderstandingiscrucialtowhatwearenowgoingtobediscussing.AlmostassoonasyouembarkonthecashﬂowmodellingexerciseIhavebeendescribing,thisdistinctionwillbebroughthometoyouverystrongly.Intheearlyyearsofaprivateequityprogrammeyouwillﬁnd,forexample,that,lefttotheirowndevices,investedcapitalmayrepre-sentonlyatinyfractionofallocatedcapitalanditmayseemthatalmostasmuchisgettingdrawndowninfeesasisgettingputtoworkininvesteecompanies.YouwillnoticethatIsay“lefttotheirowndevices”sincethereareactuallysomeverystraightforwardthingsthatcanbedonetoalleviatethissituationandwhich,bafﬂingly,manyinvestorsandtheiradviserssimplyignore.Wewilllookattheseindetaillater.Successfulmanagementofaprivateequityprogrammerequiresthesethreedifferentbutdirectlyrelatedentitiestobemanagedintelligentlyandproactively.Thisinturnrequiresactiveandknowledgeablemonitor-ingofyourportfoliofunds.IfmanyEuropeanbuyoutfundssuddenlystartexitingcompaniesatthesametime,forexample(whichisentirelypossiblegiventhatsuchthingsareusuallydrivenbyexitmarketcondi-tions),theirLPswillfallintotwobroadcategories:thosewhosawthiscomingandhaveplannedinadvanceasfaraspossiblehowtodeploythesecashﬂowsbackintosomesortofprivateequityorquasi-privateequitybucket,andthosewhodidnotandendupbeingforcedtogiveittotheirtreasurydepartmenttoinvestonthemoneymarkets.Similarly,ifGPsinvesttheirmoneyeithermorequicklyormoreslowlythantheirusualfundcyclewouldsuggest,thenthetimetodo 206PrivateEquityasanAssetClasssomethingaboutit,intermsofconsideringwhatthismeansforyourfuturecommitmentprogramme,isstraightaway,notwhenyouﬁndyourselfperformingduediligenceonﬁvefundsbutrealisingthatyouneedtocommittoatleastten,ornomorethanone.Pleasebearthisdistinctionbetweenallocated,investedandcom-mittedcapitalinmind,asitwillbecrucialaswenowturntolookattwoofthemainmistakeswhicharemadebyinvestorswhenenteringtheprivateequityarena:failuretodiversifybytime,andfailuretosetpropercommitmentlevelsintheﬁrstplace.DIVERSIFICATIONBYTIMEWhenstudyingthehistoricreturnsofbothventureandbuyoutwecametotheconclusionthattheyweresubjecttotwobroadcategoriesofinﬂu-ence:thosewhicharerelativelyconstantandlong-lasting,suchasfun-damentalreturndriversandlong-termtrends,andthosewhicharetransitorysuchasbubbles,exitwindows,equitymarketconditions,fundraisinglevels,etc.Itisthejobofaprivateequityinvestor,whetheratthefundorthecompanylevel,tostudyandunderstandtheformerandshapeinvestmentpolicyaccordingly.Itisnotpartofthejobtoreacttothelatter,or,evenworse,trytopredictthemand“markettime”one’sinvestments.How,then,dowetreatthese?Theansweristhatwesimplyignorethem.Privateequityinvestorsdealwithcashﬂowswhichareunpredict-ablebothastotheirtimingandastotheiramountwhichstretchalongwayintothefuture,becomingevenmoreunpredictablewitheveryextrayearwhichisaddedtoourprojections.Thisunpredictabilityissuchthatanyattempttomarkettimeinvolvesthepredictionofmarketconditionsandinvestorsentimentalongwayinthefuture,andalsoinvolvesassumingnotonlythatthispredictionwillbecorrect,butthatitwillcontinuetobecorrectforalongenoughperiodforalltheplannedandnecessaryinﬂowsoroutﬂowstotakeplace.Thisiseffectivelyimpossible.Instead,thesophisticatedinvestoraimstocommitcapitalevenlyeveryvintageyearsothattherewillbearoughlyequalexposuretoeveryvintageyearwithintheportfolio.Considerwhatwouldhavehap-pened,forexample,ifonehadtakentheviewthat2000wasgoingtobeabumperyearforUSventureandhaddecidedtocommitone’sentireallocationto2000vintageyearUSventurefunds.OrhaddecidedtostopinvestinginUSventurebetween1994and1996becausethelikely PlanningyourInvestmentProgramme207returnsofyour1991vintageyearfundswerenotlookinggood?Itisimpossibletoassessinadvancehowaparticularvintageyearisgoingtoperform;onedoesnotevenusuallyhaveaﬁnalﬁgurefortotalfund-raisinguntilatleast3months(intheUSA)orabout6months(inEurope)intothefollowingcalendaryear.YoumaythinkthattheﬁrstexampleIquoteintheprecedingpara-graphisfanciful.Itisnot.Notonlyisitdrawnfromlife,buttherewereanumberofnewentrantstothemarketwhodidexactlythat.Iwillnotmentionnames,butawell-knowncompanycametomeforadviceinoraboutlate1999onhowtoplantheirnewprivateequityprogrammeandIgavethemroughlythecounselwhichiscontainedinthischapter.ImaginemysurprisewhenIsubsequentlylearntthatnotonlyhadtheirprivateequityteamblowntheirentireallocationinthespaceofabout6monthsalmostentirelyonUSventurefundswithadot.comfocus,buttheyhadgonebacktotheirboardforagreatlyincreasedallocation,muchofwhichtheyproceededtotreatinsimilarfashion.Withoutgivingtoomuchaway,thesamecompanycloseddowntheirprivateequityoperationsacoupleofyearslater,andwhileofcourseIwassorrytohearit,Ididnotallowmyregrettogetinthewayofpickingupacoupleofveryattractivesecondaryopportunities.Thisisobviouslyacounselofperfection,andlikeallcounselsofperfectiontherearetimeswhenitisjustnotpossibletodoexactlywhatyouwouldliketo.Europeanbuyout,forexample,canbeaparticularproblembecausetheretendstobe“bunching”,withseveralfundscomingtomarketatthesametimeandinterveningfallowperiods.Thereisnoparticularreasonforthis;itjusthappens,ratherinthesamewaythatyouwaitforabusforanhourandthenfourarriveallatonce(althoughInowunderstandthatthereisapparentlysomearcanemath-ematicalexplanationforthisafterall).Doyoupassuptheopportunityofinvestingwithaqualityfundinoneyearsimplytokeepyourcom-mitmentlevelsintrim,ordoyoutrytostealabitofcapitalfromanothervintageyear?Theansweristhreefold.First,itisinconceivablethatanyLPisgoingtobeinvestingsolelyinEuropeanbuyout,sotheremaybescopeforunder-committingslightlythatvintageyeartootherprivateequityclassesinordertoover-commitslightlytoEuropeanbuyout.Second,ifyouwanttoborrowalittlemoneyfromanyparticularyearthenprobablylittleharmisdone.Third,manyfundclosingsstretchinpracticeacrossyearends–thisisdonedeliberatelyforpreciselythisreason.However,thekeywordshereare“slightly”and“alittle”;some 208PrivateEquityasanAssetClassﬁne-tuningisperfectlyacceptable,andindeedprobablyevendesirable,butsigniﬁcanttweaksarenot.Diversiﬁcationbytimeisprobablythesinglemostimportantconceptthatshoulddriveanyprivateequityfundinvestor.Writeitonthewallofyourofﬁce.Chantittoyourselfasyoutakeyourmorningshower.Practisingdiversiﬁcationbytimewillnotofitselfmakeyouasuc-cessfulfundinvestor(youstillneedtobeabletoidentifyandaccesstherightfunds),butitwillverysigniﬁcantlyboostyourchances,andisdeﬁnitelypreferabletoafutureinlong-termunemployment.PROPERCOMMITMENTLEVELSThesecondcommonmistakemadebyLPswhoarenewtotheassetclassisnottosetpropercommitmentlevels.Basically,thiscomesdowntoafailuretounderstandthedifferencebetweenallocated,investedandcommittedcapital.Ifyourunthesortofbroadbrushcashﬂowexercisethatweweretalkingaboutatthebeginningofthechapteryouwillquicklyseethatyouwillhavemoneycomingbackfromyourearliestfundswellbeforeyouﬁnishpayingintothosetowhichyoucommitinlateryears.Thiswillofcoursebeexacerbatedbythefactthatinnormalcircumstancesthemoneycomingbackwillbesomemultipleofthemoneypaidin.Tothosewhocherishtheprincipleofthepaybackperiod,thisisgoodnewsasitmeansthatafundprogrammecanbecomeself-ﬁnancingaftertheﬁrst7yearsorso.Tothosewhounderstandinvestmentreturnsitisadisaster,asitmeansthatmoneycomingbackhavingearnedaprivateequityreturnisgoingtoendupinvestedonthemoneymarkets,andyouarenevergoingtogetanywherenearyouroveralltargetalloca-tionﬁgure.So,howdowegetaroundthisproblem?Theanswerisquitesimple,butmanyinvestorsseemtohaveacon-ceptualproblemwithitnonetheless.Youmustover-commit.Asaroughruleofthumbyoumultiplyyourallocationbyanythingbetweenabout1.5×(conservative)and2×(aggressive),thendivideitbyeightandlooktocommitthatamounteveryyearfortheﬁrsteightvintageyears.Youwillobviouslyhavetokeeptheseamountsunderreviewasyourpro-grammeprogresses;mostprobablyyouwillneedsteadilytoincreasetheamountyouarecommittingeveryyear.So,totakeourearlierexample,ifyouhaveanallocationtoprivateequityof$100Mandyoudecidetotakeaconservativeapproach,youneedﬁrsttomultiplythisby1.6andthendivideitbyeightwiththe PlanningyourInvestmentProgramme209resultthatyounowknowyouneedtotargetfundcommitmentsof$20Mayearforthenext8years.Simple,yes,butsurprisinglyoftencompletelyoverlookedorignored.Itjustisn’tpossibletoinvestinprivateequityfundsanyotherway.Unlessyouover-commitinthiswayyouwillbeveryluckyevertoendupwithmuchmorethanabout50%ofyourcapitalactuallyinvestedatanyonetime.Theproblemisoftenthatthosesettingoutassetalloca-tionpolicyatseniorlevelswithininstitutionsdonotthemselvesunder-standthedifferencebetweenallocatedandcommittedcapital,inwhichcasethereneedstobesomesortofongoingeducationexercise.Theyneedtobereassuredthatthereisnodangeroftheallocationlevelbeingbreachedintherealworld,givenpropercashﬂowplanning;certainlyIhaveneveronceknownittobeaproblemforanyoneinmypersonal1experience.Evenifsomesortofunimaginableﬁnancialcataclysmgrippedtheinvestmentworldforaprolongedperiod,theninextremisexistinginterestscouldbesoldassecondaries,and/orfuturecommit-mentlevelsreduced.DIVERSIFICATIONBYSECTORANDGEOGRAPHYThisisamorecontroversialsubjectonwhichthereareanumberofdifferentviews.Letmeputtoyouthetwoargumentsatdifferentendsofthespectrum.Ontheonehandtherewillbethetraditionalinvestmentviewthatdiversiﬁcationisalwaysattractiveinitsownrightandthatanidealprivateequityportfolioshouldthereforeaiminanyonevintageyearforaroughlyequalsplitbetweenventureandbuyout,andbetweenEuropeandtheUSA,perhapswithadashofAsiathrownintothemixforthesakeofcompleteness.1Ihaveknowntheproblemtooccurinadifferentwaythroughmistakeninternalaccounting.DuringthebubbleperiodintheUSA,sharesinpubliccompanieswhichhadeitherbeenretainedinventurefundsordistributedinspeciesubjecttolock-upcontinuedtobeclassiﬁedas“privateequity”bysomeLPswhenitwasdemonstrablynownolongerprivateequity.Thiscausedaproblemasthesewereatveryhighvaluations,andunbalancedtheprivateequitypercentageallocationcomparedwithlesswellperformingassetclasses.Notonlywasthisapproachmis-takenfromareportingviewpoint,itwasalsoirrational.Logicallywithinthenext6to12monthsallthevaluerepresentedbythoseshareswouldeitherhavebeenrealisedincashor,intheeventofamarketcrash,wouldhavedisappeared.Eitherway,itwouldnolongerbeanissue.YetsomeLPswereforcedtodeclineinvolvementinleadingventurefunds,damagingnotonlytheirlevelofdiversiﬁcationbytimebutalsotheirprospectsofeverbeingabletogetbackintofuturefundsmanagedbytheﬁrmsinquestion. 210PrivateEquityasanAssetClassProperlyconstructed,anysuchportfolioshouldtendtogiveacom-positereturnthatistheprivateequityequivalentofapassivelymanagedglobalequitiesprogramme.Itwilleffectivelyreturntheglobalprivateequityindex,sotheargumentgoes,ifsuchathingexisted.ItiswhatI2attemptedtocaptureinmylastbookinconsideringhowprivateequityasanassetclassﬁttedintoanoverallassetallocationapproach,whenIcalculatedaglobalCapitalWeightedAverageIRRforprivateequityfunds.Iacknowledgedatthetimethatthiswasanessentiallyartiﬁcialmeasure,buthopeditwouldproveacceptabletothoseraisedonadietofglobalindicesandbenchmarks.Thereaderwillbynowknowmorethanenoughaboutprivateequitytobeabletospotvariousﬂawsintheaboveapproach.First,notallprivateequityclasseshavereturnedequalreturns;indeed,thereturnsofsomeclassesvarywidelyevenwithinthemselves,mostnotablyUSventureandEuropeanbuyout.Itisclear,then,thatnotonlymustmanagerselectionplayagreatroleinselectingaprivateequityfundportfoliobutalsothatthestageandsector(inventure)orthesizeandgeography(inbuyout)ofafund’sinvestmentfocuswillalsobelegitimateconsiderations.Iamnotawareofanyportfolioany-whereintheworld,forexample,whichcurrentlygivesanythinglikeanequalweightingtoEuropeanventure.Yetwehaveseenthatthereturnsofanyoneprivateequityclassﬂuctuatefromonevintageyeartoanother,andthatitisimpossibletopredictsuchreturnsinadvance.Soarewenot,anadvocateofthebal-ancedapproachmightargue,simplyadoptingasortofmarkettimingbystealthifwestarttweakingourmixinthisway?Shouldwenotsimplytrytochoosethebestmanagerswithineachclassineachvintageyearandleavetherelativeperformanceofeachclasstofallwhereitmay?Second,wehaveseenthatineachclassthereareasmallnumberofmanagerswhomayconsistentlyout-perform,mostnotablyinUSventurebutalsotoalessextremeextentinotherareas.Supposethatinordertomakeupourquotaof,say,theUSbuyoutfundswhichareraisingmoneythatyearwewouldbeobligedtochoosearespectablebutpotentiallyunexcitingcandidatewhenwecouldusethatmoneyinsteadtocommittoaleadingUSventurefund.IsitnotmorelikelythatwhateverhappenstotherespectivereturnsofUSbuyoutandventureasawhole,theleadingventuremanagerislikelytogiveusahigherreturnthantheunexcitingbuyoutmanager?Ah,saysthe2MultiAssetClassInvestmentStrategy,alreadyreferenced. PlanningyourInvestmentProgramme211balancedinvestor,butsupposethevintageyearinquestionturnsouttobe2000?InthatcaseyoumightendupthankingyourluckystarsthatyoustucktoyourprinciplesanddidnotthrowextracapitalintoUSventure,nomatterhowattractiveitmighthaveseemedatthetime.Thisleadsusratherneatlyintotheoppositeview,whichwemighttermtheSiliconValleytheory,forwantofanythingbetter.Thisrunsasfollows.Thereisoneassetclasswithinprivateequity,USventure,thathasconsistentlyout-performedallothers.Further,thereisasmallgroupofﬁrmswithinit,thegoldencircle,thathasconsistentlyout-performedtherestoftheclass.Sowhynotsimplyseektoidentifyandaccessthesepotentialgoldencirclefundsandsimplyignoreeverythingelsewithinprivateequity?Yes,therewillbetheoccasionallypoorvintageyearbutyouareprotectedagainstthisbydiversiﬁcationbytimeand,inthecaseofgoldencircleUSventure,thedramaticreturnswhichyoumakeinthegoodyearswillmorethancompensateyoufortheoccasionalbadone.Theseareinterestingargumentsandeachhasitsattractions,thoughinfairnessIshouldpointoutthattheSiliconValleytheoryhasbeentotallyvindicatedbythosewhohavechosentoapplyitandbeenablesotodo.However,inthewords“andbeenablesotodo”liestheAchillesheelofthisapproach.Iamsureyouwillhavespotteditalready.Inordertobeabletoadoptit,youmustbeablebothtoidentifyandaccesspotentialgoldencirclefunds.YetaccessisahugeissueinUSventurecapital;evenHorsleyBridge,thesupremeexponentofthisapproach,isnotabletoaccesseverysingleUSventurefund.Tobefair,intheircasethishardlymatterssincetheyhavesomanyoftheothers,butjustconsiderwhatyourpositionmightbeifyouarenotfortunateenoughtobeHorsleyBridge,ortohaveinvestedwiththemovertheyears.IhaveinthepastattemptedtoanalysehowmuchmoneymightberaisedinanyonevintageyearbytheUSgoldencircleﬁrms,butthishasbecomeathanklesstaskwiththefundraisingﬁguresgoingupanddownlikeayo-yoand,giventhattheyarepublishedinarrears,myeffortshaveoftenbeensupersededalmostassoonastheyhavebeenpublished.Sufﬁceittosaythatinanyoneyeartheamountofdemandforgoldencirclefundcapitalhugelyexceedsavailablesupply.MuchofthecapitalistakenupbytheGPsthemselvesandtheirstrategicinvestors(whichwillincludethelikesofsuccessfulentrepre-neurswhomtheyhavepreviouslybackedandwithwhomtheymaywishtoworkagain,andtechnologycompanieswhomaybepotentialkey 212PrivateEquityasanAssetClasscustomersanddevelopmentpartnersforportfoliocompanies).Depend-ingontheﬁrm,thiscanbeanywhereuptotwo-thirdsofthefundsize.ThentherearetheHorsleyBridgetypeplayerswhohavebackedtheﬁrmformanyyearsandareguaranteedasizeablechunkofwhatisleft.Thenthereareanumberofendowmentsandfoundationswhowillagaintypicallyhavebeenlong-termsupportersoftheﬁrm.Finallytherearealargenumberofinstitutionsﬁghtingonthefringesofthepackforwhateverscrapsmayremain.Itisintryingtoestimatetheamountsinvolvedinanyoneparticularyearthatonecancometogrief,butitisprobablysafetoassumethatinanyoneyeartheamountavailableforfringeplayers(intowhichcategorywouldfallanynewentrantstotheassetclass)wouldbecer-tainlynomorethan$1billionandprobablyalot,lotless,perhapsaslittleas$100M.Giventhateveryinvestorintheworldwouldlogicallywantasmuchofthisastheycouldhave,thenyoucanprobablysaythatwhateveramountitiswillbeatleastahundredtimesandmaybeathousandtimesover-subscribed.Inotherwords,accesstothegoldencirclefortheaverageinvestorisasnearimpossibleasmakesnodifference.Unfortunatelythisisyetanotherverybasictruthwhichappearstobelittleunderstood,promptedinpartbythelessscrupulousFundofFundsmanagerswhofudgethetrueﬁgures(andtheclassiﬁcationofwhatmayormaynotgenuinelybeagoldencirclefund)andclaimtobeabletoachievesigniﬁcantcoveragefortheirclientswheninfactthissimplyisnot(andindeedcannot)bethecase.Yes,thereareFundofFundsmanagerswhocangenuinelyputsomereasonablepartoftheircapitalintothesefunds,buttheyarefewandfarbetweenandinmanycasesneitherinvestorsnorthosewhoadvisethemseemtohaveaveryclearideaofwhichtheymaybe.SotheSiliconValleyapproachsimplyisnotavailabletotheaverageinvestor,andthatreallychangesthepicturequitedramatically.Ifyoucannotgainaccesstothegoldencircle,andthesameproblemsastoaccessapplywithgraduallydiminishingseverityasyoudescendthequalityscale,thenyouwillbestrugglingtoachieveUSventureresultswhichevenmatchtheupperquartile;infact,itisquitelikelythatsomesigniﬁcantnumberofyourfundpickswillendupinthesecondorthirdquartiles.IfyouarestrugglingtoachieveupperquartileUSventurereturns,isitstillavalidapproachtosaythatyouwilltargetthatprivateequityclass,andthatclassonly?Clearlynot.Canone,then,fallbackonthebalancedtheoryinthehopethatyouwillbeabletoachievesomesort PlanningyourInvestmentProgramme213ofblendedglobalreturn?Well,intheoryyes,butIdothinkthattheobjectionswhichweraisedtosuchanapproachmeritcarefulconsider-ation,andprobablyargueagainstastrictapplicationofsuchapureanduncompromisingpolicy.Inparticular,Iwouldbereallytroubledbythepossibilityofhavingtopassupaveryhighqualityopportunityinonecategoryjustbecauseonewouldnototherwisefulﬁlone’squotainadifferentarea.Infact,allmyexperiencesuggestsverystronglythatanysortofrigidpre-allocationatallistheenemyofoptimalreturns.Wehaveseenseveraltimesduringthebooksofarthatprivateequitydiffersfromotherclassesinvariouswaysandthisisanotherimportantone.Thedifferentialinreturnwhichcanbeearnedthroughsuccessfulmanagerselectionisalmostinﬁnite.Choosingonequotedequitymanageroveranothermightmakeadifferenceof1or2%ayear;choosingtherightprivateequitymanagercanmakeadifferenceof100%ayearinventureormaybe10or15%ayearinbuyout.Viewedinthislight,theriskofmissingoutonanoutstandingmanagerisjusttoogreattoallowpre-allocationsofthissorttogetintheway.So,Ithinkthattheanswerliessomewherebetweenthetwoextremes.Byallmeansdiscusssomebroadoutlinesastohowyouwouldlikeyourportfoliotolookintermsofventure(sector,stageandgeography)andbuyout(sizeandgeography),butbeﬂexible,andconcentrateonselectingthebestmanagersinanyonecategoryasyougoalongratherthanstrictlyfulﬁllingaquotapolicyinanyonevintageyear.TOTALRETURNWithanunderstandingofthedifferencesbetweenallocated,committedandinvestedcapitalcomesarealisationthatthereturnwhichyouearnacrossyourwholeprivateequityallocationwillbeverydifferentfromthewonderfulIRRsthatarepeddledtoyouduringpresentationsonprivateequityfundsandFundsofFunds.Thisisinonesenseaneces-saryconsequenceofthewayinwhichprivateequityreturnsaremeas-ured,butcanalsobetrayalackofunderstandingoftheassetclassgenerally.Aswesawinanearlierchapter,aprivateequityfundisasequenceofcashﬂowsandthepropermeasureofitsperformanceisanIRR.Idonotseektocriticisethisinanyway;farfromit.Saveonlyformoneymultiples,theIRRistheonlyvalidwayinwhichprivateequityfundperformancecanbemeasured.CertainlyIhopethatwehavewellandtrulydispelledanynotionthatannualreturnscaneverbeappropriate. 214PrivateEquityasanAssetClassHowever,whatanIRRoramoneymultiplemeasureswhenusedinthiswayistheperformanceofafund,whereaswhatyouwillbe(orshouldbe)concernedaboutistheperformanceofyourprogramme.Now,aswehaveseen,evenifyoudoeverythinghumanlypossibletoreduceitsimpact,youaregoingnecessarilytosufferfromunder-investment(or,perhapsmoreaccurately,sub-optimalutilisation)ofcapital.Iwouldhopethisisobvious.Youwillnotbecommittingsomeofyourmoneyforseveralyears,and,evenwhenyoudo,itwilltaketheGPofeachindividualfundafewyearstodrawallthatmoneydownandputittoworkininvesteecompanies.Hencethesub-optimalutilisation.Theoptimaluseofthatmoneyistobeinvestedintheportfoliocompaniesofbuyoutandventurefunds.Thus,anytimethatanymoneyisnotsoinvested,itisbeingusedinalessthanoptimalfashion.Yet,ifthisissoobviouswhyisitthatsofewLPstakeanyseriousstepstoplanwhattheyaregoingtodowiththeircashwhileitisnotactuallyinvestedinunderlyingcompanies?“I’monly10%investedafterthreeyears”isthesortofthingwhichyouhearonaregularbasis,towhichI’mafraidIusuallyrespond“well,whatdidyouexpect?”.Thewayinwhichaprivateequityfundprogrammeoperatesishardlyrocketscience.Youcanmodelthecashﬂowsinoutline,aswehaveseenabove,anditwillbecomeinstantlyapparentthatevenifyoudoalltherightthingsintermsofover-commitmentthereisstillgoingtobeaveryslowandprotractedtake-upofcapital.Thisinturnmeansthatwhenmanyinvestorsreferto“ourprivateequityreturn”whattheyreallymeanis“ourreturnonthatsmallportionofourallocationwhichwehaveactuallymanagedtoinvestinprivateequityassets”.Evenforsomeonewithamatureprogrammethisisonlyeverlikelytobesomepartofthewhole,andinthecaseofanewentrantitmaybepracticallynothing.ThatiswhyIfeelitwouldbehelpfulforpeopletothinkintermsoftheirTotalReturnacrossthewholealloca-tionratherthanjustthatamountwhichisactuallysittinginunderlyingcompanies.Whichpromptsthequestion:whatshouldwedowithourallocationinthemeantime?HOWTODEALWITHUNINVESTEDCAPITALTheneedtothinkintermsofTotalReturnmeansthatwecanrethinkourphilosophyofprivateequityreturns.Acceptedwisdomteachesthat PlanningyourInvestmentProgramme215youshouldchasetheverybestpossiblereturnsandthisofcourseistruewhenthinkingaboutcommittingmoneytoprimaryfunds;ifyouhave$20Mtocommitinanyonevintageyearthenyouwanttotrytoensurethatyouchoosefromamongstfundswhichyoucanaccessandwhicharelikelytoproducetheverybestreturns.However,wherecapitalwhichisallocatedbutasyetuninvestedisconcerned,differentconsiderationsapply.Inthissituationweshouldbecontenttoacceptslightlylowerratesofreturn.Logically,weshouldacceptanyrateofreturnwhichislikelytobehigherthanthatwhichwecouldearnthroughanyalternativeuseofthatcapital.Inordertoassessthisitwouldofcoursebenecessarytoknowwhatthatalternativeusemightbe,andthiswouldalmostcer-tainlyvaryfromoneinvestortoanother.Someleavethemoneywiththeirtreasurydepartment,whileothersmightleaveitwithintheirallo-cationtoquotedequitiesandstillothersmightinvestitinquotedprivateequityvehicles.Itwouldbecheeringtoreportthattheyadoptedthislattercourseinordertoearnsomesortofprivateequityproxyreturn,butinfactthisisnotthecase.Isuspectthattheydosomerelyasawayoftickingthe“privateequity”boxontheirchecklist,andinanycasetheoverallallocationtoprivateequityisfrequentlysosmallthatintruthitisnotgoingtomakeanysigniﬁcantdifferenceanyway.Irehearsedinmylast3bookthereasonswhythisisnotagoodidea.Suchvehiclesarefre-quentlycash-richthemselvesandthustheproblemisshiftedratherthanresolved.Largelybecauseofthis,itiseffectivelyimpossibletoearnanythinglikeaproperprivateequityreturnfromthem(whydoyouthinkthatsophisticatedinvestorstheworldoverprefertoinvestininstitutionalpartnerships,eventhoughthesecomeatamuchhighercost?).Also,sincesuchvehiclesarequotedtheymustbesubjectatleastinsomeparttothevagariesofpublicequitymarketsandthuslackofcorrelationwithyourquotedequityholdings(whichisoneofthetwo4mainreasonsforhavingadiversiﬁedportfoliointheﬁrstplace)willinevitablybecompromised.Forthesakeofargument,letusassumethatthealternativeuseoffundswouldbequotedequities.Thisisprobablynotabadassumptiontomake,sincequotedequitiesarestillgenerallyregardedasthemost“highrisk”(whateverthatmightmean)assetwithinmanyinstitutional3MultiAssetClassInvestmentStrategy,alreadyreferenced.4Theotherbeingtheabilitytoaccesshighreturnassetclassessuchasprivateequity. 216PrivateEquityasanAssetClassportfolios.Thus,touseclassiccorporateﬁnancetheory,weshouldacceptallprojectsfortheuseofourcapitalthatofferapotentialrateofreturnwhichexceedsthelikelyreturnonquotedequities.Givenourconcernsaboutcorrelationanddiversiﬁcation,aswellastheinternalrequirementsofstayingwithinourinvestmentmandate,weshouldhoweverqualify“projects”bysayingsomethinglike“projectsofaprivateequitynature,orofferingaprivateequity-likereturnwhichexhibitslowcorrelationwiththerestofourportfolio”.Thisclearlyopensupotherpossibilitieswhichshouldbeconsideredbut,alas,rarelyarebyinvestorsinthisposition.SECONDARIESSecondarytransactionsofferaprivateequityreturn(hardlysurprisingsincetheyareactuallyprivateequityinvestments!)intermsofIRR,butthisiscreatedbyacceptinglowermoneymultiplesforshorterperiods.Bearinginmindourmotivationformakingsuchinvestments,namelyputtingtemporarilysurpluscapitaltowork,wehavenoproblemwiththis.Onthecontrary,aprivateequityinvestmentthatreturnsitscapitalwithinashorttimeperiodisidealforourpurposes.Inpractice,mostLPswillmakesuchinvestmentsthroughthemediumofspecialistsecondaryfundsandwhilethesedoanexcellentjobIwouldurgeinvestorsnottobeafraidofventuringintothemarketthemselvesonoccasionsinadditiontotheirsecondaryfundinvestments,particu-larlyiftheyhaveagoodrelationshipwiththebuyoutorventureGPmanagingthefundinwhichthesecondaryinterestisheld.However,formany(thosewithoutanestablishedprivateequityprogramme,forexample)thiswillsimplynotbepossibleasitwillproveverydifﬁcultforthemtooriginatedeals,ortoexecutethemwiththespeedthatisusuallyrequired,sothatthebesttheyarelikelytobeabletodoistoco-investalongsidesecondaryfundsinwhichtheyhaveinvested.Thefactthatthereisathrivingsecondarymarketinprivateequityfundinterestsisconvenientlyoverlookedbythosewhogiveafearofbeinglockedintoafundfor10yearsormoreasareason(excuse?)fornothavinganallocationtoprivateequity.Infactthereisalargeandthrivingmarketwhichprovidesampleliquidityforanyonewhowantsit.Thereisasyetnopubliclyavailabledataonthetotalvalueofsec-ondarytransactionsinanyparticularperiod(thisisoneofthelastareasofprivateequitygloomtobepenetratedbythelightoftransparency), PlanningyourInvestmentProgramme2175butwecanmakesomeintelligentdeductions.ADowJonespublicationstatesthatover$5billionwasraisedbysecondaryfundsineachof2004and2005andsuggests$8billionasapossibletargetﬁgurefor2006,thoughinmyviewthislatterestimateislikelytoproveconserva-tive.Giventhattheaveragesecondaryfundthesedaystendstoinvestitscapitaloverabouta3-yearperiod(butinindividualcasesthiscanbemuchshorter),andgivenalsothattheyarenottheonlyplayersin6themarket(FundsofFundsandinstitutionalLPsalsobuyandsellsecondaryinterests)thenitseemsreasonabletoassumethatsomewherebetween$5billionand$7billionofsecondaryinterestsarebeingboughtandsoldeveryyear,andpractitionersbelievethatthemarkethasprobablybeenatthissortoflevelforthelastfewyears.Twothingsareclear:thesecondarymarketisalreadybig,andgettingrapidlybiggerwitheveryyearthatpasses–certainlyitisgrowingatmorethan10%ayearandsometimessubstantiallymorethanthat.InmyviewthisisoneareathatcouldseequitedramaticgrowthinthefutureasmoreLPswakeuptotheneedtousesecondariestohelpmanagetheircashﬂowsandcapitallevels,andasawarenessgrowsoftheneedtouseTotalReturninvesting.Oneimportantpointneedstobemadebeforeweleavethesubjectofsecondaries.Youoftenhearinvestorssaying“wedon’tdosecond-aries”,orperhaps“wewillonlylookatsecondarieswherewearealreadyinvestedwiththatGP”.Suchstatementsbetrayaconfusionoversecondariespolicyborneofalackofunderstandingofthedifferentwaysinwhichtheycan(andshould)beused.Therearetwodifferenttypesofsecondaries,anditisimportantproperlytodistinguishbetweenthem:portfoliosecondariesandtreasurysecondaries.Portfoliosecondariesarepurchasedbecauseaninvestorwantsex-posure(oradditionalexposure)toaparticularprivateequityfund,andseizestheopportunitywhenthesecondaryinterestbecomesavailable.ItmaybethataccesstothefundwasrestrictedwhenitwasraisedandtheLPwasnotabletogetintoit,ornotabletoinvestasmuchasshewouldhavewished.ItmayevenbethattheLPisbuyingtheinterestdefensively,tostopanythirdpartyfrombeinginabetterproratabar-gainingpositionwhenthenextfundisraised.AcommonsituationiswhereanLPhasinvestedwithasuccessfulGPandisoffereda5GuidetotheSecondaryMarket,PrivateEquityAnalyst2006.6Harborvestcanapparentlyputupto$2billionoftheircurrentFundofFundsintosecondaries. 218PrivateEquityasanAssetClasspieceofoneoftheGP’searlyfunds,perhapsdatingfromavintageyearevenbeforetheLPenteredtheprivateequityspace.Suchoppor-tunitiesofferatwofoldadvantage:thepotentialtostrengthentherelationshipwiththeGPandthechancetogainfurtherdiversiﬁcationbytimewithexposuretoavintageyearnotalreadycontainedwithintheprogramme.Atreasurysecondary,bycontrast,ispurchasedsolelyforreasonsofcashﬂowandcapitalmanagement.Heretheprecisenatureofthesec-ondaryinterestisirrelevant.Allthatmatters(andneedstobeanalysed)isthelikelyamountsandtimingofitsremainingcashﬂows.Indeed,myinclinationwouldbenoteventorecordthenamesoftheseinvest-mentsseparatelywithinaprivateequityprogrammebutsimplytolumpthemalltogethersimplyas“treasurysecondaries”tomakethisdistinc-tionexplicit.ThisisanimportantpointsincethereisaveryrealdangerthatGPs(usually)andLPs(often)willassumethatsomeleveloflastingrelation-shipiscreatedbythepurchaseofasecondaryinterest.Thus,respectiveexpectationsneedtobecarefullyandsensitivelymanaged,orembar-rassmentandbadfeelingcanresultthenexttimetheGPgoesfund-raising.Thedistinctionisequallyimportantinternally.ThosemakingtheinvestmentdecisionswithinanLPneedtounderstandthatthede-cisiontopurchaseaninterestinaparticularfundasatreasurysecond-arydoesnotcarryanyovertonesofendorsingthequalitiesoftheGPinvolved,andthiscanifnecessarybemadeclearexternally.So,secondaryinvestmentsrepresenttheclearestwayofmanagingsurplusprivateequitycapacity,andanyintelligentLPshouldbelookingtomakeheavyuseofthem.Rememberthatwithsecondaryfundsthevintageyearofthefundislargelyirrelevant,sincethevintageyearsofthefundinterestswhichtheypurchasewillallbedifferent.Indeed,onefurtherleveloffuturesophisticationmightbeforsecondaryfundman-agerstobeginofferingdifferentproductscategorisedbyvintageyears;theymight,say,offera“2001–2003”fundandundertakethatatleast75%oftheinterestswhichitpurchaseswillfallwithinthosethreevintageyears.Thereasonthisisimportantisthatitmeansthereisnologicalobjec-tiontoanLPputtingalargeamountoftheirprivateequityallocationinsecondaryfundsintheirveryﬁrstyearofprivateequityactivity,andthenreducingtheamountonsecondaryfundcommitmentsastheygoalongandtheamountoftheirprimarycommitmentsincreases.Indeed,Icanseenoparticularreasonwhytheyshouldnotcommitalloftheir PlanningyourInvestmentProgramme219allocationinthiswayacrossyear1,hopingtobesomethinginexcessof50%investedbytheendofyear2.MEZZANINEMezzanine,thatistosayconvertibledebt,wouldalsobeacandidatefortheuseofnon-investedcapital.Aswesawearlierwhenweanalysedhowbuyoutswork,thisistheﬁnancingstripthatsitsbetweentheequityandtheseniordebtofabuyouttransactionandthus,unsurprisingly,isdesignedtogivelessthanabuyoutequityreturnbutmorethanabuyoutdebtreturn.Itsattractionstousinourpresentpositionaretwofold.First,itispartofaprivateequitytransactionandthusisundeniablyprivateequityinnature(thismaybeimportantforthemoreofﬁciousofinternalprocesses).Second,thedebtservicingelementofitscash-ﬂowsareentirelypredictablebothastotimingandastoamount,sincethesewillbelaidoutinlegallybindingdocumentation,andthismakesitpossibletoplanexactlywheresuchinvestmentsmightﬁtintoouroverallcashﬂowplanningmodel.Forthosewhodonotwishtoventureintotheconvertibledebtmarketdirectlytherearespecialistfunds,justasthereareforsecondaries,buttheseusuallyfunctiononaprimarybasis,i.e.,providingthemezzanineelementofbuyoutdealsoveraperiodof3yearsorsoinjustthesamewayasabuyoutfunddoeswithequity.Thisobviouslymakesmezza-ninemuchlessattractiveforourpresentpurposes,sincewearegivinguponeofthekeyadvantages(predictability).However,itisbecomingincreasinglypossibletoinvestinexisting(secondary)mezzanineinter-estsandthisisanotherareawhereIfeelwewillseeincreasedsophis-ticationinthefutureasTotalReturninvestingbecomesmorewidelyaccepted,possiblywithfundsofferingaselectionofinterestswithspeciﬁcmaturityproﬁles.PRIVATEEQUITYPROXIESHerewestrayintothemorecontroversialareaofusingthereturnsofcompletelydifferentassetclasseswhichhavenodirectconnectionwithprivateequitytoproduceareturnwhichmightinsomewayapproxi-matetoorbecorrelatedwithaprivateequityfundreturn.Indeed,Ihavespokenwithpensionfundsandotherinstitutionalinvestorswhobelievethattheycanusesuchanapproachasasubstituteformakinganyprivateequityinvestmentsatall.Some,forexample,useaselection 220PrivateEquityasanAssetClassofsmallcapquotedequitiesandtryintroducingsomeleveragethroughdebt,orsomehedgingthroughderivatives.7Ishowedinmyearlierbookthatthisapproachdoesnotworkanybetterthanthealternativepolicyofinvestinginquotedprivateequityvehicles.WheneverIhavediscussedthisapproachwithonewhoisanadvocateofitIﬁndthattheprivateequityreturnwhichtheyareusingasabenchmarkiscommonlymuchtoolow,becauseaninappropriatemeasure(suchasamedianoraveragereturn)hasbeenselectedeitherthroughignorance,orsometimes,Isuspect,onaself-servingbasistojustifythesolutionthathasalreadybeenchosen.TherearethosewhoclaimtohavedetectedastrongcorrelationbetweenprivateequityreturnsandtheNASDAQindex.InmyearlierbookItriedveryhardtoreproducetheseresultssinceitwouldhaveactuallysuitedmypurposessotodo,butwasunableto.Usingannualreturns,anapproachwhichisclearlyartiﬁcialforprivateequitypur-poses,itispossibletoestablishcorrelationwithUSventure(logicallytheclosestprivateequityassetclasstotheNASDAQ,whichfunctionsatleastinpartasanexitmarketforUSventurecompanies)ofabout70%.Usingvintageyearreturnsitispossibletogetthisuptoabout76%forprivateequityasawhole.Whetherthisisacceptableisamatterofsubjectivechoice;toplaceitincontext,thecorrelationbetweentheNASDAQandS&P100isabout88%.OfcoursetherearethoseLPswhoseinternalthoughtpolicesimplywouldnotallowthemtomakethissortofdecisioninanycase,sinceinnowaycaneithertheNASDAQorsmallcapquotedstocksbeproperlyclassiﬁedas“privateequity”.However,wheretheoptionisapossibilityIthinkIwouldberelativelyrelaxedaboutusingtheNASDAQindexaslongasthisisaﬁnalfall-backoptionforuseonlyaftersecondariesandmezzanineopportunitieshavebeenexhausted,andisthusonlyeverlikelytoformaverysmallpartofourportfolio.Itwoulddeﬁnitelybepreferabletoallowingthecapitaltobeinvestedonthemoneymarketsandalsotoaddingittoourexistingquotedequityholdings.TOWARDSANEWWORLDOFPRIVATEEQUITYPROGRAMMESThisisanewandcontroversialconceptwhichIbelieveisherebeingsetoutfortheﬁrsttimeever,andsoIdonotwishtogooverboardabout7MultiAssetClassInvestmentStrategy,alreadyreferenced. PlanningyourInvestmentProgramme221itsmerits,ortobecomeundulydogmaticastowhatneedstobedone.However,itdoesseemtomethatitisbothunrealisticandunreasonabletojudgeaprivateequityprogrammeonthebasisonlyofthatverysmallpartofitwhichisactuallyinvestedatanyonetime,giventhattheelimination,oratleastamelioration,oftheresultsofslowcapitaltake-upissomethingthatcanandshouldfairlyeasilybeaddressed.OnceweviewthisasakeyskillofaprivateequityLP,justasmuchaschoos-ingtherightfunds,thensurelyitisappropriatetojudgeLPperform-anceacrossthewholeallocatedamount?ItisforthisreasonthatIadvocateTotalReturninvestingforinstitutionalinvestorseverywhere.ThisclearlyimpactsnotjustupontheLPbutalsouponthosewhoofferproductsandservicestothem.WhyshouldaFundofFundsmanager,forexample,bepaidafeeonthewholecommittedcapitaloftheirfundwhenonlyasmallpartofitwillactuallybeinvestedatanyonetime?Totakeoneobviousexample,ifaFundofFundshasa1%managementfeeandafter1yearisonly,say,5%drawndown(notimpossible),thentheeffectivemanagementfeeforthatyearisnot1%but20%–quiteadifference!WoulditnotbemorelogicaltoexpecttheFundofFundsmanagertodrawdownthemoneyupfrontandbejudgedonatotalreturnbasisoverthelifeofthefund?Afterall,theonlythingthathasreallychangedisthatthemoneyisnowinthehandsofthemanagerratherthantheinvestor;yes,ownershipoftheproblemhasbeentransferredbutthemanagerislikelytobebetterplacedtoaddressitthantheinvestor,andisbeingpaidtodoso.Grantedtheincreased(anddifferenttypesof)workwouldmeritanincreasedmanagementfeeoverall,but(1)whenmeasuredasapercentageofinvestedcapitalthiswouldbeafractionofwhatthepresentfeearrangementreallyrepresents,and(2)themanagerwillbedisinclinedtochargetoomuchashisperformance(uponwhichdependshisabilitytoraisefuturefunds)willstillbemeasuredonanetcashﬂowbasis,i.e.,netoffeesandcarriedinterest.Likeallnewideas,Ithinkthisonewillcatchonslowly,butcatchonitwill,andtotallychangethefaceofprivateequityfundinvestingintheprocess.ItshouldproveveryattractivetoLPs,sinceitwilltrans-ferfromthemtotheirmanager(s)theburdenofwhattheyseeasaparticularlydifﬁcultproblem.IanticipatethatitwillberesistedbyFundofFundsmanagers,sinceitwillinvolvetheminextrawork,andtheacquisitionofdifferentskillsanddealﬂowchannels,whilehavingtheeffectofdepressingthehighlevelsofreturnwhichtheyhavebeenaccustomedtoquoting.However,withchangecomesopportunityand 222PrivateEquityasanAssetClasstherewillsurelybesomewhochoosetoembracethenewwayofdoingbusinessandturnitintoaspeciﬁcsellingpoint.SUMMARY•Whenplanningaprivateequityfundprogrammeitisessentialtodrawupanoutlinecashﬂowmodelshowingthevariousfundstowhichitisintendedtocommit,eventhoughitmustberecognisedthatgiventheessentialunpredictablenatureofprivateequityfundcashﬂowsthiswillserveasonlyaroughguide.•Whencreatingyourmodelitisprobablyadvisabletousedefaultmultiplesof1.7×forabuyoutfundand2.3×foraventurefund.Theseshouldbekeptconstantlyunderreviewineachindividualcaseandchangedifnecessaryasspeciﬁcdataonthatindividualfundbecomesavailable.•Afailuretounderstandandrememberthedifferencebetweenallocated,committedandinvestedcapitalliesattheheartofmanyoftheproblemsexperiencedbyprivateequityLPs.Thetwomainissuesare:1.Unlessyouover-commit(minimum160%)youwillneverbemuchmorethanabout50%invested.2.Returnsarecalculatedtraditionallyonlyoninvestedcapitallessfeesandcarry.Thisisbothunrealisticandunreasonable.InvestorsshouldseekinsteadtocalculatetheirTotalReturnonallocatedcapital.•Havingmultipliedyourallocatedcapitalbyaminimumof160%,nowdivideitbyeighttogiveyoutheamountofmoneyyouneedtocommiteachvintageyear.Thisisessentialnotonlytoaddresstheproblemofunder-investment,butalsotoensureproperdiver-siﬁcationbytime.•ToachieveacceptablelevelsofTotalReturn,endeavourtoﬁndalternativeprivateequityorprivateequity-typeusesforuninvestedcapitalratherthanallowingittobedrawnintobondsorquotedequities.Secondaryandmezzanineinterestsaretheprimecandi-dates.TheNASDAQindexmightbeconsideredasaﬁnalfall-backsolutionforasmallpartoftheoverallallocation.•Aimtocommitthebulkofyourallocationtosecondariesinitially,andthenusethesecondarycashﬂowswhichresulttofundprimarydrawdowns. PlanningyourInvestmentProgramme223•TotalReturninvestingmaybeatotallynewconceptbutitwillcatchon,andwillinvolvesomefundamentalchangestohowLPsapproachprivateequityinvesting.SomeFundofFundsmanagersmayproveresistanttotheidea,butsomewillseeitasanopportunitytodevelopadifferentiatingadvantageoverthecompetition. Glossary3GAbbreviationoracronymforso-calledthirdgenerationmobiletele-phonetechnology.StrictlyspeakingthisshouldonlyapplytoUMTS,butpartlyduetodelaysinrollingthisoutithascometobeappliedbysometoGPRS,whichismuchlesspowerfulbutmuchmorewidelyandcheaplyavailable.ARoundSuccessiveroundsoffundingforaventurecompanyaregivensuccessiveletters,i.e.,theARoundwillcomeﬁrst,followedbytheBRound,etc.AnARoundisusuallydeﬁnedastheﬁrstroundinwhichapro-fessionalventureinvestorparticipates,butthisismisleadingasitcouldequallyrefertoaseedround,dependingonthestageinacompanysdevelopmentatwhichittakesplace.AnARoundmaybeprecededbyoneormoreangelroundsaswellasbyaseedround.AsharesDifferentclassesofsharearecustomarilycreatedfordifferentfundingroundsinaventurecompany.Traditionally,AsharesareissuedfortheARound,BsharesfortheBRound,andsoon.AdvisoryBoardAcommitteeofLPswithinanindividualfunddelegatedbytheGPtogiveclearanceandguidanceonanysituationsinvolvingapossibleconﬂictofinterest. 226GlossaryADSLAsynchronousDigitalSubscriberLine.Ameansofusingtraditionalcoppertelephonelinestocarrybroadband.AFICTheFrenchventurecapitalassociation.AllocatedcapitalTheamount(usuallycalculatedasapercentage)ofitsoverallcapitalthataninvestorchoosestodevotetoprivateequity.Canbethoughtofasrepresentingtheroughamountofcapitalwhichaninvestorwouldideallyliketohaveinvestedinprivateequityatanyonetime.AllocationAnotherexpressionforallocatedcapital,usuallywhenexpressedasapercentageofthewhole,e.g.,a15%allocationtoprivateequity.Alphaandbeta(customersandproduct)Alphaandbetaareuseddifferentlyindifferentsituationsbydif-ferentpeople.Iwouldofferthefollowingclassiﬁcation.Alphacustomersarethosewhoaretriallingproductwhichisstillverymuchatapilotstage,i.e.,itislikelythatbasedonthecustomersfeedbacksigniﬁcantchangesanddevelopmentmayyetbemadetotheproduct.Betacustomersarethosewhoaretriallingsomethingthatissup-posedtobeessentiallytheﬁnishedarticle.Theintentionisthatonlyminorchangeswillneedtobemade,principallytocorrecttechnicalglitchesthatariseduringthetrial.AngelSomeonewhoinvestsinventurecompanies,typicallyataveryearlystage,butisnotaprofessionalventurecapitalist.IntheUSAthesearequitelikelythemselvestohavebeensuccessfulentrepreneurs,andtobewelladaptedtodealingwiththeventureindustry.InEurope,angelstendtobesuccessfulbusinessexecutives,tohavelessmoneyavailableforinvestmentthantheirAmericancounterparts,andfrequentlytoviewventureﬁrmswithsuspicionratherthanseeingthemasusefulco-investors. Glossary227AngelroundAroundofventurefundinginwhichonlyangelsparticipate,i.e.,inwhichnoprofessionalventureﬁrmispresent.AnnexefundAseparatefundformedbytheLPsofafundtoprovideapooloftop-upcapitalwhenthereservesofthefundhaveprovedinadequate,withtheaimofavoidingtheissuesraisedbycross-fundinvesting.Anti-dilutionProvisionscommonlyfoundinthefundingagreementsgoverningroundsofinvestmentinventurecompaniesunderwhichthesharehold-ingsofcertainshareholders(typicallyearlystageinvestorsandentre-preneurs)cannotfallbelowaspeciﬁedpercentageofthewhole.Average(whenappliedtoreturns)Thearithmeticmeanofanysamplepopulationoffundreturns.Thismeasuresuffersfromagravedrawbackinthatitgivesequalweightingtoallfundswithinthesample,eventheverysmalloneswhichwillprobablynotbeofinstitutionalinvestmentgrade.TheCapitalWeightedAverage(seebelow)isgreatlytobepreferred.AverageholdingperiodΣHoldingperiodnwherenisthenumberofcompanies.Averageleverage(orgearingordebt)ΣDebtnΣEnterprisevaluenwherenisthenumberofcompanies.Seegearingratio,below.B2BOnlinebusinesswhichdealswithbusinesscustomers,e.g.,wholesale,businessservices,businessexchanges,etc. 228GlossaryB2COnlinebusinesswhichdealswithretailcustomers.Amazonwouldbeoneofthebestknownexamples.BaggageAmericanexpressionusedtodescribetheamountoftimewhichGPsaregoingtohavetospendlookingaftertheportfoliocompaniesofpriorfunds.BasispointOnehundredthof1%.Thus50basispointsis0.5%,andsoon.BidpremiumThatpartofapubliccompanysvaluewhichmaybeascribedtothepossibilityofitbeingtakenover(bidfor).Wherethereisacontrollingorblockingshareholdingtherecanbydeﬁnitionbenobidpremium.BIMBOAcronymforBuy-In/ManagementBuyout.AtypeofbuyouttransactionwhichcombinesthefeaturesofbothanMBOandMBI(seebelow).Inmostcasesaseniorexecutivewhohasworkedwithinthesamesector(andmayevenhaveworkedforthetargetcompanyinthepast)formsamanagementconsortiumwithexistingmanagersfromwithinthetargetcompany.Blindorblinded(ofdata)Funddataisblindedwhenitisimpossibletoidentifyexactlywhichindividualfundmatcheswhichindividualdataentry.ThomsonFinan-cialsVentureXpertsystemoperatesinthisway.Thedisadvantageisthatyoucannotassesstheperformanceofanyonefund.TheadvantageisthatGPswhomayotherwisebereluctanttosubmittheirdataarereassuredsufﬁcientlytodoso.BookTheBookisthesellingdocument(oftencalledaSaleMemorandum)whichispreparedbytheinvestmentbankretainedonbehalfofabusi-nessseller(vendor).Itdescribesthebusinesstobesoldandwillbecirculatedtoa(usuallyrestricted)groupofpotentialpurchasers,whowilltypicallyincludeatleasttwoorthreebuyouthouses. Glossary229Note:thistermmayalsobeusedinotherways,i.e.,bybrokersduringshareissuesasmeaningalistofunderwritersorsubscribers.BottomupThewayinwhichanalysisofprivateequityfundsmustbecarriedout,bymodellingtheindividualtransactionswithinafundinordertobuildupapictureofthewhole.BuyoutGenericnameforagroupoftransactionsinwhichdebtisusedtoassisttheacquisitionofacontrolpositioninacompany.Oneofthetwomaincategoriesofprivateequity,theotherbeingventurecapital.BuyoutdriversThereareusuallysaidtobethreemaindriversofbuyoutreturns:earnings,(earnings)multipleandleverage.Infactthereisalsoafourth:time.BVCABritishVentureCapitalAssociation.Despiteitsname,itrepresentsoverwhelminglybyfundvaluetheinterestsofpan-EuropeanbuyoutﬁrmsbasedinLondon,nottheBritishVentureCapitalcommunity.EVCA(seebelow)issubjecttosimilarterminologicalinexactitude.CapitalcallAdemandbyaprivateequityfundforsomepartofthemoneywhichhasbeencommitted(i.e.,promised)toitbyinvestors.Eachsuchdemand,andthepaymentmadepursuanttoit,iscalledadrawdown.CapitalWeightedAverage(CWA)Anaveragereturncalculatedforanygivensamplepopulationbyrefer-encetothecapitalsizeofeachindividualconstituentfund.SaveonlyforUpperQuartilereturns,itissubmittedthatthisisthemostrealisticmeasureofprivateequityreturns.CarriedinterestThatshareoftheproﬁtsmadebyaprivateequityfundwhichisreservedforthemanagementteam(GPs).Thisistypically20%,butcanbeashighas30%forsometopUSventurefundsandusuallydropsto10%foraFundofFunds. 230GlossaryCarryAnothertermforcarriedinterest(seeabove).CashsweepAspartofthebankingarrangementsforabuyouttransaction,acashsweepreferstotheprocessofcheckingallthecompanysbankaccountsonspeciﬁeddatesandautomaticallygatheringupanysparecashbalancestooffsetsomeoralloftheoutstandingloanbalances.ChangeofcontrolprovisionAclauseinabusinesscontractwhichstipulatesthatifownershipofamajorityoftheequityofacompanychangeshands,thentheotherpartytothecontracthasarighttocancel,usuallywithoutliabilityforpayinganycompensation.ClassrightsRights(suchasaliquidationpreference)attachingtoaparticularclassofsharesinacompanywhichcannotbevariedexceptwiththeconsentoftheholdersofthatclassofshare.Closed-endorclosed-endedAvehiclesuchasaLimitedPartnership,whichhasastatedlifetimeattheendofwhichitwillbewoundup.Contrastwithopen-endedorevergreenvehicles(seebelow).ClosingorcloseThesigningofanLPA(seebelow).Everyfundwillhaveaﬁrstclose,afterwhichithaslegalstatusandmaybeginoperations,usuallyfollowedbyaseriesofotherclosings.Typicallytheﬁnalclosewillberequiredtotakeplacenotlaterthanoneyearaftertheﬁrstclose.CommitmentAlegallybindingpromisebyaninvestortomakeacertainamountofmoneyavailabletoaprivateequityfundondemand.CommittedcapitalWhenusedbyaninvestor,thetotalofallcurrentcommitmentstoallfundsbythatinvestor. Glossary231Whenusedbyafund,thetotalamountofcapitalcurrentlycommit-tedtothatfundbyallinvestors.ConditionsubsequentUsedwhereacertainlegalentitlement(forexampletosomeshareoptionsinabuyoutcompany)isgrantedsubjecttoacertainthingremainingtrue,e.g.,theindividualremainingemployedbythecompanyforaspeciﬁedtime.ConstituentfundAfundwhichformspartofaspeciﬁedgroupforreturnpurposes.Forexample,aEuropeanbuyoutfundformedin1997whichturnsouttohaveareturnequaltoorgreaterthantheupperquartile,willbeaconstituentfundofthe1997vintageyearupperquartilegroup.ControlledauctionAprocesswherebythepotentialsellerofabusinesswillappointaninter-mediary(todayusuallyaninvestmentbank)toprepareasalememorandum(thebook)andsendittoanagreedlistofpotentialbuyers,whowillthenenteranauctionprocess.Practicevaries,butclassicallytherewillbeatleasttwostages,withonlysomeofthecandidatesbeingselectedtomoveontothenextstage.Theabilitytoﬁgureonthislistofpotentialbuyersrepresentsahugebarriertoentryforﬁrsttimelargebuyoutfunds.ConvertibleAshare(usuallyapreferenceshare)orloannotewhichcarriestherightinspeciﬁedcircumstances(i.e.,onaparticulardate,oronthehappen-ingofaspeciﬁedevent)tobeexchangedinwholeorinpartforequityinthecompany.Theconversionratiomaybeﬁxedoronaslidingscalecontingent,forexample,ontheperformanceofthecompany.Cross-fundinvestingWhereaﬁrminvestsinthesamecompanyatdifferenttimesfromdif-ferentfunds,i.e.,usestheircurrentfundtowardsaﬁnancingroundinacompanywhichformspartoftheportfolioofoneoftheirearlierfunds.DevelopmentcapitalAquasi-buyouttransactionwhichcantypicallybedistinguishedfrombuyoutbythelackof(1)shareholdercontroland(2)anysigniﬁcantamountofacquisitiondebt. 232GlossaryDistributedtoCommittedCapital(DCC)Themultiple(ratio)oftotalmoneydistributedtodatetothetotalcom-mittedcapitalofthefund.LikeDPI(below)thisisonlyreallymeaning-fulrightattheendofafundslife.DistributedtoPaidin(DPI)Amultiplecommonlyusedinanalysingprivateequityfunds.Itrepresentstheratioofmoneydistributed(i.e.,paidout)bythefundtomoneypaidin(i.e.,drawndown).Thisratioisreferredtoastherealisationratio,butisonlyreallymeaningfulintheverylatestagesofafundslifetime.DistributionTheprocessofafundpayingmoneytoaninvestorafterexitinganinvestment.Thiscansometimestaketheformofaninspeciedistribu-tionofshares,particularlyinthecaseofUSventurefunds.DiversiﬁcationbytimeTheneedtoinvestprivateequitymoney,whetheratthecompanyorfundlevel,steadilyoverseveralvintageyearsinroughlyequalamounts.LackofdiversiﬁcationbytimeisoneofthemostcommonmistakescommittedbynewLPsenteringtheassetclass.Dollar-weighted(returns)Amisleadingtermwhencomparedwithtime-weightedreturns(seebelow).SimplythecalculationoftheIRRofaseriesoffundcashﬂows,i.e.,thecompoundreturnovertime.Thisistheclassicmeasureofprivateequityreturns,andistobecommended.Greatcareshouldbetakennottoconfusethismeasurewithtime-weightedreturnswhich,contrarytoﬁrstimpressions,actuallymeanssomethingcompletelydifferent(andshouldbeavoidedatallcosts).Dot.comTherearebothnarrowandwidesensesinwhichthisphraseisused.Narrowly,itreferstoe-commercebusinesses,rangingfromthespectacularlysuccessfulsuchasGoogle.comandAmazon.comtothespectacularlyunsuccessfulsuchasPets.com,eToys.comandBoo.com.Inmostpeoplesmindsitisprobablymostcloselyassoci-atedwithonlineretailers(B2C). Glossary233Widely,itbecameappliedtoallparticipantsinthetechnologyandinternetbubbleofthelate1990s,totheextentthatthisisoftenreferredtoasthedot.combubble.DownsideNegativereturnswithinafundorafundprogramme.Maybeusedinparticularwhenlookingatwhichcompanieswithinafundlostmoneycomparedwiththosethatmademoney.Whenusedbyaninvestor,mayrefertotheriskofanyonefundfailingtoreturnitscapital.DrawdownSeecapitalcall.Pleasebeawarethatthistermisusedinacompletelydifferentsenseinotherareas,e.g.,hedgefunds,whereitcanmeanperiodsofdownside.DrawdownnoticeAnothertermforacapitalcall.Properlyspeaking,themechanismbywhichacapitalcalliseffected.DrawndowncapitalWhenusedbyaninvestor,thetotalamountofcommittedcapitalwhichhasactuallybeenrequestedbyitsprivateequityfunds.Whenusedbyafund,thetotalamountofcommittedcapitalwhichithasactuallydrawndownfromitsinvestors.DuediligenceTheprocessofperformingbackgroundchecksandrigorousﬁnancialanalysisonaprivateequityfund(foranLP)oronapotentialinvesteecompany(foraGP).Sinceduediligenceisalengthyandcostlyexerciseitwillnormallyonlybeenteredintoonceadecisiontoinvestinprinciple(i.e.,subjecttoduediligence)hasbeentaken.EarnoutAprovisionwhichusedtobecommonplacebutisnowincreasinglyrarewherebythebuyerofacompanyagreestopaytheselleraﬁxedmultipleoftheactualproﬁtsofeachofthenexttwoorthreeyears.Thealternativeisoftentotrytogetcertainminimumlevelsoffutureproﬁtsmadethesubjectofawarranty,butthisisnowverydifﬁcultto 234Glossaryachieveexceptinthecaseofaforcedsaleoraclassictraditional-styleMBO.EarningsUsuallythoughtofasacompanysearningsafterdeductionofallaccountingitems,e.g.,interestandtax.Canbethoughtofastheearn-ingswhichwouldnormallybeavailablefordistributiontoshareholders.FormsthebasisforthePEratio(seebelow).EBITEarningsBefore(deductionof)InterestandTax.Probablyamoreappropriatebuyoutmeasurethanearnings,butstillnotatruecashﬂowproxysinceitincludesnon-cashitemssuchasdepreciation.EBITDAEarningsBeforeInterest,Taxes,DepreciationandAmortisation.Probablythebestofallbuyoutearningsmeasuresandcertainlytheoneusedbybuyoutﬁrmsthemselves.Oflimiteduseforcomparativepurposes,however,sinceitisanon-GAAPmeasureandthemannerofitscalculationcanﬂuctuatefromyeartoyear.EIREntrepreneurinResidence.ManyAmericanventureﬁrmswillhavethreeorfouroftheseatanyonetime,encouragingthemtoincubatetheirnextbusinessstart-upideaintheirofﬁces.EndgameThemanagementofquoteddistributions.Thisisamuchunder-estimatedrequirementofanyinvestorinUSventurefunds,callingforspecialistskillsandprocesses.EnterprisevalueThetotalvalueofabusiness,thepriceatwhichitmaybesold.Canbethoughtofasearnings×PEratio(oranyoftheotherearningsmeasures×theappropriatemultiple)orasequityvalue+debt.EPSEarningsPerShare. Glossary235EquityvalueThevalueoftheequityinacompany.Canbethoughtofasenterprisevalue−debt.ERISAEmployeeRetirementIncomeSecurityAct,whichgovernsthewayinwhichUSpensionplanscaninvestinprivateequity.PrivateequityfundsmustbeERISAcompliantinordertoqualifyforcapitalfromthesesources.EVCAEuropeanVentureCapitalAssociation.EvergreenReferstoaninvestmentvehiclewhichisopen-ended,unlikeaninsti-tutionallimitedpartnership,whichwillalwayshaveastatedlifetimeandwillthusbeclosed-ended.Theseusedtobeveryprevalentincon-tinentalEuropewheretherewerebothlegalandculturalobstaclestoinvestinginlimitedpartnerships,butanumberarequotedontheLondonStockExchange,3ibeingthebestknownexample.Thesevehiclescangiverisetoparticularproblemswhenitcomestoanalysingreturns,sincetheytypicallydonotreturncapitaltoinvestors,andthusthinkintermsofNetAssetValueanddividendsratherthancompoundreturnsbasedoncashﬂows.ExclusivityAnagreementthatthepotentialsellerofacompanywilldealonlywithonespeciﬁcpotentialvendorforaspeciﬁedperiod,onpainofﬁnancialpenalties(usuallyrefundingthebuyerscosts)foranybreach.ExpansioncapitalAnothertermfordevelopmentcapital,usuallyappliedinthecaseofmoneyintransactions(seebelow).FDAThe(American)FoodandDrugAdministration.Responsibleforlicens-ingallmedicalproductsforuseintheUSA.Chieﬂyrelevanttodrugdiscoveryandrelatedareas,e.g.,genomics. 236GlossaryFirmYetanotherareaoftransatlanticambiguity.IusethewordinitsEuropeansenseofaprivateequitymanagemententity,whereasinNorthAmericaitisfrequentlytakentomeanaventurecompany,i.e.,anentityinwhichafundwillinvest.InNorthAmericathewordsgrouporGParetypicallyusedforaEuropeanﬁrmormanager.FlotationKnownasanIPOinAmerica(seebelow),theprocessbywhichacompanyssharesbecomequotedonastockmarketandthuspubliclytradeable.FrenchauctionNamedaftersomeinfamousgoings-oninFranceduringtheearlyandmid-1990s.Anauctioninwhichthereisnoguaranteethatthehighestbidderwillwin,andthatmaybereopenedtoallowthepreferredbiddertore-bid.FrenchsolutionAeuphemismemployedbyFrenchpoliticians,investmentbanksandbusinesssellers.Translated,itmeanswearegoingtoofferthiscompanyontheopenmarket,andanyonecanbuyitaslongastheyareFrench.FundI,etc.Privateequityfundsaretraditionallygivenromannumerals.Thus,DoughtyHansonIIwouldbethesecondfundtohavebeenraisedbyDoughtyHanson,ApaxVwouldbetheﬁfthfundtohavebeenraisedbyApax,andsoon.FundcycleThenaturalrhythmofafundsoperations.Verybroadly,thiswillusuallytaketheformofaninvestmentperiod(typicallyabout3years,thoughventurefundswillcontinuetoinvestmoneyintocompaniesforsomeyears),followedbyadevelopmentperiodandaharvestingperiod,whenexitsareeffected.FundofFundsAprivateequityﬁrmwhichinvestsinbuyoutandventurefunds,ratherthandirectlyintobuyoutandventurecompanies.FundofFunds Glossary237managersarefrequentlyalsoactiveparticipantsinthesecondarymarket.FundraisingTheprocessofﬁndinginvestors(LPs)tocommittoanewfund.FundraisingcycleTheperiodbetweenraisingonefundanditssuccessorfund.Typicallyabout3yearsforprimaryfundsandabout2yearsforsecondaryfunds.GAAPGenerallyAcceptedAccountingPrinciples.GearingAnotherwordforleverage(below),describingtheeffectofdebtonatransactionorcompany.GearingratioTotaldebtUsuallyexpressedasEnterprisevalueGoldencircleAphraseinventedbythewriterandnowincommonusetorefertothatverysmallnumberofUSventureﬁrmswhohavemanagedmorethanonefundwhichhassigniﬁcantlyout-performed.Whileitdeﬁesprecisedeﬁnition,itisprobablynomorethanabout20names.GPIntheUSA,andincreasinglyinEurope,amanagerofaprivateequityfundisknownasaGP(GeneralPartner)sincemostprivateequityfundstaketheformofLimitedPartnerships,andthesearerequiredbylawtohaveaGeneralPartnertomanagetheiraffairs.GPcanrefereithertothemanagemententityortoindividualpartnerswithinsuchentities.(InEuropethisambiguityisavoidedbyusingtheword“ﬁrm”fortheentitybutthiscreatesfreshconfusionastheword“ﬁrm”isusedinNorthAmericatodenoteaventurecompany–oh,dear!). 238GlossaryGPRSGeneralPacketRadioService,sometimescalled2½G,asitwasmeanttobeasteppingstoneonthewayto3G(above).Intheevent,technicalproblemsdelayedtheintroductionof3GandGPRShasinmanycasescometobeadopted(butwronglydescribed)as3G.GreatTrainRobberyColloquialepithetfortherailwayprivatisationdealsenteredintointheUKinthemid-1990s,inconditionsofconsiderablepoliticalrisk.GroupFrequentAmericanusageforaﬁrmorGP.HardcircleReferencetoaninvestor,orgroupofinvestors,whohavemadeaﬁrmdecisiontocommitmoneytoaprivateequity,subjectonlytoagreementonthelegaltermsandanyoutstandingduediligence.HockeystickAnothernameusedforthepatternmadebytheJ-curve(seebelow).Thisshouldbeavoidedifpossible,sinceitcanproperlybeappliedtoallsortsofsituationsincludingwhereannualreturnsarebeingcon-sidered,whereastheJ-curveappliesspeciﬁcallytoreturnsplottedonacumulativecompoundbasis.HomerunAbaseballtermthathasbeenimportedintoventurecapitalparlance.Inbaseballitiswhenthestrikerhitstheballoutoftheparkintothecrowd(equivalenttohittingasixincricket,butmoresointhatitsscoringispotentiallyopen-endedandcanhaveadramaticeffectontheoverallteamscore,sincealltheplayerswhoarecurrentlyonbasecanrunhome).Strictlyspeakingitmeansaninvestment(company)thatreturnstheentirecapitaloftheinvestingfundallbyitself,butasamatterofprac-tice,thishascometobegenerallyacceptedasbeinganyinvestmentwhichreturnsatleast25×.HomerunmentalityTheattitudeofmindwhichrecognisestheoverwhelmingimportanceofhomeruns,andsetsouttoachievethem.Includestheneedto Glossary239rejectaninvestmentopportunitywhichdoesnothavethepotentialtobeabigwinner,andthefocusonbuildingabusinessquicklyintoalargecompany.Sometimescalledswingingforthefence(anotherbaseballexpression).HurdleUsedinitscommonlyacceptedsenseofahurdlereturn,i.e.,thelowestpossiblereturnwhichaparticularinvestorwillaccept.However,alsousedspeciﬁcallytodescribeareturnwhichaGPhastoatleastequalbeforeanycarryiscalculatedorpayable.Thismech-anismiscommonlyfoundinbuyoutanddevelopmentcapitalfunds,butrarelyinventurefunds.InspecieALatinphrasemeaningliterallyinitsactualform.Itisusedtodescribeadistributionofshares,ratherthanadistributionofthemoneyraisedfromsellingthoseshares.Seeendgameandquoteddistributions.InvestedcapitalThetotalamountofdrawndowncapitalwhichhasactuallybeeninvestedincompanies.Inpractice,thiswillbeequaltotheamountofdrawn-downcapitallessamountswhichhavebeenusedtopayfees,orwhichareawaitinginvestment.InvesteecompanyAcompanywithinaprivateequityfund,i.e.,anentityinwhichthefundbuysshares,and/ortowhichitprovidesﬁnanceinsomeformofconvertibleinstrument.IPOInitialPublicOffering.Americantermforaﬂotation(seeabove),whichissteadilycomingintocommonusageinEuropeaswell.IRRInternalRateofReturn(socalledbecauseitwasoriginallyusedtocal-culatethereturnondifferentprojectswithinacompany).Thecompoundreturnofaseriesofcashﬂowsoveraspeciﬁedperiod(usuallyseveralyears),usedasoneofthetwomainmeasuresofprivateequityreturns. 240GlossaryThestrictbusinessschooldeﬁnitionisthatcompoundreturn,foundbyiteration,whichwillreducetheNPVofanystreamofcashﬂowstozero.J-curveTheeffectofallprivateequityfunds,irrespectiveofﬁnalperformance,exhibitingstronglynegativereturnsintheearlyyearsasmoneyisdrawndownintothefund,reversingasdistributionsbegintobemade.So-calledfromtheshapemadebythereturnswhenplottedonacumulativecompoundbasis.KickerAkickerorequitykickeristhatpartofthetermsofashareorloannotewhichconferstheconvertiblerights(seeabove).LBOLeveragedBuyout.InonesenseallbuyoutsareLBOs,sincetheyallinvolvetheuseofdebt.However,thisnowhastwomainconnotations:(1)averylargetransaction,frequentlywithmultiplebusinessactivitiesand(2)atransactionwhichisnotinitiatedbyamanagementteam.Itmaybeconvenienttothinkofitasanindustrialacquisitionwheretheacquirerjusthappenstobeabuyoutﬁrm(orconsortium).LeverageDescribestheeffectofdebtonacompanyortransactions.Seealsogearing(above).LiquidationpreferenceCommonlyfoundinventurefundingagreements,particularlyintheUSA.Aparticularclassofshareholderwillreservetherighttohavetheirinvestmentpaidbackeitheronceorsomeothermultiplefromanyexitproceedsbeforetheinterestsofanyotherinvestorsareconsidered.Originallydesigned,asthenamesuggests,toprovideprotectionintheeventofawindingup,thesehavenowcometobeusedalmostroutinelyinallcircumstances.Historicallylesscommoninotherpartsoftheworld,suchasEurope,wheresimplercapitalstructuresandamorefriendly,co-operativerelationshipbetweeninvestorshavebeenpreferred. Glossary241LPIntheUSA,andincreasinglyinEurope,aninvestorinprivateequityfundsisknownasanLP(LimitedPartner),sincemostprivateequityfundstaketheformofLimitedPartnerships.LPALimitedPartnershipAgreement,thedocumentwhichconstitutesaLimitedPartnership.Thesewillbethesubjectofdiscussionandnegotiationpriortoﬁrstclosing.M&AMergerandAcquisition.Theprocessofbuyingandsellingcompanies.ManagerInEurope,aGPwastraditionallyreferredtoasamanager,andmanystillusethisterm.MarkettimingThepracticeofadjustingyourinvestmentapproachinreactionto,orasaresultofpredictionof,conditionsinﬁnancialmarkets.Inbrief,becausethisapproachrequiresarelativelyshort-termapproachand,inparticular,theabilitytoliquidateinvestmentsatshortnotice,itisanimpossibleapproachtoprivateequityinvesting,regardlessofwhetheritmayormaynotworkinrelationtootherassetclasses.Afailuretoappreciatethisisoneofthemostfundamentalmistakesmadebyprivateequityinvestors(particularlyLPs).Seediversiﬁcationbytime(above).MBIManagementBuy-In.Atypeofbuyouttransactionwhereagroupofexperiencedexecutivesbuynottheirownbusinessbutonewhichisoperatinginthesamesector.Alsoincludesasituationwhereanexecu-tiveleadsthebuyoutofabusinesswherehehasworkedpreviously,butthiswillusuallybeaBIMBO(seeabove).MBOManagementBuyout.Atypeofbuyouttransactioninwhichtheteamofexecutivesmanagingabusinessbuyitoutfromtheparentcompanywiththesupportofabuyoutﬁrm. 242GlossaryMedianTheobservationwithinasamplepopulationthatsitsexactlyinthemiddleoftheobservationsrankedbyvalue.Sometimesusedasameasureofprivateequityreturns(especiallybythoseoutsidethein-dustry)butitsvalueassuchisquestionable,particularlywherethereisasmallsamplesizeoraheavilyskewedrangeofvalues.MezzanineConvertibleunsecureddebtwhichsitsbetweentheequityandseniordebtlayersofabuyoutstructure.IntheUSA,thetermcanalsobefoundappliedtopre-IPOfundingroundsforventurecompanies.MoneyinDescribesadevelopmentcapitaldealwheretheprivateequityfundacquiresnewsharesinthetargetcompany,thusprovidingitwithfundsforgrowth.Suchdealsarefrequentlyreferredtoasexpansioncapital.MoneyoutDescribesadevelopmentcapitaldealwheretheprivateequityfundacquiresexistingsharesfromthebusinessowner.Inotherwords,themoneygoestohimratherthanintothecompanyandisthusseenasanalogoustohimtakingmoneyoutofthecompany.NegativecontrolWhereabuyoutﬁrm,thoughtheymaynotcontrolamajorityofthetargetcompanysshares,imposearightofvetoovercertaindecisions,mostnotablyexecutiveremuneration,sharedividends,capitalexpendi-ture,borrowing,andchangesinbusinessactivity.NewcoAtermusedinstructuringdiscussionsanddiagramsbylawyers,accountants,investmentbankersandprivateequityprofessionalstodescribeanewcompanythatwillbeformedspeciallytotakesomedeﬁnedroleinacorporatetransactionorseriesoftransactions,fre-quentlyastheacquisitionvehicle(i.e.,thenewholdingcompany)inabuyouttransaction.NVCANationalVentureCapitalAssociation(ofAmerica). Glossary243ObservationAnysinglevaluewithinasamplepopulation.OfferingMemorandumAnOMisadocumentissuedbyoronbehalfofaprivateequityﬁrmwiththeobjectofraisingmoneyfromtheinvestmentcommunity.SometimesreferredtoasaPrivatePlacingMemorandum(seebelow).Open-endedSeeevergreen.OperatingdebtDebtwhichispresentnaturallywithinacompanyasworkingcapitalforitsbusinessactivities.Thiscanbereducedthroughloweringstocklevels,extendingthetimetakentopaycreditors,orpersuadingdebtorstopaytheirinvoicesmorequickly.OperatingexperienceReferstowhatisusedincontributingvalueadd(seebelow).Chieﬂyusedinaventurecontext,thoughsomebuyoutﬁrmsalsorefertoit,andmaintainapanelofkeyexecutiveswithdifferentbusinessbackgrounds.OverhangCapitalraisedbyprivateequityfundsbutasyetuninvested.Thiscanbecomeacutewhenlevelsofinvestmentfailtokeeppacewithlevelsoffundraising.Overhangwilltendtoputupwardpressureonvaluations,raisesus-picionsthatdealqualitymaybesacriﬁcedinordertoputmoneytowork,andmayalsostretchoutthefundcycle.PaybackperiodThelengthoftimewhichittakestorecoveryourinitialcapitalonanyinvestment,i.e.,fortheinvestmenttoreturn1×.Oncewidelyusedasameansofevaluatingrivalprojectsorinvest-mentsforcapitalallocationpurposesbutnowlargelysupersededbyIRR. 244GlossaryPEratioThePrice/Earningsratioisawayofstatingthevaluationofacompanyinawaywhichcanbeappliedtoandcomparedwiththoseofothercompanies:sharepriceenterprisevalueeitherorEPSearningsPEIGGPrivateEquityIndustryGuidelinesGroup,abodywhichhasproducedasetofadvisoryvaluationguidelinesintheUSA.PharmaAtermusedtorefertodrugdiscoveryactivities,andalsocollectivelyfortheverylargemultinationalcompaniesinthisarea.PICC(PaidIntoCommittedCapital)Theratiooftotalmoneydrawndownbyafundtodatemeasuredagainstitscommittedcapital.Canbeausefulmeasurewherethereisasuspi-cionthataﬁrmhasraisedtoomuchmoneyfortheircurrentfundandisstrugglingtoputitalltowork.PIPEPrivateInvestmentinPublicEquity.Whereaquotedcompanyagreestoproduceaninstrument,whichistypicallynotitselfquoted,whichcanpotentiallyofferaprivateequity-typereturn.ThesetransactionshavesofarlargelybeenconﬁnedtotheUSA.Placing(orplacement)agentAbusinesswhichactsasadviserandasourceofintroductionstoLPsforGPswhoarelookingtoraiseafund.PooledreturnAmethodofcalculatingreturnswherebyalltheconstituentfundsareconsolidatedtogetherandtreatedasiftheywereonelargefund.PortfoliosecondaryAphraseinventedbythewritertomeanasecondaryinvestmentwhichismadenotforreasonsofcashﬂoworcapitalmanagementbutspe- Glossary245ciﬁcallybecausetheinvestorwantsexposure(oradditionalexposure)tothatparticularprivateequityfund.Cf.atreasurysecondary(seebelow).Post-moneyReferstoavaluationofaventurecompanyincludingtheamountofmoneycontributedbytheventureroundinquestion.Pre-moneyReferstoavaluationofaventurecompanybeforetakingintoaccounttheamountofmoneycontributedbytheventureroundinquestion.PrimaryPrimaryinterestsarecommitmentsbyinvestorstonewfunds,asdis-tinctfromsecondaryinterests(seebelow).Oncethefundisoperating,i.e.,makinginvestments,thentheinterestwouldbecomeasecondaryinterest.Agoodwayofrememberingthedifferenceistoconsiderthepartiesinvolved.Inmakingacommitmenttofund,theonlyrelationshipwillbethatbetweentheLPandtheGP.Indisposingofanexistinginterest,thekeyrelationshipisbetweentheLPandtheotherinvestorwhoisseekingtobuytheinterestandtaketheplaceoftheLP.PrivatePlacingMemorandumOrPPM.AnotherexpressionforanOfferingMemorandum(seeabove).QuoteddistributionsDistributionsinspecie.Thatistosay,adistributionbyaprivateequityfundtoinvestorswhichtakestheformofsharesinanunderlyingcompanyratherthancashproducedbysellingthoseshares.Suchsharesmayfrequentlyberestrictedstock(seebelow).Seealsoendgame(above).RealisationratioTheratioofmoneypaidoutbyafundcomparedwithmoneypaidin.SeeD/PI(above). 246GlossaryRecapitalisationor“recap”Averyimportantbutlittleunderstoodcontributortobuyoutreturns.Whereacompanyhasmoreearningsand/orcashﬂowthanwasorigin-allyenvisaged,equityisreturnedtoinvestorsandreplacedwherenec-essarywithnewdebt.RepsandwarrantiesRepresentationsandwarrantiesbythevendorplacedinthesaleagree-mentwhenacompanychangeshands.Theymostusuallycoverthingssuchascontingentliabilities,thecompanystaxpositionandtheaccuracyofthemostrecentauditedaccounts.ReservesFundcapitalwhichisnotionallysetasidetoprovidesubsequentfundingroundsforportfoliocompanies.Thelevelofreservesshouldbekeptunderconstantreview,particularlysincewhenacompanyiswrittenoffitwillbenecessarytodecidehowtousethereservessetasideforthatcompanywhichwillnownolongerbeneeded.Exceptinthecaseofaroll-up,thisisalmostexclusivelyanissueforventurefunds.ResidualValuetoPaidIn(RVPI)Theratioofthecurrentvalueofallremaininginvestmentswithinafundtothetotalamountofcapitalpaidintodate.RestrictedstockShareswhichformpartofaﬂotation(IPO)butwhicharenotfreelytradeableforaspeciﬁedtimeusually6months.IntheUSAthisoccursautomaticallybyoperationofmarketregulation.InEuropeitisamatterforcontractualagreement,andthuscanbevariedif,forexample,thereisgreaterdemandforstockthananticipated.Roll-upAbuyouttransactionwhereafragmentedindustryistargeted,andanumberofsmallbusinessesareboughtbeforebeingconsolidatedtogetherintoonelargeentity.SecondaryAsecondaryinterestisanownershippositioninanexistingfundwhichmayormaynotbefullyinvested,buthasnotbeenfullyexitedand Glossary247woundup.Suchinterestsareusuallymoreorlessfreelytransferableandathrivingsecondarymarkethasgrownuptocaterforsuchtransac-tions,anumberofspecialistﬁrmshavingbeensetupforthepurpose.Cf.primary(seeabove).SectorStrictlyspeakingbothbuyoutandventuredealscanbesubdividedbysector,butitisoflessimportanceinbuyoutthanitisinventure,whereitisoneofthetwomainwaysofclassifyingventuredeals(theotherbeingbystage).Historically,venturecompanieshavebeendividedintothreebroadcategories:LifeScience,InformationTechnol-ogyandTelecoms.ThelattertwoareoftenreferredtotogetherasTechnology,andthedistinctionbetweenthemisbecomingincreas-inglyblurred.SeedroundAroundofventurefundingwhichtakesplaceduringtheseedstage.Maybeprecededbyanangelround,butinthiscaseitrisksbeingdeﬁnedasanARoundinsteadunlessitoccursfairlysoonaftertheseedround.SeedstageThestart-upstageofacompanysexistence.SeniordebtStrictly,debtwhichtakespriorityoverotherlayersofdebtinthebuyoutstructure,bothastorepaymentandonliquidation.However,todayitisusedgenerallytorefertostraightdebtwhichwillnotnormallyhaveaconvertibleelementandwillusuallyenjoysomeformofsecurity.SoftcircleReferencetoaninvestor,orgroupofinvestors,whohaveindicatedthattheyarelikelytomakeacommitmenttoafund,butwhohavenotyettakenaﬁrmdecision.StageTheperiodinaventurecompanyslifeatwhichinvestmentismade.Stageisoneofthetwomainwaysofclassifyinganddistinguishingventuretransactions(theotherbeingbysector)andisdividedintoseed,early,midandlate. 248GlossaryStripNotasexcitingasitsounds.Averticalsliceofthebuyoutﬁnancingstructure,usuallytakingapieceofeachoftheseniorandmezzaninedebtlayers.SweetequitySharesissuedonpreferentialterms(mostcommonlyfornominalvalue,i.e.,atamuchcheaperprice)whichareusedtogivemanagementteamsamuchlargerequitystakeinabuyoutthanwouldbejustiﬁedstrictlybytheamountofmoneywhichtheyareabletoinvest.Suchcasesarefrequentlystructuredasanoptiontoacquiresuchsharesbasedonpre-agreedperformancetargetsandconditionaluponstayingwiththecompanyuntilanexitisachieved.Morecontroversially,theyhavealsobeenusedoccasionallybybuyoutﬁrmsasasubstitute,orevenaddi-tionalformofcarry.TakeprivateAbuyouttransactionwhereapubliccompanyisacquiredandthende-listedtobecomeaprivatecompany.TelcoLiterally,anyprovideroftelecommunicationsservices,buttakenusuallytomeanoneoftheincumbentplayers,i.e.,oneoftheoldmonopolisticutilitiessuchasBT(intheUK),DeutscheTelekom(inGermany)andthevariousBellcompaniesintheUSA.ThinequityAcapitalstructureinwhichthereisalargeamountofdebtandverylittleequity.Variouscountrieshaveadoptedthinequityrulesinanattempttolimitthetaxeffectivenessofﬁnancialengineeringbybuyouthouses.Time-weighted(returns)Amostmisleadingtermasitactuallymeanstheexactoppositeofwhatitsuggests.InsteadofcalculatingtheactualIRRofaseriesofcashﬂowsoveragivenperiod(i.e.,thecompoundreturnovertime),time-weightedreturnscalculatethegeometricmean,i.e.,theaverageoftheannualpercentagereturninanyoneyear. Glossary249Thismeasureofreturnsexistsforhistoricreasonsonly.Itiscom-pletelyirrelevant(worsemisleading)forprivateequitypurposesandshouldbeignored.TotalReturnAphraseinventedbythewriterwhichreferstothereturnwhichanLPearnsonthewholeprivateequityallocation,asopposedtojustthatpartofitwhichisatanyonetimeinvestedinunderlyingbuyoutorventurecompanies.TreasurysecondaryAphraseinventedbythewritertomeanasecondaryinvestmentwhichismadepurelyforreasonsofcapitalandcashﬂowmanagement,andtheexactnatureofwhich(saveastothelikelyamountandtimingofthereturn)isthusirrelevant.Cf.aportfoliosecondary(seeabove).Turn(aninvestment)Toturnaninvestmentistobuyitandthensellitagainquickly.Insuchsituations,ahighIRRcanbegeneratedfromalowmultiple.TurnaroundAbuyoutofacompanywhichisstrugglingandpossiblyevenloss-making.Suchdealsarerelativelyrareandareanexceptiontotheprinciplethatabuyouttargetcompanywillusuallyhaveearnings(oratleastcashﬂow)whichcanbeusedtoservicedebt.TotalValuetoPaidIn(TVPI)Theratioofthecurrentvalueofremaininginvestmentswithinafundplusthetotalvalueofalldistributionstodatetothetotalamountofcapitalpaidintothefundtodate.Perhapsthebestavailablemeasureofperformancebeforetheendofafundslife.UMTSUniversalMobileTelecommunicationsSystem,popularlyknownas3G.Atechnologythatallowsdigitalcommunicationstobecarriedatbroadband-typespeedstomobiletelephones.Agreatidea,thesuccess-fulintroductionofwhichwasplaguedbytechnicalproblems,includingthedevelopmentofasufﬁcientlypowerfulbattery. 250GlossaryUpperdecileTheindividualfundwhichsits10%ofthewaydownthestatisticalsample,orcolloquiallyallfundswhichsitabovethispoint.Itisusedconceptuallywhentalkingaboutthegoldencircle(seeabove)asinventureisanupperdecilegame,butdataincludingitasastatisticalmeasureisnotpubliclyavailable.UpperquartileCommonlyusedasameasureofvintageyearreturns.Itisthereturnofthatindividualfundwhichsitsatthebottomoftheupperquartile,i.e.,onequarterofthewaydownarankedlistofobservations.Itisnotthepooledreturnsofallthefundswhichsitwithintheupperquartile.However,itisusedcolloquiallytorefertoallthefundswhichsitwithintheupperquartile,hencetheconfusion.Whilestatisticallyuseful,itslimitationsshouldberecognised.Inpar-ticular,itgivesnoindicationofthespreadwithintheupperquartile,whichcanbeenormous,especiallywhereventurefundsareconcerned.Itcanalsobeverymisleadingifthesamplefromwhichitisdrawnisnotproperlyrepresentative(asisoftenthecasewhereEuropeanventureisconcerned).USmodelThisreferstothetraditionalapproachofUSventureﬁrms,particularlythoseactiveatearlystage.Itsmaincomponentsare(1)afocusontheseedstage,(2)homerunmentalityand(3)valueadd.Interestinglyandexcitingly,thereareanumberofEuropeanﬁrmsnowadoptingtheUSmodel.ValueaddAnAmericanexpressionreferringtotheabilitytocontributecompanybuildingskillsgainedatﬁrsthandtothedevelopmentofaventurecompany,usuallyonahands-onbasis.VCOCVentureCapitalOperatingCompany,atermusedintheERISAregula-tions(seeabove).VenturecapitalistAnindividualprofessionalwithinaventureﬁrm. Glossary251VenturecompanyAninvesteecompanywithinaventurefund.OftenreferredtoasaﬁrminNorthAmerica.VenturepartnerMightbethoughtofassomethingbetweenanEIRandaGPwithinaventureﬁrm.Aventurepartnerwillusuallybesomeonewhohasbeenasuccessfulentrepreneurandwillbeusedbytheﬁrmtolookatprospectiveinvestmentopportunitieswithintheirownareaofspecialistexpertise.Venturepartnerisfrequentlyatemporarystatus.Typicallyaventurepartnerwillbeexpectedeithertojointhemanagementteamofanopportunitywhichheﬁndsexciting,ortoprogressintobeingaGP.ThestatusisalsosometimesusedforsomeonewhohasretiredasaGP,butwishestoretainapart-timerolewithintheﬁrm.VintageyearTheyearinwhichafund,orgroupoffunds,wasformed.VintageyearreturnsVintageyearreturnsshow(inrespectofanyonevintageyear)thecompoundreturnofallconstituentfundsformedduringthevintageyear,fromthevintageyeartothedatespeciﬁed.WritedownToreducethestatedvaluationofaportfoliocompany.UnderboththeEVCAandBVCAguidelines,therearesomesituationswherea25%writedownismandatory.WriteoffToreducethestatedvaluationofaportfoliocompanytozero.WriteupToincreasethestatedvalueofaportfoliocompany. IndexPagenumbersinboldrefertotermsdeﬁnedintheGlossary3Ps197–8Apax58,72,91,97,99,112,1163G122,225applicationsoftware120–180/20rule63arithmeticmean30,32Asia61,179,180ARound130,134,135,145,146,147,funds166–7225assetacquisitionprogrammes98Ashares147,225AtlasVenture128absolutetime81audit193Accel179Autonomy97acquisitiondebt53,56,64,101averageholdingperiod83,227Actelion128averageleverage(orgearingorADC122debt)83,227ADSL121,226averagereturns31–4,227advisoryboards200–1,225AFIC142,226BRound135,145,146,147,148Africanfunds166Bshares147alignmentofinterests62Baincapital112allocatedcapital10,205–6,209,barrierstoentry61–4226BaselII120alphacustomers130,195,226BCPartners91,93alphaproduct76,84,97,226Benchmark179Alpinvest112betacustomers130,195,228Altitun122betaproduct76,123,228Amazon.com127,163,164BIMBO46,228analoguecommunication121,122Blackstone57,58angelinvestors130,226Bluetooth122angelround129–30,146,227BMW75annualreturns24,26,94,140bonds24anti-dilution147,148,227redemptionyield24anti-trustlegislation73,193–4totalreturn24AOL153,164BostonConsultingGroupmatrix50 254Indexbottomline68co-investors191Bridgepoint56,63commitmentlevels208–9,230BritishTelecom96committedcapital10,24,205–6,209,BritishVentureCapitalAssociation230(BVCA)6,229compoundreturns23–9,94guidelines40concealmentﬁrms199broadband121,122control8,58–61bubble122,171,176,177convertibledebtseemezzaninedot.com4,17,123convertibleshares(convertibleinternet161stock)82,231optical123copyrightpiracy121technology51,78,143,161costandvalueofventure147–9bundledhardware127creditordays53buyout7–9,15,229cross-fundinvesting192deﬁnitions4,5CVC15–16,80,91,144effectonemployment5–6European4DRound146level194datacommunication121–2returns107–9,112dealsourcing46sizeoffunds8dealﬂow63,186,187skillbases91–2debtseeleverageUS4debt-aversion55,60buyoutcompanies192–4debtordays53buyoutfund28,194defaultrights8duediligence186–8deﬁnitionofprivateequity1–2modellingandanalysing82–7Dell127size55,101–7depreciation69,71buyoutfundraising109DeutscheBank16European110developmentcapital8,48–9,231US110digitalcommunication121,122USvsEurope111directinvesting2–4DistributedoverCommittedCapitalCandover91,96,97(DCC)38,232CapitalCall13DistributedoverPaidIn(DPI)37–8,CapitalWeightedAverage(CWA)23233–4,89–91,97,157,176,distributioninspecie14,232229diversiﬁcationbytime206–8,232IRR57,90,91,96,103,105,106,dollar-weightedreturns42,232107,158,159,176,210dot.com8,207,232–3TVPI91,96,159,170dot.combubble4,17,123Carlyle116doublecounting84cashcows50DoughtyHanson55,56,91,116cashﬂow69DrawdownNotice(CapitalCall)13cashﬂowplanning203–5drawndowncapital11,233Charterhouse96,97drugapprovalprocess126China179,180drugdiscoveryarea124Chromatis122,123duediligence18,19,46,62,67,117,Cinven91150,151,183–202,233Cisco164buyoutcompanies192–4Citibank16buyoutfunds186–8classicUSventuremodel115co-investors191co-investment3,4cross-fundinvesting192 Index255FundofFunds196–8fairvalue142monitoringprivateequityFax121funds198–201FDAapprovalprocess126,235venturecompanies194–6fees40–1venturefunds188–91FinanceDirector99DukeStreet91FinancialController99dumbmoney173Finland,telephonyin123ﬁrsttimefund62,63ERound146FondsCommundePlacementàRisquesearnings54–5,68–70,73,83,234(FCPR)11earningsgrowth72–3,97–9France8,93earningsmultiples74,83,94–7developmentactivityin49earningsratios94investmentin15EASDAQ165LifeSciencein128EastEuropeanfund166multiplesin75eBay127,164freeingupworkingcapital73EBIT70–1,72,78,234Frenchauction75,236EBITDA71–2,94,234FTSEindex95EIR(entrepreneurinresidence)FTSEPEratios96programme131–2,234fundinvesting2–4email121FundofFunds2,3,7,13,14,16,31,EmployeeRetirementIncomeSecurity94,142,196–8,236(ERISA)Act12FundV128,236enterprisesoftware121fundraising16–19,237enterprisevalue82,83,234buyout109–11entrepreneurs146entrymultiple76GDP5equityIRR78gearingseeleverageequityvalue82,235gearingratios94,237EuropeGeneralPartners(GPs)6,11averagesizeofbuyoutfunds52geography,diversiﬁcationby209–13buyout4geometricmean41buyoutfundraising110,111Germany55,75,92buyoutreturns108actualeconomiccycles100developmentactivityin49buyouts93fundsizeand170–4developmentactivityin49UpperQuartileTVPI,USvs168–9multiplesin75,144USbuyoutvs89–91globalprivateequityindex210USout-performancevs157–65goinginearnings84USvaluationvs141–3goinginequity(GI%)150–1USventuremodelin134goldencircle160–3,177,178,179,197,venture165–70211,212,237venturereturnsbystage175–6Google127,164,178EuropeanMonetarySystem98GP(privateequitymanager)4,15,237EuropeanVentureCapitalAssociationGP/LPrelationship200(EVCA)guidelines40,235GPRS122,238evergreenvehicles12,235GreatTrainRobbery96,107,144,238Eversholt97exitmultiple76happyhuntingtime131exiting138–9Harborvest2exitingdebt53hardcircle19,238expansioncapital8,49,235hardware118,119 256IndexHealthCap128LiabilityDrivenInvestment24healthcare,specialistservices125lifeofafund82HelixAssociates186LifeScience(Healthcare/Biotech)holdingperiod,IRRandmultiple,sector118,124–8,153,162trade-off35LimitedPartners(LPs)2,6,11,13,15,homerunmentality133,188–90,238241homeruns127,133,160–3,188–90,LimitedPartnershipAgreements238(LPAs)10,12,13,17,19,241impactof151–5liquidationpreferences146,147,148horizontalstrips54loannotes52Horsley,Phil16,160,198lock-upprovisions139HorsleyBridge2,133,152,160,177,LondonStockExchange165211–12long-termcompoundreturns140humangenomeproject124Lotus164Lucent122,123imperfectmarkets92–3,96incubation132M&A58,192,241IndustriKapital55,91managementbuy-in(MBI)46,241inﬂation73,98managementbuyout(MBO)45–6,59,InnovationsKapital128241integratingsoftware120marketrisk116intelligentapproach19markettiming81,241internet122,127marketingpresentation18internetbubble161meanIntuit164arithmetic30,32investedcapital11,205–6,239geometric41InvestitoriAssociati93medianreturns30–1,242investmentbanks63medicaldevices124,126investmentperiod13megafunds76,91,102–3,105–7,IPOwork63,239109–11,113,187IRR25–6,28,67,78,149–51,175,mergersandacquisitions(M&A)58,213–14,239192,241drawbackof34mezzanine54,73,79,82–3,219,242moneymultipleand,trade-off35Microsoft119,120,127Israel,mobiletechnologyin124mid-market56,57,62,63ITsector118–21,154,162mobilecommunication122,123Italy8,75,93moneyindeal49,242barrierstoentryin61moneymultiples103,137–9multiplesin76moneyoutdeal49,242monitoringprivateequityJ-curve23–9,94,107,112,140,150,funds198–201204,240monopolies(anti-trust)legislation73,jug(juggernaut)funds57,58193–4multiple34–9,73–8,149–51KKR112asdriverofbuyoutreturns68KleinerPerkins120,153,163increaseinanimperfectmarket74–6increaseinaperfectmarket77–8LatinAmerica61IRRsand159–60LBO(LeveragedBuyout)46,47,240turnover(revenue)144leverage(gearing;debt)47,51–5,68,72,73,78–9,83,100–1,137,NASDAQindex163,165,220240negativecontrol59,242 Index257netproﬁts68propertyreturns140–1Netscape153public/privatepartnershipﬁnancing51Newco53,242non-controlinvesting8QXLRicardo97NordicCapital55,91NVCA40,143,242realisationratio38,245recapitalisation(recaps)51,79–80,83,OfferingMemorandum17–18,188,246243redemptioneffect25onlypartnerspolicy188reductioadabsurdam36operatingdebt53,243redundancies93operatingleases79relationship-orientedventure176operatingsoftware120,127ResidualValuetoPaidIn(RVPI)38,operationalgearing56246operationalriskmodel60restrictedstock14,246opticalbubble123RetailPriceIndex73,98opticaltechnology122revenuemultiples144options148,193riskandreward,relationshipowner-manager59,60between129roll-up48,76,246PaidIntoCommittedCapitalRosen,Sevin163(PICC)38,244runningyield25paperingtheﬁle19Russianfunds166paybackperiod208,243PEratio68–70,72,94,95,96,163,S&PPEratio163244S&P10095,220pensionfunds16,194S&P50077percentageofholdingwithinfund151Sage120Permira57,58,73,91,109SaintBartholomew’sHospital(Barts)PFI51,80project80Philipssemiconductortransaction112Scandinavia93plantclosures93scattergunapproach18–19pooledreturns34,244Schroders58portfoliosecondaries217–18,244secondaries6–7,216–19,246–7preferencerights8sector247primaryfundinvesting6–7,245diversiﬁcationby209–13privateequityexpertise72cashﬂow13–14seed129–30deﬁnition4,5seedcapital129fundraising16–19seedstage131–2,146,247funds141seniordebt53,73,79,82,247investment15–16SevinRosen174,178proxies219–20SiliconValleytheory211,212returns24,77–8SilverLake112structure11–12size55–8PrivateEquityIndustryGuidelinessizeofmarket117Group(PEIGG)143,244Skype190PrivateInvestmentinPublicEquitysmartmoney173(PIPE)49,244SMSmessaging123PrivatePlacementMemorandum17–18,socialeconomicmodel5188,245Soﬁnnova128proﬁtsattributabletoshareholders68softcircle19,247 258Indexsoftissues185IRR90,158software118,119TVPI163,168–9Solomon’s,Dr97USventuremodel131–4,152,250SouthAmerica180inEurope134Spain8,144USAstars50averagesizeofbuyoutfunds52stocklevels53buyoutfundraising110strip54248buyoutreturns109subcomponentsﬁeld123seedstagefunds176sub-optimalutilisation214USout-performancevsSummitPartners48Europe157–65Sun164venturereturnsvstotalcapitalSweden55,92raised172ITin122vsEuropeanbuyout89–91LifeSciencein128utilities120sweetequity45,82,193,248syndication112valuation39–40,140–7aselementofstatedreturns140–1TakePrivatetransaction46,47–8,69,EuropevsUSA141–395,248guidelines142technologybubble51,78,143,161pre-moneyandpost-money145–6technologydealsseeITshareclasses147technologyrisk116,118,119variability143–5telcos123,248valueadd133–4,190,250Telecommunications(Telecoms)venture7–9sector118,119,121–4,154venturecapitalthinequitytaxrules79,248backingnewapplications116–18thirdgenerationsee3Gclassiﬁcationbysector118–28ThirdMarket165classiﬁcationbystage128–30,ThomsonFinancial91,161,163135timeasdriverofbuyoutreturns68deﬁnition4–5,115–16timevalueofmoney24–5,28employmentcreatedin5time-weightedreturns41–2,248VentureCapitalOperatingtiming73,80–2Companies(VCOCs)12,toolscompanies119250toplineentry71VentureCapitalTrust(VCT)11totalreturn213–14,219,221,249venturecapitalists52,250TotalValuetoPaidIn(TVPI)38–9,venturecompanies194–6,25189,132,161,162,89,175,venturefunds28,188–91249US3,4transaction-orientedventure176venturepartners132,251transparency94,161,216venturereturns157–81treasuresecondaries217,218,249future177–80turnover(revenue)multiples144European165–70fundsizeand170–4UK,actualeconomiccyclesin100bystage175–6UMTShandsets122,249USout-performancevsuninvestedcapital214–16Europe157–65UnlistedSecuritiesMarket165VentureOne178UpperQuartile29–30,34,157,162,VentureXpert56,91,97,101,103,176,250157,161,162,166,167,Fund157176 Index259verticalstrips54wi-ﬁ122vintageyear162,163,167,168,169,Windows120,127206–7,251buyoutfund77,80,97Yahoo127vintageyearreturn27,28,30,YaleEndowment177251YellowPages93,99votingrights8vulturecapitalist60IndexcompiledbyAnnetteMusker

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