The Private Equity Model

As the name suggests, private equity assets are not exchange-traded shares. The fact that there are no closing prices, trading volume, bids or asks, or any other publicly available information poses several challenges to investors, foremost of which is pricing and risk assessment. With no trading, there are no observed closing prices, and therefore no frequency of observable returns and therefore no volatility. The tasks related to return and risk attribution are quite different for this asset class, as we shall see further on.

There are several subclasses of private equity investments, including, for example, the two main ones—venture and leveraged buyout, along with distressed, growth, subordinated debt, and energy. According to Phalippou, private equity managers had over $1 trillion under management in 2006, roughly two-thirds of which was in leveraged buyout funds. Funds are organized as limited partnerships with the LPs as primary investors generally drawn from the ranks of large institutional investors like pension funds. Limited partners commit funds to general partners (GPs) who manage the funds and whose compensation is determined by an agreed-upon fee structure. Funds are typically organized with a specific strategy (venture or buyout), target for committed capital, and life (typically 10 years). For example, the GPs might announce the formation of a new fund with targeted committed capital to be, say, $1 billion and then solicit LPs (investors) to commit capital to the fund until the target investment level is attained. GPs draw on committed capital, investing in projects (ventures or firms), until all capital is invested. GPs then determine when and how assets are sold and distributed to LPs as dividends on their invested capital. As the fund matures, distributions are made until the fund is closed and any remaining assets liquidated and paid to LPs.

The compensation structure for GPs has typically been the “2 and 20” model—GPs fees comprise a 2 percent fee on invested (sometime committed) capital and a 20 percent share of the return over a stated benchmark. Thus, if the fund earns 8 percent on $100 invested and the benchmark (or hurdle rate) is 6 percent, then the LP pays $2 in management fees off the top and then earns 6 percent plus 0.80 times the 2 percent (in excess of the hurdle) for a total payoff of $7.60 – $2 = $5.60, or 5.6 percent, on assets under management. All other things constant, this is less than had the $100 been invested in the passive benchmark. Given the likelihood that the GPs leveraged the investment to begin with, then this return is smaller than the benchmark but with more risk.

Typically, GPs and LPs report internal rates of return on investments as the following example illustrates:

Here, the LP commits $400, which is drawn in the first three years. Distributions begin in year six and the fund is closed at the end of the tenth year. The IRR is 4 percent gross of fees.

Unfortunately, IRR measures cannot be compared to returns on publicly traded assets. This problem arises because IRR is what is referred to as a dollar-weighted return while publicly traded assets report a time-weighted return. The yield to maturity on a bond, for example, is an IRR but this is not the same as the return on the bond, and in any case, a bond's yield to maturity that is, say, 5 percent per year, is not the same thing as a 5 percent annual return on a stock. Regardless of the confusing semantics surrounding the meaning of dollar versus time weighting, the distinction between the fundamental differences between IRR and the notion of the percentage change in the market value of an asset should be clear: IRRs are not based on market prices, but are instead cash-flow dependent. To compare, then, the performance of private equity (or private real estate assets, for that matter) to publicly traded assets, analysts sometimes compute the modified Dietz return to private assets, which is basically a time-weighted return that takes the percentage change in the market value of the private assets between two points in time (which is exactly how we've been doing returns all along in this book) but adjusts the computation for intraperiod cash flows. GPs mark their assets to market quarterly (under FASB 157 guidelines) that reflect the value of comparable assets that have transacted, and although these marked-to-market values are considered proxies to true market value, it should be emphasized that they are not the assets’ market values since no transactions have actually occurred. Letting EMV and BMV stand for ending and beginning market value and CF as intervening cash flows in the form of either drawdowns or distributions (the latter being negative, since it is paid out), then the modified Dietz return for any given quarter is:

If there are no intraperiod cash flows, then the formula reduces to the standard time-weighted return. Here is an example:

This fund began with an EMV of $30.27 million at the end of the first quarter 2008. It then had a distribution in the amount of $51.2 thousand on May 28 and another quarterly valuation on June 30. As such, the return numerator is the change in market value adjusted for the cash flow distribution. The denominator is the starting value, which is the beginning market value and the time-weighted cash flows, in which the weights are the proportion of time left in the current quarter, that is, the remaining time in the quarter that the cash flow is at work, so to speak.

Modified Dietz returns are intuitively appealing as well as practical counterparts to IRRs in the case in which assets and portfolios are marked to market with stable frequency. Private equity portfolios’ performance can be compared in this fashion to that on publicly traded portfolios like the S&P 500. The weakness in this methodology lies in the marking to market; these are not actual transactions. In the preceding example, for example, the valuation reported at the end of 2008 is not an actual market value of $32 million; it is, rather, an assessment of value based on assets of similar duration and composition residing in similar sectors. The end of month closing price on the S&P 500, on the other hand, is a transacted value with no pricing error. Therefore, it should not be surprising to see pricing error on private portfolios when their assets are liquidated. Despite the incentive for GPs to overstate value (carrying assets at cost, for example), the science of valuing classes of assets like private equity is limited—private evaluation will always tend to lag market values and be based on small samples of carefully selected assets exposed to pricing error. That is why the more promising performance methodologies focus entirely on cash flows and not reported market values. We turn to these alternative pricing and performance methodologies now.