Foreword
Over the last three decades, private equity has established itself as one of the most important asset classes for institutional investors. Despite going through boom and bust periods, investments in private equity have grown steadily over time. Two important economic forces have helped drive this growth.
First, illiquid assets, such as private equity, comprise an important part of the overall market portfolio and thus provide investors with important diversification benefits. The vast majority of assets around the world are private, and despite the recent growth of private equity these assets are still underrepresented in the portfolios of institutional investors.
Second, as institutional investors have grown larger and more diversified, it is becoming harder for institutions to exercise active ownership and governance in all the companies they own. This is a serious problem, since active ownership and governance are crucial in order to realize the full value potential of a firm. By investing part of their assets in private equity funds, large institutions can delegate their active ownership to skilled intermediaries, which in turn can acquire large ownership stakes in companies and act as active owners, while still allowing the institutional investors to maintain a high degree of diversification in their overall portfolios.
Recent research has confirmed that this model seems to work: firms seem to be run more efficiently under private equity ownership, and private equity has been a major contributor to institutional investor returns. Because of this, the long-term trend in private equity growth is not likely to reverse anytime soon.
Given its growth and importance, it is both worrying and surprising that private equity is so misunderstood. Despite the positive research evidence on the impact of private equity ownership on firms, the public perception of private equity is often quite negative. Private equity funds are depicted as vultures and asset strippers, who use financial engineering to squeeze out short-term profits from firms at the expense of employment and long-term growth. These perceptions have led legislators to impose misdirected regulation, such as the European AIFM directive, which at best simply imposes some additional red tape on funds, and at worst threatens the supply of capital to European small and medium-sized enterprises. A large part of the blame for this misunderstanding should fall on the private equity industry itself, which for too long believed it was fine to lack in transparency towards the public as long as it was transparent towards their investors.
It is even more worrisome, however, that investors themselves often misunderstand the private equity asset class. Many investors enter the private equity arena relying on their experience from investing in liquid stocks and bonds, without fully realizing that investing in illiquid assets requires a completely different skill set and investment approach.
Investors are often unable to appropriately assess and evaluate their returns from private equity. The type of short-term, quarter-by-quarter benchmarking that can be done for liquid investments fails to work for evaluating private equity. The regular net asset values reported by private equity funds are very different from market valuations, and relying on these for performance evaluation will be very misleading.
The true costs of private equity investing are also much less transparent, both because of the complex fee structures of private equity funds and the substantial organizational resources an institution has to devote to assess, execute, and monitor private equity investments. In addition, the opportunity cost of future liquidity commitments is often ignored. Numerous investors have experienced disappointing private equity returns, either because they felt forced to hold an excess of low-yielding liquid assets in order to meet future private equity fund commitments, or because they were forced to sell their private equity interests at fire-sale prices in the secondary market when they were not able to fulfill their commitments. These various costs will vary substantially across different types of investors, depending on their size, liability structure, and investment horizon. While the costs may be negligible for some investors, they may be insurmountable for others.
Evaluating private equity funds is also very different from evaluating liquid investment opportunities and asset managers. Liquid investment strategies are often about market timing, with investors swiftly responding to changes in relative risk premia across different assets and markets. Investment strategies that were successful in the past are unlikely to persist for long into the future, as capital can quickly move across liquid asset classes. Private equity investment, by contrast, is primarily about identifying consistent performers, who have the proprietary skills to add operational and strategic value to their investments over a long period of time.
The liquid investment mindset also leads investors to misunderstand the risks of private equity investments. For liquid assets, we have seen large leaps forward in terms of risk measurement and risk management in the last decades. Using modern portfolio theory, risk factors can now be estimated and incorporated in asset allocation models to capture exotic risk premia and improve diversification. Risk management tools such as VAR-models are estimated using high-frequency data in order to control and limit downside portfolio risks. These tools have also been picked up by regulators around the world and incorporated in capital regulations such as the Basle and Solvency rules.
Applying these standard models to private equity, however, often gives a highly misleading view of the real risks involved. Relying on fluctuations in infrequently updated net asset values are highly inappropriate for measuring risks, guiding strategic asset allocation, and forming the basis of risk management. In contrast, the liquidity risks are often either ignored or inappropriately modeled, leading to spectacular risk management failures and large costs to investors. In addition, if regulators fail to adjust their models, this can encourage institutions to take excessive illiquidity risk and result in the under-capitalization of such investors. Conversely, inappropriate regulation may penalize investors for taking perceived risks that in reality are not present or important.
Hence, the private equity industry faces a huge challenge in educating the public, investors, and regulators about this asset class. This is where this book fills an extremely important void. The authors, Cornelius, Diller, Guennoc, and Meyer, are some of the world's foremost experts on private equity investing. They uniquely combine extensive practical investment experience with deep knowledge of state-of-the-art research and methodologies. The authors provide an extensive coverage of all major aspects of the private equity market from an institutional investor's point of view, including fund structures, return and risk measurement, and risk modeling and management, in a way that is both advanced and highly practical. In addition, the book contains numerous discussions of more specialized topics, such as secondary markets and recent industry trends, such as securitization, which are enlightening and informative even for those very familiar with the private equity industry. The book should be required reading for those investing in private equity, novices and experienced investors alike. I congratulate the authors on an impressive and important effort!
Per Strömberg
Centennial Professor of Finance and Private Equity
Stockholm School of Economics
Stockholm April 1, 2013