The assets in every investment portfolio exhibit changes in value over time and in a private equity fund, both the fund manager and the investor will want to manage the value of the fund’s holdings. In an individual portfolio, an investor may have multiple stakes in PE funds and will want to monitor them all. There are a number of ways that both managers and investors can monitor their PE assets.
PE fund managers will typically communicate with the fund’s investors regarding updates and performance on a quarterly basis. Inside the fund, however, managers are continually monitoring the status of the fund’s assets and are talking with target companies on a regular basis. For the fund’s managers, every communication with a company in the fund’s portfolio is an opportunity to determine whether the company is making the best use of the investment capital the fund placed with them and whether any changes or additional capital are necessary to achieve objectives.
In addition, the economic environment is always changing and there could be changes in how the fund invests or manages its assets as a result of those as well. As the manager monitors the fund’s existing assets, they may be on the lookout for other companies to invest in, or may be starting to plan exits with the ones that are progressing well. This means that an active PE portfolio is dynamic in nature, monitored periodically and adjusted wherever necessary to ensure that it fulfils the goals it was set out to achieve.
In this sense, even though private equity assets are less liquid than public equities, there is direct hands-on influence by PE fund managers on behalf of the investors regarding portfolio assets. In contrast, neither managers nor investors in public funds have any influence at all over the assets in the fund other than to buy or sell them. The significant degree of influence that private equity managers have over portfolio companies makes selecting the right fund manager more crucial.
A unique element of private equity funds is that Limited Partners do not provide their full capital commitment at once. Instead, the General Partner makes investments in target companies over time (perhaps 1-2 years or more) and requests money from the Limited Partners through capital calls as needed. Upon receiving a capital call notice from the fund’s manager, a Limited Partner will generally have about 7-10 days to respond. So it is important to keep track of when those are likely to come and ensure that you have appropriate amounts of cash - or liquid assets - in your portfolio to honour them.
All portfolios are affected by changes in the market, economic conditions and political decisions - whether short-term shocks or policy changes with long-term effects. Keeping track of the landscape in which your investments are operating is essential.
A quality manager will be closely monitoring market conditions and may alter how the strategy will be implemented or modify the timing of it to suit the situation. As a result, the timing of cash flows or even the make-up of the fund’s portfolio may change, which in turn may affect the Limited Partners.
Entry Multiple. This is the multiple of a company’s purchase value to its earnings at the time of investment. Specifically, the entry multiple is the company’s enterprise value (EV) divided by earnings before interest, taxes, and depreciation (EBITDA). A General Partner will seek to negotiate a low entry multiple, in the hope of increasing this ratio as much as possible during ownership.
Exit Multiple. The Exit Multiple is calculated at the time of exit in the same way as Entry Multiple (EV divided by EBITDA). A General Partner will seek to create the highest possible Exit Multiple during ownership. The two multiples are especially insightful when compared to one another, illustrating how much the fund has (or hasn’t) increased value during ownership.
IRR (“Internal Rate of Return”). IRR is a return measure of both the speed and size of an investment’s return, so it takes into account the time value of money. It is usually calculated by dividing the size and timing of a fund’s cash flows (in the form of capital calls and distributions) by its net asset value. Gross IRR is often used to show performance at the fund or company level. The gross IRR does not include fees, carried interest, or fund expenses because there is no standard method for how to build those items into a Net IRR calculation.
MOIC (“Multiple on Invested Capital”). MOIC is a measure of raw investment performance, obtained by dividing the total value of a fund by the total invested capital. Since it does not take time into account, it is most useful when combined with a measure such as IRR. For example, a fund with a MOIC of 5.0x over a period of thee years has a far better IRR than one with the same MOIC over ten years. MOIC is often shown in both Gross and Net terms - before and after fees.
TVPI (“Total Value to Paid-In”). Also known as “Investment Multiple”, this is a way of measuring the fund’s performance as a multiple of the capital invested by the Limited Partners (which may or may not represent their entire investment commitment). It is calculated by summing the cumulative distributions made by the fund and the residual value of assets still held, divided by the paid-in capital. Like MOIC, it does not take into account the time value of money.
Loss Ratio. The Loss Ratio measures how much of a manager’s prior investments were closed at a loss. It is a simple way of illustrating a manager’s track record at downside protection, reflecting their ability at investment selection and exit management to handle underperforming investments. The loss ratio is calculated by dividing the percentage of capital realised below cost (minus any recovered proceeds) by the total invested capital.
While private equity investment is generally considered to be a long game, it is still essential to keep track of performance during the life of a fund. Monitoring the value and performance of a private market asset is a lot more difficult than public assets (see sidebar below) but the principle is much the same, as it considers the following:
Value. As asset values change, the balance of the portfolio can shift - often dramatically - over time. For example, if a 20% allocation to private equity performs very well and increases in value, while 40% in public equity decreases in value due to a downturn, this could shift the dollar value of your portfolio to say 25% in private equity and 35% public equity, thus changing the overall risk profile of your portfolio.
Returns. Monitoring returns as a fund progresses can be misleading if made in isolation, as key metrics (see sidebar above) can fluctuate over time, even if the final return is attractive. With that in mind, it is worth comparing returns to comparable funds of the same vintage, as well as to the expected return at this point in the fund’s lifecycle.
Risk. Risk can also be a dynamic variable as conditions change over the life of a fund. It can be important to continuously assess whether the risk profile of a fund may have an impact on the overall performance or the timing of distributions to the Limited Partners.
Traditional asset valuation and allocation models are typically based on Modern Portfolio Theory (MPT), which takes into account certain characteristics of the portfolio and the investor:
Periodically - as the output of ongoing, regular monitoring - you should rebalance your portfolio to ensure that it remains within the return and risk margins you are comfortable with. There is no “best” frequency, but you might choose:
Up to this point, we have looked at the life of a fund as a self-contained lifetime, with a beginning and an end. But - for most investors - a portfolio will be ongoing, so planning for the end of a fund’s life is an essential part of investing in private equity.
Years after the original fund stakes were purchased and the investor became a Limited Partner, it is likely that the goals and objectives of the portfolio have changed. It could be the case that by this point, the portfolio contains a series of other private equity stakes of varying vintages, which means that replacing the closing fund is a matter of course. But - as always - it is an excellent time to take stock of the portfolio and make sure it is on track to fulfil key objectives.
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