J-Curve exposure - managing a portfolio of venture capital and private equity funds

Contents
List of Boxes xvii
Foreword xix
Acknowledgments xxi
Abbreviations xxiii
Disclaimer xxv
PART I PRIVATE EQUITY LANDSCAPE 1
1 Introduction 3
1.1 Barbarians, pirates and privateers 3
1.2 A difficult world to conquer 4
1.2.1 Get rich quick? 4
1.2.2 Chartering a course 5
1.2.3 Storms and barrier-reefs 6
1.2.4 Drawing a map 6
1.2.5 Setting out ships and navigating the oceans 7
1.2.6 Staying on course and moving into calmer waters 8
2 Institutional Investing in Private Equity 11
2.1 Limited partnership 12
2.2 Funds-of-funds 20
2.2.1 Additional layer of management fees 20
2.2.2 Jumpstarting the allocation to private equity 21
2.2.3 Diversification and scaling of investments 21
2.2.4 Access to top teams 22
2.3 Private equity funds investment program 22
3 Private Equity Environment 25
3.1 The informal VC market 26
3.1.1 Business angels 27
3.1.2 Business incubators 28
3.2 Private equity as part of alternative assets 30
3.2.1 Comparison of private equity with hedge funds 30

3.2.2 Encroachment and convergence 34
3.2.3 Distressed assets 35
3.3 Mezzanine financing 37
3.4 Overlap with public market 40
3.5 Conclusion 42
4 Risk Management Lessons from a Listed Private Equity Fund-of-Funds 43
4.1 Relevance of the Private Equity Holding case 43
4.2 The Swiss private equity funds-of-funds industry 45
4.2.1 The market for publicly quoted private equity funds-offunds
45
4.2.2 Importance for investors 46
4.2.3 Growing opportunities 47
4.3 Commitments and investments 47
4.3.1 Importance of over-commitments 48
4.3.2 Best practices 48
4.3.3 Over-commitments and risks 49
4.4 The rise and (near) fall of Private Equity Holding 50
4.4.1 Opportunities and growth 51
4.4.2 The ‘new economy’ 53
4.4.3 Clouds gathering 54
4.4.4 Iceberg ahead 59
4.5 Definition and analysis of ratios 61
4.5.1 Comparison of Private Equity Holding and Castle Private
Equity 62
4.5.2 Other factors 66
4.6 Lessons and epilogue 68
Appendix 4A Adjusted current ratio methodology 70
PART II THE ECONOMICS OF PRIVATE EQUITY FUNDS 71
5 Venture Capital Fund Fair Value 73
5.1 Valuation Guidelines 73
5.2 Motivation 77
5.3 Current practices 78
5.4 Problem areas 80
5.4.1 The negative impact of the J Curve 80
5.4.2 The high workload associated with valuation reviews 81
5.4.3 Entry barriers for new investors in venture capital 82
5.4.4 Current valuation techniques do not capture risk 83
5.4.5 The J Curve creates a false sense of security 83
5.4.6 Models can be abused 84
5.5 Conceptual questions 84
5.6 Can one do without judgment? 84
5.7 Is there a pragmatic way forward? 85
5.7.1 Differentiate between young and mature VC
funds 86

5.7.2 Accept different standards for reliability 86
5.7.3 Assure reliability through valuation process reviews 87
6 Model-Based Approach to VC Fund Valuation 89
6.1 Why model? 89
6.1.1 Modeling simplification 90
6.1.2 Model limitations 91
6.2 The private equity data market 91
6.2.1 Players in the private equity data market 92
6.2.2 Data providers 93
6.2.3 Data service providers 95
6.2.4 Users of data 98
6.2.5 Quality of data 99
6.2.6 The economics of the VC data market 100
6.2.7 Conclusion 103
7 Private Equity Fund Valuation Approaches 105
7.1 Determining the economic value of a private equity fund 105
7.1.1 Modified bottom-up approach 106
7.1.2 Modified comparable approach 108
7.1.3 High-level comparison of modified bottom-up approach and
GEM 117
7.2 Accounting valuation of a fund’s portfolio of investee
companies 119
7.2.1 Surveyed portfolio of private equity funds 119
7.2.2 Assessing compliance with IPEV guidelines 120
7.2.3 Assessing the degree of compliance 121
7.2.4 The impact of the new IPEV guidelines on valuations 121
7.2.5 The implications for limited partners 125
7.2.6 Model valuation process 127
7.3 Conclusion 136
8 Distribution Waterfall 137
8.1 Introduction 137
8.1.1 Terms and conditions 139
8.1.2 General partner investment in fund 140
8.1.3 Management fees 140
8.1.4 Profit and loss 143
8.1.5 Carried interest 145
8.1.6 Vesting 146
8.1.7 Main drivers of distribution waterfall 148
8.2 Basic waterfall model 150
8.2.1 Preferred return and hurdle rate 155
8.2.2 Catch-up 161
8.3 Impact of carried interest distribution approaches 162
8.3.1 Fund-as-a-whole 162
8.3.2 Deal-by-deal 165
8.3.3 Considerations and possible solutions 166

8.4 Clawback 169
8.4.1 Controversy 172
8.4.2 Protection of investors 172
8.4.3 Escrow 174
8.4.4 Timing 175
8.4.5 Limited partner clawback 175
9 Break-even Analysis 179
9.1 Objective of break-even analysis 179
9.2 Methodology 180
9.2.1 Step 1: capital contributions 181
9.2.2 Step 2: use of the contributions 181
9.2.3 Step 3: net asset value 182
9.2.4 Step 4: distributions 183
9.2.5 Step 5: distribution waterfall 184
9.2.6 Step 6: break-even IRRs 186
9.3 Scenarios and sensitivity analysis 187
9.4 Additional analysis 188
9.4.1 Incentive scheme analysis 188
9.4.2 Analysis of the wealth transferred 188
9.4.3 IRR distributions 189
10 Track Record Analysis 191
10.1 Due diligence 191
10.1.1 Performance persistence 191
10.1.2 Gathering and evaluating the data 196
10.1.3 The perils of charisma 197
10.1.4 Improving investment decisions – luck or skills? 199
10.2 Benchmarking 200
10.2.1 Classical relative benchmark 201
10.2.2 Public market equivalent 205
10.2.3 Absolute benchmarks 206
10.2.4 Prospective performance analysis 210
10.3 Track record analysis tools 210
10.3.1 Portfolio gross performance stripping 211
10.3.2 Performance dispersion (profit and losses) 212
10.3.3 Realized track record 214
10.3.4 Winners dependence analysis 214
10.3.5 Backing the winners analysis 214
10.3.6 Value creation analysis 218
10.3.7 Deal structuring analysis 219
10.3.8 Multiple arbitrage analysis 219
10.3.9 Added-value analysis 221
10.4 Limitations 222
10.5 Conclusion 223
Appendix 10A Performance spread between best and worst
manager 224

PART III MANAGING UNDER UNCERTAINTY 227
11 Grading and Fitness Landscapes 229
11.1 Fitness landscapes 231
11.1.1 VC market as an evolutionary system 232
11.1.2 VC firms’ genetic code 232
11.1.3 Does this allegory hold? 234
11.1.4 Extinctions in VC markets 235
11.2 Grading-based evaluation of private equity funds 236
11.2.1 Can we predict success? 239
11.2.2 Why not invest only in P-A graded funds? 241
11.3 Grading as portfolio management tool 245
11.4 VC market dynamics – power laws 247
11.5 Searching landscapes 249
11.5.1 Exploitative search 249
11.5.2 Explorative search 250
11.6 Conclusion 250
12 Private Equity Funds and Real Options 253
12.1 Agency problems and contracting 256
12.1.1 Incomplete contracting 257
12.1.2 Renegotiation and real options 257
12.2 Changes in limited partnership agreements 258
12.2.1 Main findings 258
12.2.2 Changes related to promising funds 260
12.2.3 Changes related to problematic funds 260
12.2.4 Other observations 261
12.3 Braiding 262
12.4 Summary 267
13 Co-investing 271
13.1 Motivation 272
13.1.1 Relevance 272
13.1.2 Co-investment approach 273
13.2 Co-investment risk and rewards 275
13.2.1 Limited partner perspective 276
13.2.2 Fund manager perspective 277
13.2.3 Experiences with co-investment programs 277
13.3 Potential issues related to co-investments 277
13.3.1 Second-guessing fund managers 277
13.3.2 Cherry-picking 278
13.3.3 Conflicts of interest 278
13.4 Implementation issues 279
13.4.1 Speed of execution 279
13.4.2 Team set-up 280
13.5 Portfolio management 281
13.5.1 Managing portfolio composition 281
13.5.2 Link to other strategies 282

13.5.3 Leveraging international network 283
13.6 Conclusion 283
14 Side Funds 285
14.1 ‘Classical’ side funds 285
14.1.1 ‘Raison d’être’ 285
14.1.2 Structuring 288
14.2 Side funds – similar structures 291
14.2.1 Re-investment of proceeds 291
14.2.2 Top-up funds 293
14.3 LPs structure or how to increase flexibilty 294
14.3.1 Conditional commitment 294
14.3.2 Limited partners’ staged investment 295
14.4 Conclusion 298
15 Limited Partner Decision-Making Fallacies 299
15.1 Decision-making with poor data 299
15.2 Herding as a response to uncertainty 300
15.2.1 Betting on every horse 301
15.2.2 Imitate and turn to experts 301
15.2.3 Protect one’s reputation 302
15.2.4 Creating reality 302
15.2.5 VC industry as ‘crisis hunter’ 304
15.3 Decision-making biases 305
15.3.1 Mental accounting 306
15.3.2 Anchoring 308
15.3.3 Endorsement effect 309
15.3.4 Status quo bias 309
15.3.5 Regret 310
15.3.6 Home bias 311
15.3.7 Over-optimism 311
15.4 Conclusion 312
PART IV MANAGING PORTFOLIOS OF PRIVATE EQUITY FUNDS 315
16 Portfolio Construction Principles 317
16.1 Private equity and modern portfolio theory 317
16.1.1 Fitting private equity into the requirements for MPT 318
16.1.2 Private equity fund risk 320
16.1.3 Private equity fund exposure 321
16.1.4 How much to allocate to a private equity funds investment
program? 324
16.1.5 Other issues 328
16.2 Creating a portfolio of private equity funds 328
16.3 The risk profile of private equity assets 331
16.3.1 Private equity funds 331
16.3.2 Portfolio of private equity funds 341
16.3.3 Further remarks 346

16.4 Risk dimensions 346
16.4.1 Stage focus 347
16.4.2 Vintage year 348
16.4.3 Industry sector 349
16.4.4 Geography and currencies 350
16.4.5 Agent concentration 350
16.4.6 ‘Naïve’ diversification 350
17 Portfolio Construction Rules of Thumb 355
17.1 What we know 356
17.2 What we think we know or simply don’t know 360
17.3 Exploitation vs. Exploration 364
17.3.1 Structured exploring 364
17.3.2 Core/satellite portfolio 365
17.3.3 Uncertainty budget 366
17.3.4 Balancing exploitation, exploration, growth and
survival 366
17.3.5 Adapting, shaping & insuring 368
17.3.6 Diversification and portfolios as networks 370
18 Guidelines, Monitoring and Corrective Actions 371
18.1 Investment guidelines as framework 372
18.1.1 Trade-offs 374
18.1.2 Investment policies 374
18.1.3 Investment strategy 375
18.2 Implementation of investment policies 375
18.2.1 Negative screens 376
18.2.2 Positive screens 376
18.2.3 Best-of-sector approach 376
18.3 Monitoring investment restrictions 377
18.3.1 Investment restriction checking 377
18.3.2 High-level process description 378
18.3.3 Conceptual questions 380
18.3.4 Statement of assurance 382
18.4 Monitoring strategy implementation 383
18.4.1 Portfolio limits 383
18.4.2 Portfolio benchmarking 383
18.5 Corrective actions 387
18.5.1 Rebalancing through secondary sells 388
18.5.2 Portfolio segmentation 388
18.5.3 Conclusion 393
19 Securitization 395
19.1 Structure of private equity CFO 395
19.1.1 Introduction to securitization techniques 395
19.1.2 The CFO market 397
19.2 Which private equity assets? 400

19.3 Parties involved and their objectives 402
19.3.1 Overview 402
19.3.2 The originator 403
19.3.3 Fund managers 404
19.3.4 Investors 404
19.4 Modeling the transaction – simulating the performance of
the assets 406
19.4.1 Monte Carlo simulation 406
19.4.2 Modeling approaches 408
19.4.3 Use of historical data 409
19.5 Modeling the transaction – structural features 411
19.5.1 Investment guidelines 411
19.5.2 Cash flow management 412
19.5.3 Interest rates 415
19.5.4 Currency 417
19.5.5 Liquidity 417
19.5.6 Waterfall 417
19.6 External rating 417
19.6.1 Rating approach 417
19.6.2 The management review 418
19.6.3 Surveillance 418
20 J Curve Exposure 423
20.1 Cultural influences 423
20.2 Blurred boundaries 424
20.3 Limited scalability 425
20.4 End-game? 425
References 427
Index 441