INSEAD Library

Includes bibliographical references and index and glossary

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Beyond the J-Curve Managing a Portfolio of Venture Capital and Private Equity Funds Contents List of Boxes Acknowledgements Disclaimer PART I PRIVATE EQUITY ENVIRONMENT 1 Introduction 1.1 Routes into private equity 1.2 The limited partner's viewpoint 1.3 The challenge of venture capital fund valuation 1.4 Hard figures or gut instinct? 1.5 Managing with fuzzy figures 1.6 Making the grades 1.7 Outline 2 Private Equity Market 2.1 Funds as intermediaries 2.2 The problem of predicting success 2.2.1 Can success be repeated? 2.2.2 What is success? 2.2.3 Tolerance for failure 2.3 Broad segmentation of investment universe 2.3.1 Institutional quality funds 2.3.2 Newcomers 2.4 Private equity market dynamics 2.4.1 Boom-and-bust cycles 2.4.2 The relationship between limited and general partners 2.4.3 Life cycle of limited and general partner relationship 2.5 Conclusion xv xvii xvii 1 3 3 4 4 5 5 5 7 9 10 15 15 17 18 18 18 21 22 22 23 24 26 viii Contents 3 Private Equity Fund Structure 3.1 Key features 3.1.1 Corporate governance 3.1.2 Investment objectives, fund term and fund size 3.1.3 Management fees and expenses 3.1.4 Carried interest 3.1.5 Preferred return or hurdle rate 3.1.6 General partners' contribution 3.1.7 Key person provision 3.1.8 Termination and divorce 3.1.9 Distribution waterfall 3.2 Conflicts of interest 3.3 Finding the balance 4 Buyout and Venture Capital Fund Differences 4.1 Valuation 4.2 Business model 4.3 Deal structuring 4.4 Role of general partners 5 Funds-of-funds 5.1 Structure 5.2 Value added 5.2.1 Diversification 5.2.2 Resources 5.2.3 Selection skills 5.2.4 Incentives 5.3 Costs 5.4 Private equity investment programme 5.4.1 Funding 5.4.2 Management fees and profit sharing 5.4.3 Investment activities Appendix 5A PART II INVESTMENT PROCESS 6 Investment Process 6.1 Key performance drivers 6.1.1 Fund manager selection 6.1.2 Management of diversification 6.1.3 Commitment management 6.2 Process description 6.2.1 Portfolio objectives 6.2.2 Portfolio design 6.2.3 Liquidity management and valuation 6.2.4 Monitoring 6.2.5 Action and implementation 27 29 30 31 31 32 33 34 35 36 37 38 38 41 43 44 45 45 47 47 48 49 49 50 50 51 52 53 53 54 54 57 59 59 60 60 60 61 61 62 63 64 64 Contents 6.3 Risk management 6.3.1 Risk-measurement framework 6.3.2 Risk control 6.3.3 Risk mitigation 6.4 Tackling uncertainty 6.4.1 Reducing uncertainty 6.4.2 Strategies under uncertainty 7 Risk Framework 7.1 Market value 7.2 Market or credit risk? 7.2.1 Market risk 7.2.2 Credit risk 7.3 Conclusion Appendix 7A: Incorporating private equity into the traditional VaR framework 7A.1 VaR calculation based on reported financial data 7A.2 Marking-to-model 8 Portfolio Design 8.1 Portfolio design framework 8.1.1 Modern portfolio theory 8.1.2 "Naive" allocation 8.2 Portfolio construction techniques 8.2.1 Bottom-up approach 8.2.2 Top-down approach 8.2.3 Mixed approach 8.2.4 Portfolio monitoring 8.3 Risk­return management approaches 8.3.1 Core­satellite approach 8.3.2 Diversification 9 Case Study 9.1 Looking for the optimal programme size 9.1.1 Data 9.1.2 The model 9.1.3 Results 9.1.4 Extension 9.1.5 Conclusion 9.2 Overcoming entry barriers: long-term strategies 9.2.1 Data 9.2.2 Modelling 9.2.3 Results 9.2.4 Conclusion Appendix 9A: Formulae Appendix 9B: Skewness and kurtosis Appendix 9C: Expected utility ix 65 65 65 67 68 69 69 73 75 77 77 77 78 79 79 80 81 81 81 83 83 84 84 85 87 88 88 90 95 95 96 97 98 100 102 104 104 105 106 106 111 112 113 x Contents 10 The Management of Liquidity 10.1 Liquidity management problem 10.1.1 Modelling 10.1.2 Impact of liquidity returns 10.1.3 Over-commitments 10.1.4 Conclusion 10.2 Liquidity management approaches 10.2.1 Sources of liquidity 10.2.2 Foreign exchange risk 10.2.3 Distributions-in-kind 10.2.4 Consequences for performance measurement 10.3 Investment strategies for undrawn capital 10.3.1 Publicly quoted private equity 10.3.2 Other alternative assets 10.4 Cash flow projections 10.4.1 Estimates 10.4.2 Forecasting 10.4.3 Scenarios 10.4.4 Control framework 10.5 Conclusion Appendix 10A: Cash flow estimation technique 10A.1 Cash flow estimate--example 1 10A.2 Cash flow estimate--example 2 10A.3 Cash flow estimate--example 3 Appendix 10B: Cumulative net cash flow statistics Appendix 10C: Liquidity management tests 10C.1 Main tests 10C.2 Liquidity tests 10C.3 Performance tests 10C.4 Matching tests 10C.5 Scenario validity tests 115 115 117 118 119 122 123 123 124 128 130 130 131 132 133 135 138 142 144 145 145 145 145 146 147 147 148 148 149 149 149 PART III DESIGN TOOLS 11 Established Approaches to Fund Valuation 11.1 Bottom-up approach to private equity fund valuation 11.2 Inconsistency of valuations 11.3 NAVs do not tell the full picture 11.4 Portfolio companies cannot be valued in isolation 11.5 Conclusion 12 Benchmarking 12.1 Specific issues 12.2 Individual funds 12.2.1 Performance measures 12.2.2 Classical relative benchmarks 151 153 154 157 157 159 162 165 165 166 166 167 Contents 12.2.3 Other relative benchmarks 12.2.4 Absolute benchmarks 12.3 Portfolio of funds 12.3.1 Performance measures 12.3.2 Benchmarks 13 A Prototype Internal Grading System 13.1 Grading of private equity funds 13.2 The NAV is not enough 13.3 Existing approaches 13.3.1 Fund rating by external agencies 13.3.2 Internal VC fund assessment approaches 13.3.3 Comparison of approaches 13.4 New approach to internal fund-grading system 13.4.1 Grading formalisation 13.4.2 Expected performance grades 13.5 Summary--NAV- and grading-based valuation Appendix 13A 14 Fund Manager Selection Process 14.1 Relevance of fund manager selection 14.2 Why due diligence? 14.2.1 Due diligence as a requirement for prudent investors 14.2.2 Due diligence as a basis for better investment decisions 14.3 The due diligence process 14.3.1 Limitations 14.3.2 Due diligence questionnaires 14.4 Fund manager selection process 14.4.1 Determination of the "wish list" 14.4.2 Deal sourcing 14.4.3 Screening 14.4.4 Meet the team 14.4.5 Evaluation 14.4.6 In-depth due diligence 14.5 Decision and commitment Appendix 14A: Illustrative due diligence questionnaire--venture capital funds 15 Qualitative Fund Scoring 15.1 Scoring approach 15.2 Scoring dimensions 15.2.1 Management team skills 15.2.2 Management team stability 15.2.3 Management team motivation 15.2.4 Fund strategy 15.2.5 Fund structure 169 169 170 170 171 173 173 174 176 176 178 180 180 180 181 188 189 193 193 194 194 195 195 195 196 197 197 198 198 198 199 200 201 202 219 219 221 221 224 225 227 229 xii Contents 15.2.6 External validation 15.2.7 Overall fit 230 231 233 233 237 238 239 241 241 242 242 242 243 243 245 248 248 251 253 253 254 254 256 257 257 261 264 265 265 266 269 271 272 272 273 273 274 276 276 279 281 282 285 16 Grading-based Economic Model 16.1 Approach 16.2 Internal age adjustment 16.3 Private equity fund IRR projections 16.4 Expected portfolio returns 16.5 Discussion 16.5.1 Verification of approach 16.5.2 Reliance on assumptions 16.6 Conclusion Appendix 16A 16A.1 Identifying bottom funds 16A.2 Identifying top funds Appendix 16B Appendix 16C: Grading-based private equity fund valuation--how fair is my valuation? 16C.1 The revised 1AS 39 16C.2 Valuation model (mark-to-model) 17 Private Equity Fund Discount Rate 17.1 The capital asset pricing model 17.1.1 Risk-free rate 17.1.2 Equity risk premium 17.1.3 Beta 17.2 Private equity fund betas 17.2.1 Estimation based on quoted comparable 17.2.2 Alternatives to the "standard" regression betas 17.3 The alternatives to the capital asset pricing model 17.3.1 The opportunity cost of capital 17.3.2 The historical performance 17.4 Summary and conclusion PART IV MANAGEMENT TOOLS 18 Monitoring 18.1 Approach to monitoring 18.1.1 Monitoring as part of a control system 18.1.2 The trade-offs 18.2 The monitoring objectives 18.2.1 Protecting downside 18.2.2 Creating value 18.3 Information gathering 18.3.1 Standard monitoring 18.3.2 Specific monitoring 18.4 Evaluation 18.5 Actions Contents xiii 19 Case Study: Saving Your Investments--Approaches to Restructuring 19.1 The valley of tears 19.2 The report to the board 19.3 The terms of the restructuring 19.4 Epilogue Appendix 19A: Investment proposal Appendix 19B: Track record 19B.1 Greenlight 1 19B.2 Greenlight buyout 20 Secondary Transactions 20.1 Sellers and their motivations 20.2 Buyers and their motivations 20.3 Secondary market prices 20.3.1 Factors for valuation 20.3.2 Top-down analysis 20.3.3 Bottom-up analysis 20.3.4 Comparables 20.4 Transactional issues 20.5 The fund manager perspective PART V EMBRACING UNCERTAINTY 21 Deviating from Top Funds 21.1 Strategic investments 21.2 Policy objectives 22 Real Options 22.1 Real options in private equity 22.2 Real option analysis 22.3 An expanded strategy and decision framework 22.3.1 Decision framework 22.3.2 Strategy framework Appendix 22A: A real option example 23 Beyond the J-curve 23.1 Some do it better 2S.2 Deadly sins 23.3 Structure instead of "gut instinct" 23.4 Patience is a virtue 23.5 Turning water into wine Glossary Bibliography Abbreviations Index 287 288 289 291 293 293 294 294 295 297 297 299 300 303 304 306 307 307 308 311 313 313 314 319 319 321 322 322 322 324 327 327 327 328 328 329 331 341 351 353