Strong returns: Are managers or the market due credit?

At the 2013 Milken Institute Global Conference, Apollo's Leon Black was quoted as saying, "We're selling everything that's not nailed down." It appears more than a few private equity fund managers pulled out their pry bars and removed some of those pesky metal restraints in 2014 and 2015.

As measured by dollar volume, the last several years have been the best exit years in the history of private equity markets with record levels of distributions to LPs. So what is the problem?

Simply put, the problem is the reinvestment decision. To what extent can the attractive returns be attributed to the market and, by contrast, how much can be attributed to the manager?

Despite a low-growth economy, private equity fund managers have enjoyed a unique environment in which – in addition to the aforementioned strength of the exit market – they have access to abundant low-cost debt and have seen very high levels of dealflow.

Due to the nature of the assets and the holding periods in private equity, market timing is less of an issue than in some other asset classes. However, private equity managers can still benefit – or suffer – from market conditions, and it is difficult for LPs to delineate clearly the market's contribution to performance from that of the manager. This is especially important as it is unlikely that the current, beneficial conditions will last through the next full private equity fund lifecycle.

To quantify this issue, the chart above presents the total value to paid in (TVPI) quartiles for funds at the end of their fourth year of operations over recent vintages, excluding the top 25% performing funds and the bottom 25%. For example, the ratio displayed for 2005 vintage funds relates to the TVPI as of December 31, 2008. The fourth year is relevant as it is common for fund managers to be raising their subsequent funds at that interval and LPs would be making their reinvestment decision with similar interim performance data.

From crisis to boom
There is an obvious shift upwards in the distribution of TVPIs over the period in the graph. The upward drift can be attributed to numerous factors. Funds raised in 2005 and 2006 almost certainly would have invested a large portion of their capital prior to the global financial crisis, when private equity prices were high. Furthermore, vehicles of those vintages would typically have been exiting some of their portfolio companies during the worst part of the crisis. Also, the performance of many portfolio companies was impacted negatively by the poor economic conditions created by the financial crisis.

Thus, TVPIs likely were depressed below normal levels for the 2005 and 2006 vintages. Conversely, the 2010-2012 vintages have seen the best exit markets in the history of private equity and, consequently, their TVPIs likely are elevated above normal levels.

While it is likely that both exit markets and changes in valuation methodology contributed to upward drift [in fund TVPI levels], it remains the case that fund managers in recent years are performing well, relative to historical norms" – William Charlton, Pavilion Alternatives Group

Another factor that would have contributed to an upward drift is that fund managers have moved to mark-to-market valuation methodologies due to regulatory changes.

While it is likely that both exit markets and changes in valuation methodology contributed to the upward drift, it remains the case that fund managers in recent years are performing well, relative to historical norms. Particularly noteworthy is that the 25th percentile TVPI for 2012 funds was 1.11x, which is not far below the 2005-vintage vehicles' 75th percentile of 1.14x.

Have private equity managers' capabilities been enhanced that significantly in seven years? Alternatively, has the investment opportunity set improved that much? While both of those are possibilities, sufficiently significant changes in either, over a comparatively short period, seem unlikely. However, the relative comparison does highlight the interaction of market conditions on fund performance. It is also relevant to note that interim performance in year four of a fund's life, while being somewhat predictive, is far from being deterministic of the ultimate performance of a fund.

Active fundraising environment
The reinvestment of distributions and the number of LPs increasing their private equity allocations or entering the space for the first time have created a very active fundraising market. Recognising this, some GPs have short-cycled their funds and are raising earlier than they normally would, or are offering alternative vehicles or strategies. Many LPs have realised that missing the next vehicle of a quality fund manager may result in losing future access to that GP. This places even more pressure on LPs to make good investment decisions with limited information while knowing that market conditions may have influenced that information significantly.

Clearly, the best situation is to invest in good managers under good market conditions. However, accurately forecasting market conditions is exceedingly difficult, especially over the 10-year life of most private equity investment vehicles. Thus, the strategy that many LPs employ is to invest in good fund managers and use vintage year diversification to mitigate market risk.

Making the distinction between market beneficiaries versus value creators requires extensive experience in various private equity markets as well as deep knowledge of the individual fund managers, including their team dynamics, strategies and value creation capabilities. Generally, LPs have a dim view of a GP that exhibits a trading or opportunistic mentality as their primary strategy. Ironically, with the receptive exit markets over the last several years, GPs may be viewed negatively if they did not remove some of the irksome spikes on at least a few of their portfolio companies and capitalise on a historic opportunity.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• LPs
• Performance
• Top story
• Fund performance