Valuation of Portfolio Companies
- Valuations of unrealised investments, each quarter
- International PE and VC Valuation Guidelines (IPEV - updated Dec 2018) Report investments at Fair Market Value
- Methodologies:
- Price of recent investment
- Earnings multiple
- Net Assets
- Discounted cash flows or earnings ( of underlying businesses)
- Discounted cash flows (from the investment)
- Industry valuation benchmarks
- Early-stage companies: price of recent investment which is:
Recent investment = cost is a good indicator of fair value. Validity of cost is eroded over time
- Companies with revenues but no profits or +ve cash flow: price of recent investment or DCF (but watch as subjective), confirm with industry benchmarks
- Companies with revenues, maintainable profits and /or maintainable cash flows (eg buyout): earnings multiple
Regulation of PE
FCA regulated in UK. 11 Principles of Business
Regulated activities include:
- arranging deals in investments
- managing investments
‘Guidelines for Disclosure and Transparency in Private Equity’ (Walker Review, 2007)
Applies where portfolio companies:
1/2 revenues in UK and >1000 full-time UK employees and:
(1) enterprise value > £500 million when acquired by PE firm,
or
(2) public to private transaction with market cap > £300 million
Guidelines Monitoring Group established
Non -compliance: firm name disclosure, expulsion from BVCA
(Walker Review, 2007) - Principal Recommendations for Private Equity Firms
- Publish annual review
- Valuation methods requirements
- Reporting to LPs
- Data to be provided by portfolio companies and PE firms to BVCA
- Audited accounts on company website no more than 6 months after year end
- Identify PE fund that owns company, provide details on board composition
- Financial review to cover risk management objectives and policies in light of principal risks and uncertainties facing company
- Include S417 business review (incl part 5 applicable to public companies: future performance, material contracts, environmental, employee matters)
Public Reporting
Post Walker Review: increased transparency
- How funds create value
- Net returns
- Breakdown of investors
- Portfolio companies: turnover, profits, no of employees, details of management
- Average leverage and debt/equity ratio for portfolio
- Details on fund’s operational structure
- Breakdown of firm’s own fund accounts
Advantages of investing in PE for the investor
- Returns outperform markets
- Diversification
- Not correlated to mainstream market movements
- Investment expertise of manager
- Developing markets
- Inside information
- Access to entrepreneurial talent
Disadvantages of investing in PE for the investor
- Illiquid; long-term
- Needs specialist expertise / reliance on fund manager
- Blind pool investing
- Fees paid to managers
- Returns not so superior if risk adjusted
Quoted Markets vs Private Equity
- Quoted markets are constantly re-evaluated and repriced
- Markets keep adjusting to new information received
- PE investments held for medium to long term – no opportunity to rebalance portfolio
- GP has much greater influence over investment performance
Public markets
Risk = volatility
A stock whose performance is more volatile than the stock market as a whole is perceived to carry more risk than one which is less so.
Measuring PE returns
- Multiples and TVPI (total value / paid in capital) – not time weighted
- Net asset value
- IRR - performance based on cash investments and cash returns plus value of unrealised investments
- Gross versus net returns
There is no continuous market price for PE unlike public equity
Multiple - return/cost
TVPI - Total value of funds / initial amount Paid In
Net asset value - GPs report quarterly on NAV
Gross vs. net - fund performance figures calculated after deducting mgt fees, carried interest and any other charges to investors
Multiples
Total value multiple (TVPI) : total amount distributed + residual value / paid-in capital
Distributed multiple (DPI) : total amount distributed / paid-in capital
Residual value multiple (RVPI) : residual value / paid-in capital
Look at IRR and Multiples together, IRR is time-weighted (measures efficiency of fund through cash flows)
IRR
Annualised internal rate of return achieved over the life of the investment based upon cash flows and valuations
Takes into account capital redemptions, capital gains on exit and income through fees and dividends.
J-Curve
- Set-up costs and management fees
- Valuation policy – interim IRRs
- Write-downs and write-offs
J-Curve effect
When early interim valuations of a private equity portfolio decline relative to the capital the investor has contributed.
Investment through drawdowns
Money is called from limited partners and invested over a five year interval
Divestment through distributions
Money is returned to investors as soon as investment companies are exited
Net investment is smaller than commitment
Net cash flows resulting from subtracting drawdowns from distributions
Return Measurement Periods
Measures milestone years return against total return since inception
Risk in PE
- Diversification reduces risk and increases returns
- Selection ability reduces risk and increases returns – avoid bad fund managers to increase performance
- Diversification by vintage years more effective than by number of funds
- Diversification over VC funds by vintage year has to be higher to reach same risk level as for buyout funds
Managing risk in portfolio
Huge variation in performance levels
Challenges for investors:
- select managers who will outperform
- reduce risk due to wide variation in returns
Diversification – by investing in range of different funds
- reduces idiosyncratic risk
- enhances overall returns
