Private equity is booming. Frustrated by traditional portfolio performance as of late, investors are clamoring for alternatives. It should come as no surprise, then, that 2022 was the second most active year for private equity in ten years..
The allure is understandable. Private equity has outperformed the MSCI AWCI index by over 700 basis points over the last 20 years.1 Source: PitchBook, Bloomberg, iCapital Investment Strategy, as of January 3, 2022. Note: All return data is as of March 30, 2022. Global Private Equity is a composite of all private equity funds on the PitchBook platform. Horizon IRR is a cap-weighted pooled calculation that shows the IRR from a certain point in time. Historical IRRs are included solely for the purpose of providing information regarding private market industry returns and returns of other asset classes over certain time periods.
This premium is substantial. It may still understate the outperformance of private equity when you consider that the difference between top-quartile and bottom-quartile managers has been over 2,100 basis points over the last decade.2 Sources: Lipper, NCREIF, Cambridge Associates, HFRI, J.P. Morgan Asset Management, as of August 31, 2022. For illustrative purposes only. Global Equities (large cap) and Global Bonds dispersion are based on the world large stock and world bond categories, respectively. *Manager dispersion is based on the annual returns for Global Equities, Global Bonds, and U.S. Core Real Estate over a 10-year period ending 2Q 2022. U.S. Non-core Real Estate, U.S. Private Equity and U.S. Venture Capital are represented by the 10-year horizon internal rate of return (IRR) ending Q1 2022 Choosing the right private equity manager is crucial in the private markets industry where the return dispersion is this massive.
How can an investor increase the likelihood of choosing the best managers in an industry that is thought to be less than transparent? Here are 7 key considerations investors should look at when conducting due diligence and selecting a private equity manager.
There are 3 primary value-creation drivers, and managers usually employ them all. Investors should examine these attributes to look for consistent patterns and assign the highest value to growth in revenue and/or EBITDA.
This typically refers to increasing a company’s leverage ratio or adjusting the capital structure to boost equity returns. While leverage can be a useful tool to increase returns, it isn’t without risk. Leverage magnifies both potential gains and losses.
While applying debt in an acquisition model is an important method to create value (as debt is cheaper than equity), we generally view leverage as a commodity and not a distinct differentiator of creating value. In fact, what we look for is whether the manager has historically used a prudent amount of leverage and not overly relied on it.
This occurs when a manager sells a portfolio company at a higher entry valuation multiple than the multiple at which the manager acquired it (i.e., buying at 8x EBITDA and selling at 10x EBITDA). This can be evidence of a disciplined buying strategy and/or an experienced manager who knows how to optimize value by choosing the right time to sell.
Private equity firms are not paid to “time the market,” so to speak, and must deploy capital throughout all cycles. So, it is particularly important to examine the entry multiples that a manager paid to acquire companies during frothy parts of the cycle to see if they maintained a disciplined approach.
A combination of factors drive this approach. Operational improvements, streamlining costs, add-on acquisitions, organic growth, and/or upgrading members of the senior management team. Essentially, it involves a private equity firm implementing improvements in a company’s financial performance from entry to exit. In turn, the firm should realize a gain on the investment even if it applied zero leverage and sold the portfolio company at the same multiple at which it was acquired.
This is the most important driver and the hardest to consistently generate. Over the past 20 years, as private equity has become more competitive. many top-tier managers have engaged senior operating executives and deepened their industry expertise in order to better implement value-creation strategies.
It is critical to evaluate the capabilities of the team that will be sourcing, negotiating, monitoring, and exiting the fund investments. Prospective investors should investigate the backgrounds and experience of the investment professionals. They should also consider the team’s continuity and experience in working effectively together.
Investors must understand the key person provisions in the legal documents. This helps ensure that the appropriate investment professionals will be devoting a specific amount of time to the fund.
Considering whether the terms of the fund properly align the economic interests of the investment team with those of their investors matters, too. If management fees represent a disproportionate amount of the manager’s total compensation, it may reduce the incentive for the team to generate outsized returns. Further, investors should ensure that the most effective members of the investment team (who may not always be the most senior members) receive an appropriate portion of the fund’s carried interest.
A manager’s ability to source a sufficient volume of high-quality investment opportunities is key. Their ability to identify and connect with target companies before competitors may turn into major differentiator.
To generate proprietary opportunities, most private equity managers utilize a combination of their networks, cold-calling programs, and the formation of specific investment themes within their core sectors. The value of these variables is highest when a manager has a structured process in place to prioritize and evaluate these opportunities efficiently.
Investors should use both quantitative and qualitative analyses when examining historical performance. Ideally, investors should analyze the historical performance based on several key attributes. This allows you to properly assess the consistency of a strategy. It may also help identify the true value drivers and detractors over time.
Focus on attributes such as:
These lenses may empower investors to make more informed decisions when selecting a private equity fund.
Typically, a meaningful proportion of a fund manager’s past investments remain unrealized when the manager begins raising capital for the next fund. This can mask a potential deterioration in the manager’s overall track record.
Analyzing these unrealized companies may provide a more comprehensive view of the factors in play that could impact performance. In some cases, those investments are on track to generate returns that will support, or even improve, the current valuation of the fund. Sometimes they are underperforming, which will likely detract from the fund’s overall value.
Regardless, it is important that the manager has the proper resources to oversee these companies while deploying the new capital raised in the successor fund. ny underperforming companies may absorb additional bandwidth as the team works to get them back on track.
A manager’s track record may be attractive on an absolute basis. It could be, however, that certain vintage years have outperformed others due to favorable market conditions. It is vital to compare the manager’s historical performance to other similar funds in the same vintage year. This should illustrate relative performance.
Investors should also compare past performance to a relevant public market benchmark. This aids in measuring the illiquidity premium that one should expect for investing in a private equity structure without daily liquidity.
Be sure to assess whether the private equity manager’s strategy aligns with the market environment that is expected over the investment period of the fund. Try to confirm that the go-forward strategy is consistent with the manager’s past practices. It could be the case that a secular trend that a fund manager benefited from in the past may have run its course, forcing the manager to find opportunities in different sectors or strategies in which the manager has less experience.
As the capital committed to private equity funds continues to grow, the need for a careful, rigorous manager selection process is even more essential.
Private equity funds offer the possibility of strong performance and may be a valuable addition to a well-diversified portfolio. Thoughtful manager selection determines how much value.
If you’re interested in hearing more about private equity, our Due Diligence Before Investing webinar is an excellent place to start. Want to learn more about other distinctive investments? You may find the following webinars interesting:
For more information about our on-demand webinar series, click here.
This is an updated version of an article originally published on February 3, 2016. It was previously updated on September 25, 2018.
©2023. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Nick Veronis is a Co-Founder and one of the Managing Partners of iCapital, where he is Head of Fund Management. He is also a member of the company’s Operating Committee. Nick spent 11 years at Veronis Suhler Stevenson (VSS), a middle market private equity firm where he was a Managing Director responsible for originating and…
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