Private Equity Asset Research Articles

Size matters: Unpacking the relationship between institutional investor size and private equity asset allocation within diverse institutional contexts

This study examines the relationship between institutional investors’ size and their inclination towards private equity investments, hypothesizing a U-shaped pattern. It also explores how this relationship is influenced by the institutional context. Using a dataset of 5668 firms across 52 countries from 1991 to 2017, we observe that small and large institutional investors exhibit a stronger preference for private equity compared to intermediate-sized counterparts. Smaller investors show heightened interest in private equity within favorable contexts, while larger investors pursue such opportunities in unfavorable contexts. Our research offers valuable insights for policymakers and investors of diffferent sizes making private equity investments in diverse institutional contexts.

Private equity valuation under time-inconsistent preferences

Our research expands on the private equity (PE) valuation theory by incorporating the limited partner’s (LP) time-inconsistent preferences. Our findings show that time inconsistency has a detrimental impact on the LP’s certainty-equivalent valuation, which is dependent on the duration of investment and the value of PE asset. Through a comparative static analysis of the risk-attitude parameter and the future self arrival intensity, we have determined that the negative effects of time inconsistency can be mitigated by a more conservative attitude on the part of LP, while a higher future self arrival intensity exacerbates the impact of LP’s time inconsistency on their certainty-equivalent valuation.

An Economic Case for Transparency in Private Equity: Data Science, Interest Alignment and Organic Finance

The private equity asset class has grown rapidly since 2008, attracting institutional investors in need of higher returns than those expected from public markets. But while most investors would say they have been rewarded with good performance, this success is hard to objectively demonstrate due to intransitive metrics and unmeasured risks. It is our belief that there is a pressing need to substantiate the economic case for private equity. In this article, we describe a new transparency framework, which we situate in our research agenda on ‘organic finance’. The framework uses data science technology to operationalize private equity data and institute a scientific approach to performance measurement. We elucidate what scientific measurement should look like in private equity, incorporating examples of technologies in use today. We also reveal how bringing new levels of transparency into the asset class can, on its own, create significant value. Finally, we look at the effect of organic finance on the industry, connecting greater transparency to a structural shift that enables efficiencies, expansion, and innovation. The magnitude and sustainability of this shift reinforces the economic case for private equity, albeit with far more transparency than is practiced today.

A dual portfolio approach to a student managed fund

PurposeThe purpose of this paper is to describe an investment program that offers students with the opportunity to simultaneously manage a private asset fund and a public asset fund. The program has been in operation since 2013 and has made significant progress in student placement and connectivity with local, regional and national financial firms.Design/methodology/approachThe authors describe the structure, methods used and challenges encountered in this dual portfolio environment and add relevant thoughts for discussion. The authors discuss potential conflicts of interests that may arise in managing a private equity portfolio, the concern of proper deal flow, the issue of the investment timeline when investing in private equity and the problems encountered when measuring private equity performance.FindingsWhile public asset funds have been around for decades and are relatively well accepted throughout all levels and types of higher education institutions. The uses of private equity funds, though not unheard of, are much less prevalent. Allowing the same group of students to manage both type of portfolios is relatively unique and provides with a more comprehensive learning experience.Originality/valueA primary distinguishing attribute of this program is that accepted students are given the opportunity to simultaneously manage both public and private equity assets throughout an academic year. The goal is to create a comprehensive portfolio management program that replicates a changing investment management environment where private equity is an increasingly significant asset class.

Does Sustainability Affect Private Equity Asset Class?

In private equity industry ESG (Entrepreneurial, Social and Governance) metrics are gaining room, passing from the risk management process to influence the orientation of investment strategies. Motivations refer both to a firmer performance of the invested portfolios during the overall investment cycle and to a growing interest of fund subscribers in sustainable investments. Referring to the investment period from 2006 to 2015, we considered a sample of 126 PE investment vehicles. Amongst them 70 are ESG compliant (the main sample) and 56 are non-ESG. In terms of geographies we covered both Europe and North America. We have found that ESG funds generated more stable returns, in terms of net IRR standard deviation, in comparison with non-ESG vehicles, even if the latter showed a superior net IRR. This evidence is in favour of ESG funds as a more stable asset class in the medium-long period. Moreover, we have found that ESG funds contributed to a better portfolio diversification inside large institutional investors. In fact, their average Treynor Ratio is better than that figured out for non-ESG funds. The better performance didn’t depend on absolute returns, in fact the Sharpe Ratio was lower, but on a weaker dependence on the systematic risk as well as on a lower value for their total risk ratio. Finally, we have found that ESG funds were able to pursue a better risk hedging against sources of operating volatility, through a superior stability of their portfolios composition. Evidence was obtained comparing their average total risk ratio with that for the non-ESG funds. This research offers a valuable contribution to the literature on sustainable finance with a specific focus on private equity asset class.

Rates of return for crowdfunding portfolios: theoretical derivation and implications

ABSTRACTCrowdfunding (CF) is emerging as a fast-growing new class of private equity investment. But research on the rates of return that CF investments should yield is sparse. In this paper, we analyse CF investments from the perspective of an investor that exhibits non-satiation behaviour (seeks the maximum return for a given investment risk). Using internal rate of return (IRR) as the return metric, we apply modern portfolio theory, efficient market theory, the Central Limit Theorem and historical returns data for three private equity asset classes – equity funds (1112 funds), venture capital funds (1,474 funds) and Angel investments (1137 exited investments) – to find the efficient frontier of the private equity market. Applying the efficient frontier to CF investments enables us to show with 99% confidence that the target IRR for an efficient CF portfolio is at least 28% if the CF asset class is 10% riskier than Angel investments. We further show that the set of companies that qualify for CF collapses to that small subset that can achieve the revenue growth, and/or can accept the capital structure required to achieve the target IRR.

Introducing Objective Benchmark-Based Attribution in Private Equity

Private equity asset owners (“LP”s) seeking to reduce downside risk and increase upside probability would logically benefit from indexing prospective asset managers (“GP”s) by their skill. However, theoretical deficiencies and a lack of rigorous market calibration prevent the metrics and techniques commonly used in private equity from isolating GP skill. In this paper we introduce a new conceptual framework for a repeatable decomposition of private equity returns that disambiguates the quantification of GP skill. Modern proxy benchmarks are a key component of the framework for their definition of systemic returns specific to the target asset. They satisfy Andrew Lo’s (2016) fundamental properties of an index (systematic, transparent, and investable), and the CFA Institute’s “SAMURAI” criteria for a valid benchmark. However, we propose that the integrity of the decomposition requires the benchmark’s similarity (to target) and its stability be systematically derived, measured quantities. We discuss these two new properties in conjunction with the technology that enables the construction of modern proxy benchmarks and their active management over time. With systemic returns thus defined, excess returns against the modern proxy benchmark are attributed to dynamic elements under the control of the GP, which we define as manager alpha. Systemic returns in excess of a broad/policy benchmark are deemed static elements. Static elements measure the portion of returns attributable to size and sector selection, which a GP tends to ‘specialize’ in and which are known to the LP prior to investment. While both static and dynamic elements contribute active returns to the investment, it is the dynamic elements – alpha – that should merit attention (and high fees) from LPs.

Political Representation and Governance: Evidence from the Investment Decisions of Public Pension Funds

We examine how political representatives affect the governance of organizations. Our laboratory is public pension funds and their investments in the private equity asset class. Representation on pension fund boards by state officials or those appointed by them — often determined by statute decades past — is strongly and negatively related to the performance of private equity investments made by the fund. This underperformance is driven both by investment category allocation and by poor selection of managers within category. Funds whose boards have high fractions of members who were appointed by a state official or sit on the board by virtue of their government position (ex officio) invest more in real estate and funds of funds, explaining 20-30% of the performance differential. These pension funds also choose poorly within investment categories, overweighting investments in small funds, in-state funds, and in inexperienced GPs with few other investors. Lack of financial experience contributes to poor performance by boards with high fractions of other categories of board members, but does not explain the underperformance of boards heavily populated by state officials. Political contributions from the finance industry to elected state officials on pension fund boards are strongly and negatively related to performance, but do not fully explain the performance differential.

Can using geographical factors leverage private equity to deliver sustainable development results?

Alternative financing mechanisms are needed to deliver on the sustainable development goals that African countries have committed to. Private equity is an asset class that could leverage the geographical factors behind Africa’s economic growth to deliver impact in a variety of areas related to sustainable development. This paper uses a geographic lens to assess the challenges and opportunities presented by global goal setting for achieving development results and the role that can be played by the private equity asset class. Policy options for countries to choose from are identified for effective development of private equity as a solution for achieving selected development results.

The Cost of Private Equity Investing and the Impact of Dry Powder

Private equity (PE) has developed into a well-established asset class with strong growth in capital commitments over the last decades. Consequently, fund returns have decreased over time and investors have become more cost conscious. We analyze whether the maturing PE asset class has become less costly over time. Costs are defined as the difference between gross and net returns (return spread) and provide a spread benchmark useful for investors to evaluate a fund’s costliness. Althoug return spreads have decreased over time, when controlling for falling gross returns causing lower performance-based fees, the cost of PE investing has increased. The higher costs are related to increased levels of unused capital (dry powder) because of swelling capital flows into the industry. The PE industry is thus a victim of its own success, suggesting that investors in the asset class should consider a more anti-cyclical investment approach.

Multistage stochastic optimization for private equity investments

Long-term investments such as Private Equity (PE), present timing differences in cash inflows and outflows. When allocations in PE are not planned correctly, investors can suffer liquidity problems when paying for unexpected commitments. We present a multistage stochastic optimization model that includes PE assets as free cash flows projects. This model can determine PE allocations, in relation to public equity, under different market settings. Using a factor-based model to construct public and private equity markets, the major findings are: Liquidity problems can be avoided by planning PE allocations in advance and according to market conditions. Our tool reduces commitments taken for more volatile PE market or when investor target is lower. For target returns above 20 per cent, PE allocations enhance portfolio annual returns from 2 to 3 per cent (no volatility increase) only if PE net present value volatility is below 15 per cent. Beyond this point, higher returns comes with more risk. When PE investments are less correlated with public equity, the latter threshold extends to 45 per cent. PE allocation weight changes in time and according to its age. For favorable market conditions and high investors’ appetite, PE investment value can be greater than the entire wealth at some time periods. Leverage option for PE investments decreases performance, even in low PE volatility market. Potential PE gains are offset by debt interest payments and risk becomes higher.

Private Equity Asset Allocation: How to Recommit?

Private Equity Asset Allocation: How to Recommit?

Private Equity Asset Allocation: How to Recommit?

For institutional investors in private equity, a recommitment strategy to achieve a desired asset allocation is at least as important as the decision about the asset allocation itself. Because cash flows (both capital drawdowns and distributions) for the asset class are highly unpredictable up front, achieving the desired allocation in a portfolio context represents a multiperiod dynamic optimization problem. This article’s approach determines new commitments to private equity funds based on distributions, the amount needed to adjust asset class weights back to the desired portfolio asset allocation (rebalancing amount), as well as the current investment degree of the portfolio. Annually recommitting distributions and the rebalancing amount—both weighted by the inverse of the current period investment degree—optimizes institutional investors’ private equity asset allocation.

Unambiguous Performance: Towards a Less Imperfect Way of Measuring, Analyzing, and Understanding Private Equity Performance

In this paper, we elaborate on the particular challenges in understanding and measuring private equity performance. We examine commonly used measures including IRR (internal rate of return), the cash and value multiple, including TVPI (Total Value to Paid-in or Total Value Multiple), DVPI (Distributed Value to Paid-in), RVPI (Residual value to paid-in) and discuss their limitations in assessing true performance. We also explore the Modified IRR (MIRR), which despite not being in wide use, is a suggested complement to conventional IRR. We also propose t various approaches to combining these measures to arrive at a less ambiguous way of analyzing performance. Investors aware of these key concepts and tradeoffs will be in a better position to make appropriate choices and realize the full return potential of the private equity asset class.

The Cost of Private Equity

Private equity (PE) has developed into a well-established asset class with strong growth in capital commitments over the last decades. Consequently, fund returns have decreased over time and investors have become more cost conscious. Based on a unique data set of 358 PE buyout funds with vintage years between 1983 and 2007, we analyze whether the maturing PE asset class has become less costly over time. We define costs as the difference between gross and net returns (return spread) and provide a spread benchmark useful for investors to evaluate a fund’s costliness. Next, we show that, in line with our expectations, return spreads have decreased over time. However, when we control for falling gross returns causing lower performance-based fees, surprisingly, the cost of PE investing has increased. We relate the higher costs to increased levels of dry powder due to swelling capital flows into the industry. We conclude that the PE industry is a victim of its own success, suggesting that investors in the asset class should consider a more anti-cyclical investment approach.

The Price of Diversifiable Risk in Venture Capital and Private Equity

This paper demonstrates how the principal-agent problem between venture capitalists and their investors (limited partners) causes limited partner returns to depend on diversifiable risk. Our theory shows why the need for investors to motivate VCs alters the negotiations between VCs and entrepreneurs and changes how new firms are priced. The three-way interaction rationalizes the use of high discount rates by VCs and predicts a correlation between total risk and net of fee investor returns. We take our theory to a unique data set and find empirical support for the effect of the principal-agent problem on equilibrium private equity asset prices. The Author 2013. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

Editor’s Letter

1. F. John Mathis 1. Editor Private equity assets under management have surpassed $3 trillion, of which just over $2 trillion is unrealized portfolio value and slightly over $1 trillion is dry powder—according to the latest quarterly report by preqin. At the same time, private equity deal

The European Venture Capital and Private Equity country attractiveness indices

We calculate composite indices to compare the attractiveness of 27 European countries for institutional investments into the Venture Capital and Private Equity asset class. To achieve this we use 42 different parameters, and propose an aggregation structure that allows for benchmarking on more granulated levels. The United Kingdom leads our ranking, followed by Ireland, Denmark, Sweden, and Norway. While Germany is slightly above the average European attractiveness level, the scores are rather disappointing for France, Italy, Spain, and Greece. Our analyses reveal that while the UK is similar to the other European countries with respect to many criteria, there are two major differences, which ultimately affect its attractiveness: its investor protection and corporate governance rules, and the size and liquidity of its capital market. The state of the capital market is likewise a proxy for the professionalism of the financial community, for deal flow and exit opportunities. We determine a reasonable correlation between our attractiveness index scores and actual Venture Capital and Private Equity fundraising activities and prove the robustness of our calculations. Our findings across all the European countries suggest that, while investor protection and capital markets are in fact very important determinants for attractiveness, there are numerous other criteria to consider.

Private Equity in Emerging Markets

Why is there such a strong private equity market in the United States or the United Kingdom? Why is activity relatively low in several other economically important countries? And why is it zero or close to zero in many emerging regions? Spatial variations of private equity activity result from numerous factors. In this paper I summarize the literature contributions on the determinants of national private equity activity and comment on the consequences for the development of the private equity asset class in emerging markets.

Private Equity in Emerging Markets

Why is there such a strong private equity market in the United States or the United Kingdom? Why is activity relatively low in several other economically important countries? And why is it zero or close to zero in many emerging regions? Spatial variations of private equity activity result from numerous factors. In this paper I summarize the literature contributions on the determinants of national private equity activity and comment on the consequences for the development of the private equity asset class in emerging markets.