– Moving Beyond 10-Year PE Funds
– Negotiate VC Fund Investments Based on a 14-Year Life
– Prices are Near Highs, but There’s a Case They’re Reasonable
– Canada’s La Caisse Successfully Increases Direct Investment in PE
– CalPERS’ Closely Watched Performance Report is Out
THE THEME IN BERLIN: MOVING BEYOND THE STANDARD 10-YEAR PE FUND. Chatter at last week’s SuperReturn conference in Berlin centered on alternatives to classic 10-year private equity funds and their “2 and 20” formula of management fees and capital gains sharing. “I’ve never seen a period of time when we’ve had the extent of titanic shifts that we are seeing right now,” declared James Coulter, co-founder of TPG, in a Wall Street Journal story. The most important change is that “the share of companies acquired through traditional PE funds” is decreasing “as new models emerge,” he said. As reported by the New York Times DealBook, Joseph Baratta, head of private equity at the Blackstone Group, told the conference that his firm is “speaking with large investors about a new investment structure that would aim for lower returns over a longer period of time.” Longer-life funds may increase overall returns – despite lower annual appreciation – by avoiding fallow periods and by charging lower fees. Meanwhile, KKR has “been making investments from its own balance sheet,” which similarly permits longer-term investments. “I don’t know why Warren Buffett should be the only person who can have a 15-year, 14 percent sort of return horizon,” Blackstone’s Barratta noted in an LBO Wire story.
LPs SHOULD NEGOTIATE VC FUND INVESTMENTS BASED ON A 14-YEAR LIFE, contends Diane Mulcahy, a senior fellow at the Kauffman Foundation, a major investor in venture capital. Her eye-opening piece in Institutional Investor magazine notes that “the median fund takes slightly longer than 14 years to end,” “a paltry 7 percent of VC funds” finish within their “projected 10-year time frame,” while 46 percent of funds “take 15 years or longer” to fully liquidate. “Maintaining an obsolete 10-year fund structure makes sense for VC firms,” but not for investors she writes. Investors “remain tied up in illiquid investments for several years longer than expected, and in many cases, continue to pay additional management fees and fund expenses. We fail to obtain excess returns to compensate us for the costs of extended fund lives. Then we disregard data in our own portfolios about actual fund duration and continue to invest in venture capital funds structured with a projected 10-year life.” She concludes: “It’s time to accept the reality that the decades of the decade-long VC fund are over.”
PRICING IN PRIVATE EQUITY-BACKED DEALS MAY BE REASONABLE, NOT FROTHY, despite historically high valuations. While the Financial Times reports that private equity firms in Europe bought companies for an average of 10-times cash flow, in 2014, “a post crisis high,” there’s reason to believe that much of PE’s money is going into “internet or digitally focused companies” that “promise investors higher growth” than the companies that were purchased in previous cycles. “The mix of businesses within that 10 times has changed,” says Ken McGrath, co-head of financial sponsors for Europe at Barclays. Encouraging the idea that PE-backed deals represent a fairly moderate risk for investors, the average level of equity in deals is “above 40 percent,” notes McGrath. “That compares with about 30 percent equity before the financial crisis.”
CANADA’S SECOND LARGEST PENSION FUND IS SUCCESSFULLY INVESTING DIRECTLY in PE transactions. Bellwether investor La Caisse de depot et placement du Quebec generated a 12 percent annual return last year, with “less-liquid portfolio assets,” like private equity, generating 12.7 percent over four years,”outperforming” other asset classes, according to peHUB. La Caisse’s annual press release on performance notes that PE investments returned 12.1 percent in 2014 and 13 percent annually over the last four years, a period during which the $226 billion-in-assets plan favored direct private equity investment over fund investment. The weighting of funds in La Caisse’s PE portfolio went from 68 percent in 2009 to 44 percent at the end of 2014,” with the balance going to direct investments. The decision to shift PE investments away from funds “was profitable” as direct investments “outperformed during the past four years,” reports La Caisse. Success should inspire others to follow in La Caisse’s footsteps, making fundraising tougher and the PE acquisitions market more crowded in coming years.
CALPERS’ CLOSELY WATCHED PE PERF0RMANCE REPORT IS OUT. The report for the second half of 2014 from the U.S.’ largest pension fund, with $296 billion in assets under management, has a wealth of data concerning both the industry and CalPERS’ $31 billion PE portfolio. CalPERS’ PE program returned 14.6 percent in 2014, 15.9 percent annually over five years and 12.9 percent annually over ten years, with the long-term performance “above CalPERS’ expected return.” Other highlights: despite a plan to “shift away” from venture capital, the category outperformed all others in 2014, returning 18.9 percent versus 14.4 percent for fourth-placed buyouts; direct investments – including co-investments made alongside managers – have higher five and ten-year annualized returns, at 18.3 percent and 18.9 percent, than funds or secondaries; and CalPERS’ fund managers have “significant dry powder,” amounting to $11.1 billion, 26 percent of which remains unspent despite having exceeded the standard five-year period in which funds are expected to make investments.