When it comes to allocating your capital to private equity, like any other asset class, you’re looking for the best returns possible, which ultimately depend on fund manager selection. Choosing a guardian for your capital requires thorough due diligence to ensure minimal risk and the best chance of securing your expected level of return.
But how can you predict top performing private equity fund managers?
As the saying goes, past performance is not a guarantee of future performance but a private equity firm’s historical performance data is undoubtedly the most important place to start the due diligence process. If you look beyond headline performance numbers and dig into the underlying data, track record analysis can provide you with the questions you need to ask to evaluate the likelihood of future success.
Here are five of the most important areas of a track record you need to scrutinize as a potential investor
A well-known fact in the industry is that IRR is a nice, easy number to evaluate performance on but it is not always a true representation of value, especially when it comes to negative IRRs. Because IRR is a time-sensitive calculation, it is relatively easy for a high IRR to be “baked-in” early in the investment through things like dividend recapitalisations, for example. This is why it can’t be relied upon in isolation, but should be viewed in conjunction with TVPI to give a better representation of performance. For an exhaustive discussion of the limits of IRR see this post.
Another area of performance to investigate is what deals have contributed to stellar performance. You may often find that a few outliers have boosted performance of the whole fund. If so, it’s important to dig into these deals and understand how likely replication in the future is. Stripping out these outliers can also give an interesting view of how the portfolio would have performed without them.
An increasingly popular area of performance is comparing private equity performance to public markets, achieved through public market equivalent (PME) calculations. As an investor it is important to know how a firm’s returns have fared against listed equities, whether this is then used to identify manager generated alpha or as an opportunity cost calculation, to name a few uses, is up to the specific investor.
2. Value Creation
Once you understand and decipher the performance numbers, it is worth understanding the catalysts of the performance: how exactly has this firm created value within their portfolio?
A value creation or valuation bridge is the most common way to analyze this aspect of a fund. It breaks down value into a range of factors to let you see where value has been generated, as shown in the image below.
3. Unrealized Deals
What % of their portfolio is still unrealized? A high percentage of unrealized deals will greatly affect the level of confidence in the portfolio as NAVs may not reflect the final exit price and so will have a bigger impact on returns.
It’s also worth noting that it’s not uncommon for NAVs to peak before a firm goes out to market. This is why investigating unrealized deals and seeing what impact changes in exit date, multiples, and valuations will have on the portfolio is worthwhile.
4. Specialization vs. General
Another element to consider is the industry or region focus of the firm.
When looking at a specialist fund, it is worth comparing it side-by-side to a generalist fund to see whether or not this focus produced market-beating benefits. If not, then it may be worth looking elsewhere. [For a pro/con discussion of a Fund of Fund approach see this post].
5. The Team
Potentially the most critical aspect of any firm: the team. These are the individuals who are out their putting capital (potentially yours) to work.
Investigate who have been the key players in leading successful deals. Has performance been largely dependent due to just one or two star players? Once you have figured this out, find out if this team still exists in a similar dynamic. Changes in team members, especially the key players, will have a different effect on future performance.
The Bottom Line: Track record analysis does not provide all the answers. It is not the panacea of due diligence. However, by really getting into the details of performance, you can understand how the factors that led to previous success align with the firm’s future fund strategy and uncover the questions you need to ask to make your due diligence meaningful, your fund manager selection effective, and your returns top quartile.
TopQ is a web-based suite of private equity performance analysis tools that makes due diligence and portfolio monitoring faster, more accurate, and more effective. By saving investors valuable time and resource in preparing analysis, TopQ allows for more time to be spent carrying out deep, meaningful analysis for informed decision making and improved returns. Visit www.topquartile.com to find out more.