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Implementing a private equity programme

What does it take to be a successful private equity investor? A good understanding of risk and return, for a start. Wilshire Associates explains its approach and runs through some of the attributes of leading private equity investors.

Implementing a private equity programme

Successful private equity investors have similar traits. From the start, these institutional investors understand the differences between public and private investments and their respective roles. Further, they understand the unique requirements for implementing private equity without being consumed by the complexity and time required to make partnership investments*.

The role of private equity
On average, large US institutional investors have private equity allocations above 7 per cent overall and ten to 25 per cent of overall equity. A number of European investors are now moving toward these levels. Investors can treat private equity as an enhancement to the equity portfolio or as an asset class. Leading funds consider private equity as an enhancement to the overall fund's return and specifically to the equity component. However, it is often useful to include private equity in the asset allocation exercise for management control purposes and thus forecasts of return and risk are useful for setting expectations and internal hurdle rates-of-return.

Investors should view return assumptions for private equity as a required return rather than as an expected return. A required return is a risk-adjusted approach using corporate finance principles to require each investment to stand on its own merits. This approach is necessary in an inefficient and opportunistic market. This stands in contrast to public equity where most investors develop expected returns based on long-term relationships between asset classes.

The required return, net of all fees, for a globally diversified portfolio of private equity should be about 3 per cent above the expected return for public equities. This objective, described below, should compensate the investor for the additional risks and provide for a long-term return above public equity.

Returns and risk
Wilshire's private equity return forecasts are shown in Table 1. We have studied actual returns earned by large institutional private markets portfolios over 15 years using Wilshire's own databases and Venture Economics, a firm specialising in measuring private equity returns. Our forecast returns are based upon past results as well as a financial assessment of the added risks in private equity.

Wilshire's risk forecasts are also reported in Table 1. These are expected standard deviations of annual returns. Risk forecasts for private equity are especially challenging because short-term returns cannot be calculated because of infrequent partnership valuations. Risk estimates based on accounting data consistently understate risk. The best approach has been to estimate risk by drawing parallels to the public markets and adjusting for added risk contributed by financial leverage, the absence of liquidity, or greater business risk.

Table 1
Forecast returns and risk (US$)

* Returns are net of carried interest and management fees.
** Assumes a portfolio mix of 50 per cent buy-out, 40 per cent venture capital and 10 per cent non-US buy-out

US Buy-outs
The US buy-out forecast return is 12.25 per cent, which is lower than prior years as the amount of leverage, which increases required return, has declined over the last year. Also, a much higher fraction of buy-outs are now categorised as growth-oriented and require greater equity capital.

Buy-outs is the largest private equity segment. Opportunities for buy-outs and subsequent returns are created, in part, by barriers to corporate ownership. Since efficient public markets for capital shares have only limited influence on corporate management, much of corporate ownership and management control is protected by corporate, bankrupcy and securities law. These barriers allow for the survival of mismanaged companies that operate inefficiently or are in financial disorder. In the face of these barriers, an investor can bring about change and create value by taking control of the company. This control is frequently obtained through acquisition prices that are below the public markets with more efficient financing arrangements.

Wilshire's risk forecast, expressed as standard deviation of annualised return, is 30 per cent for buy-outs. This forecast is considerably higher than the 17 per cent risk for public stocks and is attributable to greater financial risk due to a more leveraged capital structure in buy-out companies.

Venture capital
Venture capital has been a financing source for decades in the US. It became an institutional strategy in the 1970s when pension fund legislation in the US changed to allow it. Venture capital remains primarily a US opportunity with $70bn raised last year for investment. Technology and healthcare are the two industries most appropriate for venture capital.

To gauge the risk characteristics of venture capital investments we examined three public market proxies: the Hambrecht & Quist (H&Q) Growth index, the Wilshire Internet Index, and the performance of aggressive growth mutual funds investing primarily in post-venture technology and biotech companies. Historical return standard deviations for the H&Q index and the mutual funds were approximately 37 per cent. The Wilshire Internet Index had a higher 45 per cent standard deviation. We increased the 37 per cent measure for public post-venture companies by a factor of 1.2 to estimate a 45 per cent risk for private, earlier stage, venture capital. This would give venture capital the same risk level as pure internet stocks.

This methodology enables us to calculate a correlation of 0.6 between venture capital and US stocks. This is high because of the dependence of venture capital returns on a strong IPO market. This is clearly demonstrated by events over the past three years.

Private markets portfolio
The forecast return for a diversified private markets portfolio is 12.50 per cent. This level of return is 3.00 per cent above the 9.50 per cent expected return for US stocks. The forecast risk for the diversified private markets portfolio is 32 per cent, almost twice the forecast risk of US stocks.

The make-up of the private portfolio is:

 The weightings were chosen because they represent private market allocations by large institutional investors and the universe of global private equity. The weightings result in return and risk assumptions that help institutions set the right expectations for and the role of private equity.

Implementation
Whether investing through a fund of funds or directly into partnerships, leading private equity investors tend to adhere to all or most of the following ‘best practices':

• Broad scope of opportunities - High-risk adjusted returns seldom persist. Leading investors analyse opportunities created by financial disruption, supply/demand imbalances and new ideas.
  
• Long-term involvement - Successful investors have a reputation for being long term oriented, reliable and continuous market participants.
  
• Research - A large portion of private equity, especially venture capital, is technology-based, so an investor must understand this sector.
  
• Disciplined process - An illiquid asset, private equity lacks short-term measures of performance and risk. Leading investors place emphasis on the investment process to control risk.
  
• Efficient decision process - Investing is time-sensitive and needs a fast, clear and efficient decision process. Private equity investing is more opportunistic than strategic with leading firms looking for the right opportunity rather than passively responding to investments.
  
• Network - The private equity industry has a limited number of players. A strong network is necessary to access superior groups.
  
• Model return and risk - Explicitly model return and risk of each investment to understand its sources of potential value added.
  
• Preference for low duration strategies – Prefer strategies with faster than average capital payback. Time is a key factor in overall return.
  
• Investor-friendly terms - Proactively negotiate terms that align interests. While many industry standard fee terms are not negotiable there are many other areas that are crucial to review. Dedicated private equity legal counsel is essential.
  
• Diversification by sector and time - Diversify by sectors including buy-out and venture as well as economic sectors and growth/value strategies. Time diversification is also an important element of a program. However, too many investments dilute return. Private equity is one area where leading investors do not seek index-like returns. 
  
• Personnel - The successful private equity programs have highly skilled and experienced professionals dedicated to the area.
  
• Monitoring - In the short-term, evaluation is based on peers, planned commitment levels and qualitative measures. Over the longer term, evaluation is against risk-adjusted equity benchmarks for each investment and the program. Proactive involvement in partnerships enables investors to learn of problems early and to reduce the negative impact on returns.

*A majority of pension funds implement private equity programs through partnership investing.

Wilshire Associates is a full-discretion fund of funds manager, with commingled and segregated accounts managed for clients throughout the world.  The firm's approach is to construct concentrated portfolios comprising of only high quality fund opportunities, with a focus on superior returns rather than broad (indexed) exposure.

The Wilshire Private Markets Group has on-the-ground investment research capabilities in Santa Monica, Pittsburgh, Amsterdam and Canberra, providing the basis for the firm's global reach in sourcing top quality investment opportunities for its clients.

Wilshire offers investors the ability to invest in a global private equity program through separate accounts or co-mingled funds. Wilshire raises one fund of fund each vintage year and has raised four of these funds. Each fund invests in the US and Europe with the ability for clients to specify their geographic preferences. Additionally, each fund follows Wilshire's time tested strategy of focusing on middle market buyouts and early stage venture capital that have provided Wilshire with top quartile performance.

Daniel E Allen CFA is a managing director & principal at Wilshire Assocaites. He sources and conducts due diligence on investments in Europe and is a member of the Private Markets Group Investment Committee. In addition, Mr Allen manages the Private Market Group's European office. He has over 17 years of global investment experience.
Thomas K Lynch CFA, JD is a managing director and principal at Wilshire Associates. He sources and conducts due diligence on investments in all private market sectors and regions and is a member of the Private Markets Group Investment Committee. In addition, Mr Lynch manages global operations for the group. He has 18 years of investment experience including pension and private markets consulting, portfolio management, and security analysis.
Erica C Bushner, CFA, CPA, is a managing director and principal at Wilshire Associates. She sources and conducts due diligence on investments in all private market sectors and regions and is a member of the Private Markets Group Investment Committee. She has 18 years of investment experience.

CONTACT INFORMATION

DANIEL ALLEN
Managing Director
Wilshire Associates
Prins Hendriklaan 43
1075 BA Amsterdam

Phone (31) 20 305 7530, e-mail dallen@wilshire.com

© Wilshire Associates, May 2001