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Dr. Denis Schweizer Associate Professor of Finance John Molson School of Business, Concordia UniversityMailing address: 1455 de Maisonneuve Boulevard West, Montreal, Quebec H3G 1M8Office: MB 11.305Phone: +1(514)-848-2424, ext. 2926Fax: +1(514)-848-4500E-Mail: [email protected]
3. Private Equity
Investment Analysis
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Page 2Investment AnalysisDenis Schweizer
Agenda
I. Private Equity as an Asset Class
II. Investment Process of a Private Equity Fund
III. Private Equity Returns
IV. Strategic Asset Allocation
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Page 3Investment AnalysisDenis Schweizer
What is Private Equity?*
Private Equity
= „any equity investment in a company which is not quoted on a stock exchange…“
What about companies which were publicly listed but are taken private?
Special Purpose Acquisition Companies (SPACs)?
Buying stakes in a company, with the major intention to gain ownership of underlying
assets (e.g. real estate)?
Secondary transactions?
Activism strategies?
…
A famous judge in the UK said: “It is hard to define what an elephant is, but you still
recognize one when you see it!”
* See Frasor-Sampson (2007)
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Page 4Investment AnalysisDenis Schweizer
What is Private Equity?*
Private Equity means providing medium- to long-term funds to companies in a criticalphase of their development without sufficient collaterals and if required entrepreneurialsupport. The intent to sell the stake in the future guarantees risk adjusted profit-taking.
The following counts as Private Equity as well:
Mezzanine Capital: Funds which are (per se) not provided by shareholders but do havemore or less characteristics of equity
De-listing respective Taking-Private of publicly listed firms (LBO)
Activism strategies
Special Purpose Acquisition Companies (SPAC)
Private Investments in Public Equity (PIPE)
…
* See Sahlman (1990)
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Page 5Investment AnalysisDenis Schweizer
Systematization of Private Equity by Funding
Phase Helps to Classify
The investment spectrum spans over all stages of corporate life
Public-to-Private
St. Ex.Growth Stage
Seed
Production
design
• Conceptassessment
• Businessanalysis
• Marketanalysis
First-Stage
Production start
• Marketentry
• First
sales
Start-up
Formation ofthe company
• Marketingconcept
• Develop-ment ofproducts
Second-
Stage
Scaling
• Market entry
• Marketleader
• Private Equity
• MBO / MBI
• Mezzanine Capital
• Venture Capital
• Private Equity
• Mezzanine Capital
• Loans
• Business Promotions
• Invest-mentbanks
• Free Float
• Early Stage
Venture Capital
• Incunators• Business Angels
• StrategicInvestors
• Entrepreneur
• Small businesspromotion
• Friends, Relatives
• Business Angels
• Incubators
Take-Private
Stage
Delisting
• Undervaluation
• Acquisition
Third-
Stage
Standard-ization
• Internat-
ioanliza-tion
Fourth-
Stage
Pre-IPO
• Prep-aration of
IPO• Acquisition
Early Stage
S t a g e
o f l i f e
S o u r c e o f
f u n d i n g
Venture Capital Buy-Outs / MezzanineSpecial Situations
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Page 6Investment AnalysisDenis Schweizer
Typical Factors of Success and Risks
Characterize Different Private Equity Segments
Late StageEstablished GrowthStrong GrowthEarly StageStage of Life
Typical
Investment
Phase
Typical
Earnings
Development
Typical Factors
of Success Technology Marketing Operations
Financial RiskManagement and
Financial RiskMarket RiskProduct RiskMain Risks
Profit zone
Loss area
Private Public
Seed Start-upExpansion /
Development
Late Stage
Pre-IPO
Turn
aroundMBO / MBI
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Page 7Investment AnalysisDenis Schweizer
Every Funding Phase Requires Specific Skills
by the Private Equity Manager
Late StageGrowth StageEarly Stage
DistressedMatureMiddle MarketGrowthEarly Stage
Venture Capital
• Technical Know-How
•Infrastructure / Seed
Capital
•Often Minor Stakes
Examples:
Buyout
•Operational / Strategic
Expertise
•Financial Know-How
Examples:
Special Situations
• Turnaround, Distressed
•Mezzanine
•Financial Know-How
Examples:
Source: Partners Group
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Page 9Investment AnalysisDenis Schweizer
Buy-Out Funds Dominate the Private Equity
Fundraising Market in Europe
Source: Thomson Reuters / EVCA (2000-2006) & EVCA / PEREP Analytics (2007-2011)
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Page 10Investment AnalysisDenis Schweizer
Global Private Equity Fundraising
Fundraising activity remains moderate
Source: Preqin, Credit Suisse / IDC
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Deal Activity and Size
Lower investment volumes but still high number of deals
Source: Preqin, Credit Suisse / IDC
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Private Equity Exit Activity
Exit activity slowed down somewhat in Q3 2012
Source: Preqin, Credit Suisse / IDC
E M k S i i A d
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Page 14Investment AnalysisDenis Schweizer
European Market Statistics – Amount and
Number of Companies
M th 50% f th P i t E it I d t I
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Page 16Investment AnalysisDenis Schweizer
More than 50% of the Private Equity Industry Is
Funded by Investors from the U.S. and the U.K.
32.4
23.9
8.8
5.7
5.5
4.3 3.4
Allocated Funds by Country 2010(Bn. €)
USA UK France SwedenNetherlands Germany
Asia
29.2
19.6
15.5
10.9
9.6
9.4
4.03.9 5.7
Allocated Funds by Investors2010 (Bn. €)
Pension Funds Funds of FundsBanks Insurance CompaniesPrivate GovernmentsCorporates UniversitiesOther
S o u r c e
: B V K S p e c i a l P r i v a t e E q u i t y
i n E u r o p e , o w n p r e p a r a t i o n
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Page 17Investment AnalysisDenis Schweizer
Agenda
I. Private Equity as an Asset Class
II. Investment Process of a Private Equity Fund
III. Private Equity Returns
IV. Strategic Asset Allocation
Private Equity is a Heterogeneous Asset Class
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Page 18Investment AnalysisDenis Schweizer
Private Equity is a Heterogeneous Asset Class
with Diverging Investment Alternatives
Region Vintage Funding Stage
Instruments
USA, Europe,
Asia, others
Investment
environment is
changingcontinuously (new
regulation /
deregulation, etc.)
1991, 1992 …
2007
Every vintage year
is characterized byspecific market
conditions with
strong impact on
return
Venture Capital
Buyout Special Situations
Every corporate stage of
life has key successfactors for an effective
investment (leverage,
cost structure, economic
cycle, exit options, etc.)
Primaries
Secondaries Manager Secondaries
Financial Secondaries
Listed Private Equity
Direct-/Co-Investments
SPAC
Due Diligence and
management process
alter with the underlying
Relative attractiveness of divergent instruments, funding stages, vintages and regions variesstrongly
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Page 19Investment AnalysisDenis Schweizer
Return Sources for Private Equity (1/2)
Value generation
approach
Levers of valuecapturing
Increase in equity
value throughchanges in valuation
Levers of value
creation
Increase in equity
value by changes in
profitability
(revenue, margin,net debt)
Financial
arbitrage
Secondary levers Levers with no
direct bottom line
effect, but the ability
to reinforce primary
levers
Financial engineering
Increasing operational
effectiveness
Increasing strategicdistinctiveness
Parenting effects
Reducingagency costs
Primary levers
Levers with directbottom line effect
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Page 20Investment AnalysisDenis Schweizer
Return Sources for Private Equity (2/2)
V a l u e g e n e r a t i o n a p p r o a c h
L e v e r s o f v a l u
e
c a p t u r i n g
L e v e r s o f v a l u e
c r e a t i o n
Financial
Arbitrage
Financial
Engineering
Increasing operat.effectiveness
Increasing strategic
distinctiveness
Parenting effects
Reducingagency costs
… based on changes in market valuation (A-1)… based on private information about the portf. Company (A-2)
… through superior market information (A-3)… through superior dealmaking capabilities (A-4)… through optimization of corporate scope (A-5)
Optimizing capital structure (B-1)Reducing corporate tax (B-2)
Cost cutting and margin improvements (C-1)
Reducing capital requirements (C-2)Removing managerial inefficiencies (C-3)
Corporate refocusing (D-1)Buy and build strategies (D-2)
Reducing agency costs of free cash flow (E-1)Improving incentive alignment (E-2)Improving monitoring and controlling (E-3)
Restoring entrepreneurial spirit (F-1) Advising and enabling (F-2)
Productivity and Employment Growth for PE-
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Page 21Investment AnalysisDenis Schweizer
Productivity and Employment Growth for PE-
Backed Companies, 2005 – 2011
Behind PE outperformance and PE value creation, productivity (as measured by EBITDAper employee) and employment are key drivers of business performance
PE has been able to improve productivity significantly (6.9% on average p.a. in Europe)
Employment grew by an average of 2.2% p.a. under PE ownership
Dotted lines for Benelux show productivity and employment growth without outliers. N=178 (excluding deals with insufficient data
S o u r c e : E r n s t & Y
o u n g d a t a , D a t a S t r e a m
EBITDA Growth Attribution by Investment
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Page 22Investment AnalysisDenis Schweizer
EBITDA Growth Attribution by Investment
Rationale, 2006 – 10
Organic revenue growth accounted for over 40% ofEBITDA growth. Cost reductions were responsible
for approximately 30%, and acquisitions also beganto play a significant role, representing about 20% ofgrowth
Good investors follow a simple rule: They look forthe fat in the company — and those guys are really
good — and cut it off. The trick is not to cut off themuscles (Professor Steven Kaplan - UniversityChicago / Booth School of Business)
Jesse Edgerton (FED economist) showed that theprobability of having an airplane three years after aPE investor in the company is roughly 40% lower
compared to their rivals Immediately after the acquisition of TXU (an
energy supplier) by KKR and TPG for a recordsum of $ 43.3 billion they sold companies‘
Gulfstream-V-Jet
Source: Ernst & Young
Impact of Vintage and Funding Stage on Return
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Page 23Investment AnalysisDenis Schweizer
Impact of Vintage and Funding Stage on Return
is Substantial
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Historical Discounts on NAV
What is the relationship between the discount and the IRR?
Source: NYU Salomon Center
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Page 26Investment AnalysisDenis Schweizer
Private Equity Vintage Returns
Historically, recession vintage years were attractive
Source: Preqin, Credit Suisse PB Research
U.S. Equity Contribution and Purchase Price
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q y
Multiples
Purchase prices have decreased and equity contribution has increased since 2007
Source: Preqin, Credit Suisse / IDC
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Page 28Investment AnalysisDenis Schweizer
Source: Reuters LPC/DealScan
Monthly Debt Volume
What are the consequences for „private equity“ investments?
Private Equity Funds as an Interface Between
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Page 31Investment AnalysisDenis Schweizer
Entrepreneur
Capital needs for:
• Business idea
• Growth• Operational
management• Funding
Exit strategy via Trade-Sale, IPO etc.Return Flow
Limited Partner (LP)
Capital Provision
Particularly:
• Insurances• Pension funds
• Corporate groups• Family Offices
• etc.
General Partner (GP)
Provides minor capital
stakes and manages the
private equity fund:
• Evaluation
• Employ strategies
• Offer value added
• Operate
• Impart knowledge• etc.
General Partner (GP)
q y
Investors and Companies
Exposure in Private Equity Is Set Up Slowly,
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q
however, Capital Is Locked Up
Set up of exposure starts with the so-called (Over-) Commitment. Cumulated Capital Calls
(Drawdown Capital) indicates the amount of committed capital which has been called by the General
Partner (GP). Invested Capital describes the interest of Drawdown Capital, which has been called orrefunded, respectively. The setup of a desired exposure can take several years.
0
200
400
600
800
1,000
1,200
M i l l i o n U . S . $
Invested Captial CommitmentCumulative Capital Calls Cumulative Profits
Dry Powder - Committed but Un-Invested
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Capital
Managers are well equipped to take advantage of upcoming opportunities
S o u r c e : P r e q i n , C r e d i t S u i s s e / I D C
The J-Curve Effect Dominates Short-Term
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Refunds
An investment process for Private Equity can feature a several years lasting J-Curve
Effect
1 Year 2 Years 3 Years 4 Years 5 Years 6 Years
N A V
Ca. 36 months J-Curve Effect
Growth Phase
Private Equity Instruments Feature Divergent
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--
P e r f o r m a n c e ( N
A V + R e f u n d i n g )
Year 3 Year 6 Year 9 Year 12
-
Manager Secondaries
Partly well-known and appraisableportfolio
A relative small fraction of firms in theportfolio has seen appreciation
Financial Secondaries
Promises to pay are mostly called and invested Portfolio is known and appraisable
A predominant fraction of firms in the portfolio hasseen appreciation
‚J-Curve Effect‘
Investors give the General Partner a promise to pay Portfolio is unknown at this stage Incurring management fees do have, among others, a
negative effect on the NAV (J-Curve Effect)
Primaries
Source: Partners Group
What are the resulting risk andreturn profiles?
Value-Creation Potential
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Page 36Investment Analysis
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Agenda
I. Private Equity as an Asset Class
II. Investment Process of a Private Equity Fund
III. Private Equity Returns
IV. Strategic Asset Allocation
Return Differences of Private Equity Funds
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Page 37Investment Analysis
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Source: BVI, Venture Economics calculations by Braun & Schreiber
U S V C
Return p.a.
in %
Between Top and Bottom Quartile Are Substantial
Only TOP Funds outperform other asset classes sustainably
E U
B O
E U
V C
U S
B O
-20
0
20
40
60
80
100
M o n e y m a r k e t f u n d s , E
U R
M o n e y m a r k e t f u n d s , I n
t e r n a t i o n a l
F i x e d i n c o m e f u n d s ,
E U
R ,
G e r m a n y
F i x e d i n c o m e f u n d s ,
E U
R
F i x e d i n c o m e f u n d s ,
U S
D
F i x e d i n c o m e f u n d s ,
I n t e r n a t i o n a l
F i x e d i n c o m e f u n d s ,
C o
r p o r a t e B o n d s
E q u i t y f u n d s ,
G e r m a n y
E q u i t y f u n d s ,
E u r o p e
E q u i t y f u n d s ,
N o r t h A m
e r i c a
E q u i t y f u n d s ,
I n t e r n a t i o
n a l
U S M e z z a n i n e f u n d s
1.Quartile 2.Quartil 3.Quartil 4.Quartil1.Quartil
Return and Risk Measures of Private Equity Vary
Ti A A l i i N
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Calculation base per 30.6.2003. Continuous quarterly returns (TWP) for 10 years each from starting year.
Calculation on pooled Cash-Flows and NAVs of floating years 1980 – 2003. Risk free rate 3% p.aSource: TFSD Venture Economics,
B&S Research
0
5
10
15
20
25
-2
0
2
4
6
8
10
US Venture Capital
Rendite, Volatilität, Semivolatilität
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
Return, Volatility, Semivolatility
Sharpe Ratio, Schiefe, Kurtosis
1980 – 1990
1982 – 1992
1984 – 1994
1986 – 1996
1988 – 1998
1990 – 2000
1992 – 2002
1980 – 1990
1982 – 1992
1984 – 1994
1986 – 1996
1988 – 1998
1990 – 2000
1992 – 2002
US Buy-Out
0
5
10
15
20
25
-2
0
2
4
6
8
10
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
1980 – 1990
1982 – 1992
1984 – 1994
1986 – 1996
1988 – 1998
1990 – 2000
1992 – 2002
1980 – 1990
1982 – 1992
1984 – 1994
1986 – 1996
1988 – 1998
1990 – 2000
1992 – 2002
Rendite, Volatilität, Semivolatilität
Sharpe Ratio, Schiefe, Kurtosis
Return, Volatility, Semivolatility
Sharpe Ratio, Skewness, Kurtosis Sharpe Ratio, Skewness, Kurtosis
over Time – an Accurate Analysis is Necessary
How Does the Internal Rate of Return Method
(IRR) W k?
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Page 39Investment Analysis
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Example: + = = + = for not realized + = −+ = 0
(IRR) Work?
The IRR is the interest rate for which the following holds: the sum of capital values of all Cash-In-
Flows/ Refunds (CIF) must equalize the sum of capital values of all Cash-Out-Flows / Investments
(COF):
1 A B C D
2
Year COF CIF
Nett
CashFlow
3 0 -1
-1
4 1 -2 1
-1
5 2 -3 1
-2
6 3 2
2
7 4 2
2
8 5 4
4
9
IRR=
26%
=IKV(D3:D8)
-1-2
-3
1 12 2
4
-4
-2
0
2
4
6
0 1 2 3 4 5
C a s h - F l o w
Year
COF CIN
Solution: + + + + + + + +6% +6% +6% +6% 4+6% 1 +6% 3+6%
Vintage Year and Access to “Top-Quartile”
D t i R li d IRR’ S b t ti ll
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Determines Realized IRR’s Substantially
IRR Distribution of VE Funds
e
r c e n t
1 9 8 5
1 9 8 6
1 9 8 7
1 9 8 8
1 9 8 9
1 9 9 0
1 9 9 1
1 9 9 2
1 9 9 3
1 9 9 4
1 9 9 5
1 9 9 6
1 9 9 7
1 9 9 8
1 9 9 9
2 0 0 0
2 0 0 1
2 0 0 2
2 0 0 3
2 0 0 4
0
50
100
EU BO
1 9 8 5
1 9 8 6
1 9 8 7
1 9 8 8
1 9 8 9
1 9 9 0
1 9 9 1
1 9 9 2
1 9 9 3
1 9 9 4
1 9 9 5
1 9 9 6
1 9 9 7
1 9 9 8
1 9 9 9
2 0 0 0
2 0 0 1
2 0 0 2
2 0 0 3
2 0 0 4
0
50
100
EU VC
Mean per Vintage Year
Is the IRR an adequate performance measure?
Is there a J-Curve?
Problems in Applying the IRR as PerformanceM
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Measure
The IRR is strongly determined by the time structure of cash flows – accounting Cash-In-Flows at closer dates increases the IRR and leads to higher manager-performance
The IRR method implicitly assumes that the whole Commitment until Drawdown (COF)and all CIF (subject to distribution) can be re-invested at the IRR. This is not applicable ingeneral as equivalent investment projects are missing (re-investment hypotheses)
The calculation of the IRR neither has to lead to a unique solution (polynomials of higher
degrees) nor any solution (within the real numbers – fundamental law of algebra)
∙ = ≥ 1 , ∈, ≠ 0
A typical solution for this problem is to use multiples: Total Value to Paid In (TVPI) accounts for the distribution of realized and outstanding
investments:
Problems of the IRR stem from the underlying calculation method:
IRR vs TVPI a Case of Time Dependence?
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IRR vs. TVPI – a Case of Time Dependence?
For high IRRs the timing is important: the TVPI is the same for all three cases
But different IRRs:
Different IRRs can yield to the same TVPI:
TVPI = 2
Year Distribution DrawdownDistribution DrawdownDistribution Drawdown
1 0 500 0 100 0 100
2 0 0 0 100 250 100
3 0 0 0 100 250 100
4 0 0 0 100 250 100
5 1000 0 1000 100 250 100
IRR =
Scenario 1 Scenario 2 Scenario 3
18.9% 35.2% 145.9%
How to Calculate a Pooled IRR for a Portfolio?
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How to Calculate a Pooled IRR for a Portfolio?
In most cases the invested capital, fund volume, commitment etc. is used as a weightingfactor
What is the pooled IRR for a portfolio of funds (Fund of Private Equity Funds)?
IRRs are not additive – but TVPIs are additive
Year Fonds 1 Fonds 2 Fonds 3 Pooled CF
1 -1000 -500 -500 -2000
2 0 0 700 700
3 0 750 0 7504 0 0 0 0
5 1120 0 0 1120
Pooled IRR 2.9% 22.5% 40.0% 10.5%
Mean IRR 21.8%
Weighted Mean IRR 17.1%
Weight 2 1 1 4
IRR vs TVPI
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IRR vs. TVPI
Which fund is favored?
A long holding period can trigger a high TVPI when the IRR is comparable low
Year Distribution DrawdownDistribution DrawdownDistribution Drawdown
1 0 500 0 500 0 500
2 0 0 0 0 700 0
3 0 0 750 0 0 0
4 0 0 0 0 0 05 1120 0 0 0 0 0
IRR =
TVPI= 2,24 1,50 1,40
Fund 1 Fund 2 Fund 3
22,3% 22,5% 40,0%
The Results of IRR and TVPI DivergeSignificantly
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Significantly
Trade-off between IRR and TVPI
Why are the TVPIs forthe VC funds in general
higher compared to the
buyout funds?
TVPI Distribution of VE Funds
I
1 9 8 5
1 9 8 6
1 9 8 7
1 9 8 8
1 9 8 9
1 9 9 0
1 9 9 1
1 9 9 2
1 9 9 3
1 9 9 4
1 9 9 5
1 9 9 6
1 9 9 7
1 9 9 8
1 9 9 9
2 0 0 0
2 0 0 1
2 0 0 2
2 0 0 3
2 0 0 4
1
2
3
4
5
6
EU BO
1 9 8 5
1 9 8 6
1 9 8 7
1 9 8 8
1 9 8 9
1 9 9 0
1 9 9 1
1 9 9 2
1 9 9 3
1 9 9 4
1 9 9 5
1 9 9 6
1 9 9 7
1 9 9 8
1 9 9 9
2 0 0 0
2 0 0 1
2 0 0 2
2 0 0 3
2 0 0 4
1
2
3
4
5
6
EU VC
Mean per Vintage Year
IRR Distribution of VE Funds
1 9 8 5
1 9 8 6
1 9 8 7
1 9 8 8
1 9 8 9
1 9 9 0
1 9 9 1
1 9 9 2
1 9 9 3
1 9 9 4
1 9 9 5
1 9 9 6
1 9 9 7
1 9 9 8
1 9 9 9
2 0 0 0
2 0 0 1
2 0 0 2
2 0 0 3
2 0 0 4
0
50
100
EU BO
1 9 8 5
1 9 8 6
1 9 8 7
1 9 8 8
1 9 8 9
1 9 9 0
1 9 9 1
1 9 9 2
1 9 9 3
1 9 9 4
1 9 9 5
1 9 9 6
1 9 9 7
1 9 9 8
1 9 9 9
2 0 0 0
2 0 0 1
2 0 0 2
2 0 0 3
2 0 0 4
0
50
100
EU VC
Mean per Vintage Year
Risk Structure of Private Equity Investments IsNot Comparable to Traditional Asset Classes
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Not Comparable to Traditional Asset Classes
Private Equity returns are not normally distributed
Calculation base: Continuous Quarterly returns based on pooled Cash-Flows and NAVs of floating years 1980 – 2008. All VY from starting year to 30.06.2001.
Source: TFSD Venture Economics,Bloomberg, B&S Research
-15% -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55%
R e l a t i v e F r e q u e n c y
US Venture Capital
-15% -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55%
Nasdaq Composite
R e l a t i v e F r e q u e n c y
-15% -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55%
R e l a t i v e F r e q u e n c y
US Buy-Outs
-15% -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55%
R e l a t i v e F r e q u e n c y
S&P 500
Agenda
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Agenda
I. Private Equity as an Asset Class
II. Investment Process of a Private Equity Fund
III. Private Equity Returns
IV. Strategic Asset Allocation
What Is the Value Added of Private Equity inTraditional Portfolios?
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Traditional Portfolios?
Fraction in Private Equity
P o r t f o l i o V
o l a t i l i t y p . a .
10% Fraction of Private Equity increases Portfolio Stability
Source
Yale Endowment – Private Equity Has theLargest Portfolio Weight
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g W g
Private Equity allocation increased monotonically until 2011 up to 35.1%
S o u r c e : Y a l e E n d o w
m e n t R e p o r t 2 0 1 1
Heterogeneity of this Asset Class Complicatesthe Problem of Optimal Asset Allocation
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p
Private Equity is a very heterogeneous asset class and shows low correlation within
itself
What is the optimal allocation in single instruments and funding stages?
Why do we find such a heterogeneity in the return distributions?
Source: Bloomberg, Thomson Venture Economics (quarterly cash flow summaries), period 1.1.1993 - 30.06.2006
US VC US BO US Mezz US All PE EU VC EU BO EU All PE
US VC 1.00 0.50 0.55 0.92 0.51 0.57 0.63
US BO 0.50 1.00 0.39 0.80 0.37 0.33 0.43
US Mezz
0.55 0.39 1.00 0.57 0.35 0.40 0.38
US All PE 0.92 0.80 0.57 1.00 0.51 0.53 0.62
EU VC
0.51 0.37 0.35 0.51 1.00 0.66 0.76
EU BO 0.57 0.33 0.40 0.53 0.66 1.00 0.86
EU All PE 0.63 0.43 0.38 0.62 0.76 0.86 1.00
Use of Historical Return Time Series in PortfolioOptimization Context leads to Misallocation
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p
The evaluation of a Private Equity investment does not have to coincide with its true value
due to diverse biases… Stale Pricing – Book values of stakes do not reflect actual market values and react
delayed to Public Equity Why?
Appraisal Smoothing – Volatility is underestimated due to backing on valuation history
of illiquid investments (Gompers and Lerner, 1997) Why?
Illiquidity –
Based on longer valuation periods (low numbers of observations) volatilityis underestimated (Geltner, 1991) Why?
Managed Pricing – GP disposes of scope in assessing illiquid investments (often
problematic in situation of total losses) Strategy?
Direct, naïve calculation of performance measures from Venture Economics (orequivalent databases) time series results in too low volatilities and correlations as well as positive autocorrelation!„True“ values need to be calculated with adjustments (e.g. Geltner’s or Getmansky,
Makarov and Lo’s method)
An Intensive Analysis of Characteristics ofPrivate Equity Gains Importance
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q y p
A representative benchmark has to be the starting point of strategic asset allocation
Potential biases distort return / risk profile, leading to distortion of allocation andundesired return / risk profiles
Cash-Flow patterns are important for multi-periodic models, the compound interest effectshould not be underestimated
Only if the benchmarks’ return time series are representative, the
specification and calibration of a model will be successful
Private Equity – Benchmarking
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q g
0
100
200
300
400
500
600
700
800
Feb. 99 Jun. 00 Nov. 01 Mrz. 03 Aug. 04 Dez. 05 Apr. 07 Sep. 08
I n d e x
Datum
Private Equity
CepreX - US Growth/Small Buyout CepreX - US Venture Capital
VE US VC VE US BO
LPX Venture LPX America
LPX Buyout
CepreX - US
Growth/Sma
ll Buyout
CepreX - US
Venture
Capital
Venture
Economics
US VC
Venture
Economics
US BO
LPX Venture
LPX
America
LPX Buyout
CepreX - US Growth/Small BO
1,00
0,06
0,19
0,18
0,02
-0,10
-0,05
CepreX - US VC 0,06 1,00 0,28 0,21 0,27 0,23 0,21
Venture Economics US VC 0,19 0,28 1,00 0,52 0,59 0,49 0,25
Venture Economics US BO 0,18 0,21 0,52 1,00 0,55 0,47 0,41
LPX Venture 0,02 0,27 0,59 0,55 1,00 0,80 0,62
LPX America -0,10 0,23 0,49 0,47 0,80 1,00 0,75
LPX Buyout -0,05 0,21 0,25 0,41 0,62 0,75 1,00
Low correlation of all indices
Venture Economics data is only available on
a quarterly base with a six month lag andexhibit appraisal smoothing
CepreX data is available on a monthly basis,
but exhibit a 6-9 month lag.
All non-listed Indices show an appraisal
smoothing
Listed indices have stock market risk
See Appendix A for a construction idea of
adequate private equity benchmarks
Agenda
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I. Private Equity as an Asset Class
II. Investment Process of a Private Equity Fund
III. Private Equity Returns
IV. Strategic Asset Allocation
Appendix A - Private Equity Benchmarks and Portfolio
Optimization
Motivation – Cumming, Haß and Schweizer(2014)
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Private equity is an established asset class, but its performance measurement is
ambiguous sharp measurement is important for e.g. portfolio optimization,risk management
Three different index methodologies are used with different strengths and weaknesses
Listed Private Equity Indices have the strength of daily data availability and (high) liquidity,
Overstated volatility due to stock market influences (data provider: LPX Group)
Appraisal Value Based Indices have the strength that there are no stock market influences, but
have a show appraisal smoothing and a one quarter time lag (Data provider: Thomson Reuters
VentureXpert)
Transaction Based Private Equity Indices have the strength that they are based on realized cash
flows (Case-Shiller approach), but can only be computed with considerable time lag (Data
provider: CEPRES)
Idea: Combine strengths of different index methodologies in one index toadequately represent private equity as an asset class
Idea of Constructing a Private EquityBenchmark
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Appraisal Value Based Index
De-Smoothed Monthly AVBI
Up-to-date De-smoothedMonthly AVBI
De-Smoothing and Re-scaling:
Getmansky, Lo, Makarov (2004)
Forecasting:
Gompers and Lerner (1998)
Autocorrelation-Structure of Appraisal ValueBased Private Equity Indices
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Lag 1 Lag 2 Lag 3 Lag 4
US Buy Out 0,3355 0,3005 0,2314 0,1508
US Venture Capital 0,6153 0,4998 0,3905 0,0450
January 1995 to December 2008 for the Lag 1 to 4 — bold formatting represents the significance at least at thelevel of 95%.
Correction for Autocorrelation – Intuition (1/2)
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New method by Getmansky, Lo und Makarov (2004) is especially for alternative
investments and real estate
Private Equity return series show autocorrelation du to appraisal smoothing, stale pricingetc.
The observed returns -
- are the weighted sum of the previous returns:
− . . . − , ∈ 0,1 , 0, … , , and 1 . . .
It follows:
∙ ≤ with ≡ . . .
Correction for Autocorrelation – Intuition (1/2)
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To solve the problem Getmansky, Lo and Makarov (2004) show a de-smoothing technique
1. step: Estimation of the parameters . . . with Maximum Likelihood (MLE)
2. step: Calculation of the true returns and variances
Example:
0 . 2 5 ∙ 0 . 2 5 ∙ − 0 . 2 5 ∙ − 0 . 2 5 ∙ −3 0.25
It can be seen that the true variance is four times higher then the observed variance
Private Equity – Benchmarking
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Appraisal Smoothing can be „corrected“ with method of Getmansky, Makarov und Lo
(2004) Increase in volatility from 10.36% to 17.77%!
The missing six months can be estimated with a forecast model which uses theinformation from the Listed Private Equity indices
Forecasts of Private Equity Indices – RegressionResults of the Forecast Model
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Running the following regression toidentify the driver of private equity
returns: ∙ ∙ BO
3 ∙
4 ∙
∙ℎ 6 ∙ 7 ∙ 8 ∙
9 ∙
∙ ∙
, ℎ 1, … ,
U.S. BuyoutU.S. Venture
Capital
Beta BetaConstant 0,0045** 0,006*
LPX Buyout 0,0204
LPX Venture Capital 0,113**
EA 0,4623** 0,733*
GDP 0,6511 2,070
Interest (short) 1,2993* 2,929*
Interest (long) 0,0017 -1,026Inflation 0,2797 0,180
Nasdaq 0,055NYSE 0,1076**
NYSE Liquidity -0,3196
Nasdaq Liquidity 1,204
Nobs 167 167F-Test 15,00** 11,68** Adj, R 2 40,28% 33,99%** and * indicate statistical significance at the 1% and 5% levels,
respectively.
Zeitraum: Januar 1995-Dezember 2008
Monthly Descriptive Statistics for Private EquityIndices
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US Buy Out
(smoothed) US Buy Out LPX 50
US Venture
Capital
(smoothed)
US Venture
CapitalLPX 50
Mean 0,72% 0,72% 0,58% 1,14% 1,14% 0,16%
Standard
Deviation1,42% 2,73% 6,09% 2,99% 5,72% 8,48%
Skewness -0,65 -1,14 -3,70 1,64 1,51 -0,32
Kurtosis 3,31 7,68 23,05 8,86 19,88 4,28LPM 0,30% 0,62% 1,63% 0,53% 1,12% 3,17%
CVaR (α= 95%) -2,73% -7,32% -18,00% -3,83% -11,10% -19,32%
Maximum Drawdown 23,34% 25,69% 79,96% 52,65% 57,17% 89,07%
arque-Bera 1 1 0 1 1 0 A Jarque-Bera value of 1 means that the assumption of the normal distribution at the level of 1% can be rejected.
January 1999 until December 2009
Descriptive Statistics for all Asset Classes
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NIKKEI
500 S&P 500 DJ EURO
STOXX
JPM
EUROPE
JPM
US JPM UK JPM
Japan NAREIT S&P GSCI HFRI LIBOR
Mean 0,41% 0,92% 0,27% 0,65% 0,51% 0,30% 0,71% 1,10% 0,96% 0,63% 0,45%
Standard
Deviation6,59% 4,13% 6,27% 2,81% 1,37% 3,70% 2,66% 3,75% 5,77% 1,71% 0,09%
Skewness 3,04 3,13 4,12 3,31 3,79 8,92 3,03 4,72 2,93 6,92 2,02
Kurtosis 0,52 -0,29 -0,11 0,32 -0,46 1,21 0,11 -0,56 0,07 -0,15 0,03LPM 2,44% 1,26% 2,23% 0,78% 0,33% 1,15% 0,72% 1,01% 1,84% 0,36% 0,00%
CVaR (5%) -10,10% -8,24% -13,81% -4,73% -2,63% -6,90% -4,79% -7,22% -10,40% -2,92% 0,29%
Maximum
Drawdown66,69% 43,07% 77,12% 23,16% 4,84% 31,45% 11,22% 26,32% 47,51% 13,08% 0,00%
arque-Bera 0 1 1 0 1 0 1 1 1 1 1 A Jarque-Bera value of 1 means that the assumption of the normal distribution at the level of 1% can be rejected.
January 1999 to December 2009
Correlation
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NIKKEI S&P500
DJSTOXX
JPMEurope
JPM US JPM
Japan JPMUK
NAREIT GSCI HFRI LPX VC LPXBO
PE BO PE VC SPAC
NIKKEI 1,00
S&P 500 0,52 1,00DJ
STOXX 0,54 0,87 1,00
PMEurope
-0,02 -0,19 -0,23 1,00
PM US 0,13 -0,04 -0,36 0,41 1,00
PM
apan 0,02 -0,20 -0,43 0,39 0,73 1,00
PM UK 0,10 0,05 0,00 0,56 0,35 0,21 1,00
NAREIT 0,34 0,75 0,71 -0,12 -0,27 -0,24 -0,09 1,00
GSCI 0,16 0,27 0,36 -0,26 -0,24 -0,40 0,09 0,11 1,00
HFRI -0,15 -0,33 -0,22 0,07 -0,10 -0,25 0,01 -0,21 -0,06 1,00
LPX VC 0,63 0,58 0,73 -0,04 -0,25 -0,28 0,12 0,55 0,32 -0,18 1,00
LPX BO 0,47 0,75 0,85 -0,08 -0,29 -0,33 0,16 0,72 0,39 -0,17 0,82 1,00
PE BO 0,05 0,04 0,03 -0,06 0,01 -0,05 0,05 0,05 -0,05 -0,04 -0,05 0,06 1,00
PE VC 0,03 0,07 0,14 -0,13 -0,15 -0,15 0,04 0,07 -0,05 -0,02 0,05 0,17 0,85 1,00
SPAC 0,37 0,50 0,63 -0,25 -0,44 -0,39 -0,06 0,47 0,42 -0,15 0,55 0,62 0,02 0,03
Zeitraum: September 2003-Dezember 2009
Efficient Multi-Asset Portfolios
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Portfolio weights forPrivate equity indices
Mean Standarddeviation
LPM CVaR VaR MaxDD Sharpe-Ratio
Minimum-variance portfolio
without PE7,26% 3,04%*** 0,00% -0,66%*** -0,37%*** 1,12%*** 1,73***
Minimum-variance portfolio
with PE7,30% 2,11%*** 0,00% -0,26%*** -0,08%*** 0,52%*** 2,51***
Average-variance portfolio
without PE
8,64% 3,90%*** 0,00% -0,90%*** -0,53%*** 1,61%*** 1,71***
Average-variance portfolio
with PE8,65% 3,57%*** 0,00% -0,69%*** -0,45%*** 1,21%*** 1,86***
Maximum yield portfolio
without PE10,01% 6,43%*** 0,01% -1,81%*** -1,33%*** 3,25%*** 1,26***
Maximum yield portfolio
with PE9,97% 5,65%*** 0,01% -1,44%*** -1,04%*** 2,50%*** 1,41***
***, **, And * indicate statistical significance at the 1%, 5%, and 10% levels for a different average return, standard
deviation, LPM, CVaR, VaR, and MaxDD for a portfolio without private equity in comparison to one with private equity.For the Sharpe ratio it is tested whether it is greater for the portfolio of private equity compared to the portfolio withoutprivate equity.
Optimization result of the multi-asset portfolios
Efficient Multi-Asset-Portfolios (1/3)
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0%
2%
4%
6%
8%
10%
12%
14%
16%
18%20%
5.60% 5.80% 6.00% 6.20% 6.40% 6.60%0%
2%
4%
6%
8%
10%
12%
P r i v a t e E q u i t y P o r t f o l i o W e i g h t
Expected Portfolio Return
V o l a t i
l i t y
Minimum-Variance-Optimization
Efficient Frontier (VentureCapital Appraisal Value BasedBenchmark)
Efficient Frontier (LPX)
Efficient Frontier (Venture
Capital Appraisal Value BasedPrivate Equity Index)
Venture Capital Appraisal ValueBased Benchmark Portfolio Weight
LPX Portfolio Weight
Venture Capital Appraisal ValueBased Private Equity IndexPortfolio Weight
Efficient Multi-Asset-Portfolios (2/3)
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0%
2%
4%
6%
8%
10%
12%
14%
16%
18%20%
5.60% 5.80% 6.00% 6.20% 6.40% 6.60%0%
1%
2%
3%
4%
5%
6%
7%
8%
P r i v a t e E q u i t y P o r t f o l i o W e i g h t
Expected Portfolio Return
L o w e r P a r t i a l M o m e n t 2
LPM-Optimization
Efficient Frontier (VentureCapital Appraisal Value BasedBenchmark)
Efficient Frontier (LPX)
Efficient Frontier (Venture
Capital Appraisal Value BasedPrivate Equity Index)
Venture Capital Appraisal ValueBased Benchmark Portfolio Weight
LPX Portfolio Weight
Venture Capital Appraisal ValueBased Private Equity IndexPortfolio Weight
Efficient Multi-Asset-Portfolios (3/3)
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0%
2%
4%
6%
8%
10%
12%
14%
16%
18%20%
5.60% 5.80% 6.00% 6.20% 6.40% 6.60%0%
2%
4%
6%
8%
10%
12%
14%
16%
P r i v a t e E q u i t y P
o r t f o l i o W e i g h t
Expected Portfolio Return
C o n d i t i o n a l V a l u e a t R i s k
CVaR-Optimization
Efficient Frontier (VentureCapital Appraisal Value BasedBenchmark)
Efficient Frontier (LPX)
Efficient Frontier (Venture
Capital Appraisal Value BasedPrivate Equity Index)
Venture Capital Appraisal ValueBased Benchmark Portfolio Weight
LPX Portfolio Weight
Venture Capital Appraisal ValueBased Private Equity IndexPortfolio Weight
Portfolio-Risk in Correspondence to ChosenPrivate Equity Proxies
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0
100
200
300
400
500
600
700
800
900
- 1 4 . 4 7 1 %
- 1 2 . 9 9 0 %
- 1 2 . 0 0 2 %
- 1 1 . 0 1 4 %
- 1 0 . 0 2 6 %
- 9 . 0 3 8 %
- 8 . 0 5 1 %
- 7 . 0 6 3 %
- 6 . 0 7 5 %
- 5 . 0 8 7 %
- 4 . 0 9 9 %
- 3 . 1 1 1 %
- 2 . 1 2 4 %
- 1 . 1 3 6 %
- 0 . 1 4 8 %
0 . 8 4 0 %
F r e q u e n c y
CVaR
20% Private Equity
LPX
Venture Capital Appraisal Value Based Benchmark
Buy Out Appraisal Value Based Benchmark
0
100
200
300
400
500
600
700
800
900
- 1 3 . 7 6 7 %
- 1 2 . 3 5 7 %
- 1 1 . 4 1 7 %
- 1 0 . 4 7 7 %
- 9 . 5 3 8 %
- 8 . 5 9 8 %
- 7 . 6 5 8 %
- 6 . 7 1 8 %
- 5 . 7 7 8 %
- 4 . 8 3 8 %
- 3 . 8 9 8 %
- 2 . 9 5 9 %
- 2 . 0 1 9 %
- 1 . 0 7 9 %
- 0 . 1 3 9 %
0 . 8 0 1 %
F
r e q u e n c y
CVaR
10% Private Equity
LPX
Venture Capital Appraisal Value Based Benchmark
Buy Out Appraisal Value Based Benchmark
Technical Appendix: De-Smoothing Method byGetmansky, Lo and Makarov (2004)
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Statistical Details (1/6)
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is the true return of a private equity segment like venture capital and satisfies thefollowing one-factor model:
Λ
,
0,
Λ,
~
,
≡
However, the true return is not observable, but only the reported return in t which ismodeled as follows: − .. . − ,
∈ 0,1 , 0, … , , and
1 .. .
The following statistical properties are derived from the above described smoothingprocess:
∙
≤
≡ ∙ ≥ ≡
(continued)
Statistical Details (2/6)
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, − +−= 0 ≤ ≤ ,0 > ,
whereas
≡ .. .
≡ .. .
≡ 1 .. .
, ≡ . It can be derived from the statistical properties of the observable returns that the expected
returned is not changed, but the variance is lower therefore the Sharpe ratio is increased bythe factor
Statistical Details (3/6)
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Estimation procedure (Maximum Likelihood) for a general form of smoothing. Whereas stands for the mean-adjusted return-generating process , with the following properties for
:
−.. .− 1 .. .
~ 0 , , from the previous it is obvious that
is a moving-average-process of order k or a MA( k ).
Statistical Details (4/6)
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For given observations ≡ ⋯ ′ one can write the following Likelihood-function
ℒ , 2 − − ′− with ≡ ′ , whereas ≡ ⋯ ′ and the co-variance matrix is a function of the parameter and. It can be shown that ℒ , ℒ , and therefore a further identification is
not necessary
Brockwell and Davis (1991) show that we can re-formulate the Likelihood-function to
ℒ , 2 − ⋯ − − 12 −= ,
whereas ⋯ ′, 0, , … , − , ≥ 2 and
+ +
is the so called one-step-ahead-estimator, and is calculated recursive for 1 , … ,
Statistical Details (5/6)
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For given observations
≡ ⋯ ′ one can write the following Likelihood-function
ℒ , 2 − − ′− w ith ≡ ′ , whereas ≡ ⋯ ′ and the co-variance-matrix is a function of the parameter and. It can be shown that ℒ , ℒ , and therefore a further identification is
not necessary
Brockwell and Davis (1991) show that we can re-formulate the Likelihood-function to
ℒ , 2 − ⋯ − − 12 −= ,
whereas ⋯ ′, 0, , … , − , ≥ 2 and
+ +
is the so called one-step-ahead-estimator, and is calculated recursive for 1 , … ,
Statistical Details (6/6)
Af i l diff i i f h Lik lih d f i i h i i b i h
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Page 76Investment Analysis
Denis Schweizer
After partial differentiation of the Likelihood-function with respect to it is obvious that
the Maximum-Likelihood-estimator for
is given by
− −= , which results in
ℒ log − −= .
This Likelihood-function can be minimized in
, subject to its side constraints. Under
above given specification is invertible for the set: 1 , < 1 2 , < 1 2 and the Maximum-Likelihood-estimator
for satisfies the following conditions:1 ,
~ 0 , , 1 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 1 2 .
Agenda
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Page 77Investment Analysis
Denis Schweizer
I. Private Equity as an Asset Class
II. Investment Process of a Private Equity Fund
III. Private Equity Returns
IV. Strategic Asset Allocation
Appendix B - Are Private Equity Investors Boon or Bane for an
Economy?
Appendix B - Are Private Equity Investors Boonor Bane for an Economy?
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Denis Schweizer
In 2011 Private Equity and Hedge Funds AreRegulated on EU Level
Financial market crisis and the so called „Heuschreckendebatte“ have lead to a demand for a more
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Denis Schweizer
Structure of the new RegulationImplications for Private Equity
Reasons for Regulation
Prevention of debt overload and „Asset
Stripping“ of portfolio companies
Increasing transparency of private equity fundsfor the investors and potential target companies
Regulation Procedure
Control of debt volume for portfoliocompanies (e.g. LBOs)
Extensive duty to supply information for
investors regarding the strategic intentions within acquisitions of publicly listed companies
with more than 250 employees
Distribution of equity and special reserves are
not possible with two years after the acquisition
Source: Bundesfinanzministerium, Financial Times Deutschland
„
intensive regulation since the industry was regulated on a low level only
The new regulation was passed at November 11, 2010 on EU level and has to be implemented in
national law until 2013 for all member states
ESMA (EU-supervision
of securities)
ESRB (European
Systemic Risk Board)
National controlling
institution
EU-FundsFunds from Third
Country
Funds report:
Leverage level
Self given leverage restrictionFive main creditors Target markets / concentration risk Further involved managers
2013 2018Issue of a
EU-wide
accreditation
Issue
„EU-Pass-port“
Development of technicalstandards
Handle of a central register
Connect between nationalregulation authorities
Consolidated considerationof the controllinginstitutions
Evaluation of systematicrisk
Literature
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Page 80Investment Analysis
Denis Schweizer
Brockwell, Peter J., and Richard A. Davis, 1991, Time Series: Theory and Methods (2nd
Edition, Springer, New York).
Cumming, Douglas, Lars Helge Haß and Denis Schweizer (2013): Portfolio Optimization with Private Equity, Journal of Banking & Finance 37 , 3515-3528 .
Getmansky, Mila, Andrew W. Lo., and Igor Makarov, 2004, An Econometric Model ofSerial Correlation and Illiquidity in Hedge Fund Returns, Journal of Financial Economics 74,
529-609.
Geltner, David M., 1991, Smoothing in Appraisal-Based Returns, Journal of Real Estate
Finance & Economics 4, 327-345.
Gompers, Paul A., and Josh Lerner, 1997, Risk and Reward in Private Equity Investments: The Challenge of Performance Assessment, Journal of Private Equity 1, 5-12.
Gompers. Paul A., and Josh Lerner, 1998, What Drives Venture Capital Fundraising?,Brookings Papers on Economic Activity-Microeconomics (July), 149-92.
Motivation Literature Research approach Results Model Summary/outlook
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Are Private Equity Investors Boon or Bane for anEconomy? – A Theoretical Analysis
Sebastian Ernst Christian Koziol Denis Schweizer
WHU – Otto Beisheim School of Management
59th Annual Meeting of the Midwest Finance Association
Las Vegas, February 24-27, 2010
Sebastian Ernst/Christian Koziol/Denis Schweizer Are Private Equity Investors Boon or Bane for an Economy? 1
Motivation Literature Research approach Results Model Summary/outlook
Motivation
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Too high leverage
Short-term profits
”Locusts”
Typical criticism:
at the cost of
long-term investments
Private Equity (LBO)
Source of financing
New, superior
better monitoring
Arguments for PE:
management concept
Lower agency costs,
for companies
Sebastian Ernst/Christian Koziol/Denis Schweizer Are Private Equity Investors Boon or Bane for an Economy? 2
Motivation Literature Research approach Results Model Summary/outlook
Literature
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• Empirical studies do not document negative impact of PE:
Significant increase in productivity and operating profit(Kaplan (1989), Lichtenberg/Siegel (1990), Muscarella/Vetsuypens
(1990), Smith (1990), Harris et al. (2005))
No significant negative effect on employment and investment(Amess/Wright (2007), Davis et al. (2008))
• Limitations of empirical studies:
Comparison to situation without PE acquisition not possible
No identification of reasons for potential negative impact
=⇒ Model-theoretic analysis required
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Motivation Literature Research approach Results Model Summary/outlook
Research approach
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• PE investor negative for economy if:
Takeover of a target company
Inefficient investment decisions (in comparison to standard investor)
• Goal of the paper:
Modeling of both acquisition and investment decisions
Identification of characteristics that cause inefficient behavior
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Motivation Literature Research approach Results Model Summary/outlook
Results
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• Characteristics of PE that do not result in inefficient behavior:
Higher target return
Operational improvements/productivity increases
Lower risk aversion
Shorter investment horizon
• Characteristics of PE that may result in inefficient behavior:
Higher leverage
Better information about target company
Sebastian Ernst/Christian Koziol/Denis Schweizer Are Private Equity Investors Boon or Bane for an Economy? 5
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Motivation Literature Research approach Results Model Summary/outlook
Model: basic structure
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• Investors identical except that P has higher target return: r S < r P
• Investors are risk-neutral with objective function:
OF i = E(Πi ) = O (x i ) − (x i + p i ) · (1 + r i ), i ∈ {S ,P }
• Goal: comparison of acquisition price p i and investment volume x ∗i
• Allocation inefficient if
i x := arg maxi ∈{S ,P }
x ∗i = i p := arg maxi ∈{S ,P }
p i
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Motivation Literature Research approach Results Model Summary/outlook
Results
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• Characteristics of PE that do not result in inefficient behavior: Higher target return
Operational improvements/productivity increases
Lower risk aversion
Shorter investment horizon
• Characteristics of PE that may result in inefficient behavior:
Higher leverage
Better information about target company
Sebastian Ernst/Christian Koziol/Denis Schweizer Are Private Equity Investors Boon or Bane for an Economy? 8
Motivation Literature Research approach Results Model Summary/outlook
Model: higher target return (base case)
• Optimal investment volume x∗ implicitly given by:
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• Optimal investment volume x i implicitly given by:
O (x ∗i ) = 1 + r i , i ∈ {S ,P }
• Maximum acquisition price p i :
p i = O (x ∗i )
O (x ∗i
) − x ∗i , i ∈ {S ,P }
• Result: S pays higher acquisition price and invests more than P
=⇒ Allocation efficient
=⇒ PE investor does not take part in the market
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Motivation Literature Research approach Results Model Summary/outlook
Results
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• Characteristics of PE that do not result in inefficient behavior: Higher target return
Operational improvements/productivity increases
Lower risk aversion
Shorter investment horizon
• Characteristics of PE that may result in inefficient behavior:
Higher leverage
Better information about target company
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Motivation Literature Research approach Results Model Summary/outlook
Model: differences in risk aversion
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• Investor S becomes risk averse with preference function:
OF S = E(ΠS ) − b · V(ΠS )
• Optimal investment volume x ∗S implicitly given by:
1 + r S = O (x ∗S ) · 1 − 2 · b · σ2 · O (x ∗S )
• Maximum acquisition price p S :
p S = O (x ∗S )O (x ∗S )
· 1 − b · σ2 · O (x ∗S )1 − 2 · b · σ2 · O (x ∗S )
− x ∗S
Sebastian Ernst/Christian Koziol/Denis Schweizer Are Private Equity Investors Boon or Bane for an Economy? 11
Motivation Literature Research approach Results Model Summary/outlook
Model: differences in risk aversion
p i σ =
r P −r S
2·b ·O (x ∗S
)·(1+r P )
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σ
pi
p P
p S
σσ
x ∗S > x ∗P x ∗S < x ∗P
(S
) ( + P )
σ = (1+r
P )·((1+r
S )·(x ∗
P −x ∗
S )+O (x ∗
S ))−(1+r
S )·O (x ∗
P )
b ·(1+r P )·O (x ∗
S )2
=⇒ Situation possible where S acquires the companybut P would invest more
=⇒ No negative impact of PE investor
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Motivation Literature Research approach Results Model Summary/outlook
Results
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• Characteristics of PE that do not result in inefficient behavior: Higher target return
Operational improvements/productivity increases
Lower risk aversion
Shorter investment horizon
• Characteristics of PE that may result in inefficient behavior:
Higher leverage
Better information about target company
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Motivation Literature Research approach Results Model Summary/outlook
Model: leverage
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• P can take on debt with volume D , r D < r P
• Result: P takes over companies when debt volume and spreadr P − r D is high
• Investment volume of P does not change
=⇒ Leverage increases maximum acquisition price of P without changing its investment behavior
=⇒ Inefficiency caused by P possible
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Motivation Literature Research approach Results Model Summary/outlook
Results
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• Characteristics of PE that do not result in inefficient behavior: Higher target return
Operational improvements/productivity increases
Lower risk aversion
Shorter investment horizon
• Characteristics of PE that may result in inefficient behavior:
Higher leverage
Better information about target company
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Motivation Literature Research approach Results Model Summary/outlook
Model: informational asymmetries about target company• Uncertainty about quality (µ) of target company for S :
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After acquisition/before investmentBefore acquisition
z
µ = z G ⇒ Good firm
µ = z B ⇒ Bad firm
π
1 − π
• P has no information problem
• Result: S invests more and acquires bad firms
• P acquires good firms if uncertainty ( z G
z B ) is high and successprobability (π) small
=⇒ Inefficiency caused by P possible
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Motivation Literature Research approach Results Model Summary/outlook
Summary/outlook
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• Theoretical foundation of the debate about the economic impact of
private equity transactions
• Identification of reasons for inefficient behavior:
High leverage
Informational asymmetries
• Separation between relevant and plausible but non-relevant reasons
• Political implications:
Debt restrictions Enhancement of transparency
Sebastian Ernst/Christian Koziol/Denis Schweizer Are Private Equity Investors Boon or Bane for an Economy? 17