How to build a successful private equity portfolio

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<ul><li><p>Establ ish Asset Al locat ion</p><p>T here are two principal situations that require dif-ferentiation when discussing asset allocation: the establishment of a new program or the expansion of an existing program or programs. In addition, it has to be said that asset allocation in private equity, given the particular characteristics of the asset class, always requires a top-down (establishment of the allocation parameters) as well as a bottom-up (availability of suitable funds) per-spective. </p><p>When establishing a new program, the initial step prior to developing the actual private equity asset alloca-tion is to define the size of the program, as this will help </p><p>to establish the appropriate geographic and product mix for the portfolio. The important driver here is diversifica-tion. As shown in Figure 1, a portfolio should be diversi-fied across vintage years as well as different strategies in order to enhance returns and minimize risk. </p><p>Geographic diversification is a secondary consider-ation and is driven by the desired currency mix as well as the overall size of the program, with larger programs requiring a wider geographic focus in order to ensure the availability of a sufficient number of top-tier private equity managers. </p><p>In order to eliminate the risk of losing money in a private equity portfolio, the minimum diversification that should be achieved, is a total of three to five funds over </p><p> 527</p><p>The route to a successful private equity portfolio is a four-step process that requires an in-depth un-</p><p>derstanding of private equity as an asset class as well as the skills to select promising opportunities </p><p>from available offerings. The first step is to set out and define general allocation guidelines. These </p><p>initial guidelines then have to be refined based on the availability of adequate investment opportuni-</p><p>ties. The third step involves selecting the most attractive funds from a pool of target funds. And lastly </p><p>the portfolio must be monitored on an ongoing basis to track its overall development as well as its </p><p>enduring performance. Benchmarking the overall performance of the portfolio as well as individual </p><p>managers is an integral part of this. In the following sections, each individual step is discussed and </p><p>explained in more detail. 2009 Wiley Periodicals, Inc.</p><p>How to Build a Successful Private Equity Portfolio</p><p>Correspondence to: Katharina Lichtner, Managing Director, Capital Dynamics, Bahnhofstrasse 22, 6301 Zug, Switzerland, +41 41 748 8402 (phone), +41 41 748 8440 (fax), klichtner@capdyn.com.</p><p>SpeCiaL SeCtion of private equity</p><p>By</p><p>Katharina Lichtner</p><p>published online in Wiley interScience (www.interscience.wiley.com). 2009 Wiley Periodicals, Inc. DOI: 10.1002/tie.20296</p></li><li><p>five to nine years. This results in commitments to about 30 managers at least. As $10 million is typically the mini-mum for a fund commitment, a program that envisages direct fund investments should have an initial size of at least $300 million. Programs that are smaller should add fund of funds to a number of select direct fund commit-ments or cover all private equity exposure through fund of funds. Experience has also shown that programs under 150 million cannot be run cost-effectively given staff re-quirements unless fund of funds are used. Therefore, it is suggested that a typical global program of about 300 million targeting diversification across all strategies (i.e., buyout, venture, and special situations) and covering the United States, European Union, and Asia should utilize fund of funds. Home markets can be covered with direct investments into funds, while all other regions or special strategies should be covered by fund of funds to ensure adequate diversification without generating prohibitive costs for the program. Programs in excess of U.S. $/EUR 500 million should move to investing predominantly into funds directly. </p><p>The main focus for the expansion of existing pro-grams is a detailed analysis of the portfolio, to ensure that any further investment activity optimizes it. In these in-stances, it is important to develop a detailed understand-</p><p>528 spEciAL sEction on privAtE Equity</p><p>thunderbird international Business review Vol. 51, No. 6 November/December 2009</p><p>ing of the geographic, currency, vintage year, and strategy mix. It is also important to understand any concentration risks of the portfolio. With the equivalent number of fund methodology, any clumping risks in portfolios with commitments of unequal size can be calculated in order to rebalance it through future commitments. In addition, it is important to calculate the future value development as well as the expected cash need of the existing portfolio to adequately size and time any further commitments (see Figure 2). With a detailed understanding of diversi-fication, clumping risks as well as the future development of the portfolio, a geographic expansion, for example, can be integrated. </p><p>Al locat ion opt imizat ion</p><p>After establishing the details of the allocation, it is neces-sary to verify whether implementation is possible. Unlike the public markets, high-quality investment opportunities are not always available for all strategies. Private equity managers typically come back to market with a new fund in three-year intervals, and with open windows for com-mitment ranging from six to twelve months, which can ac-tually be as little as a few weeks for a very good manager, if access for new investors is possible at all. In between these </p><p>figure 1 Diversification aspects</p></li><li><p>How to Build a Successful private equity portfolio 529</p><p>DOI: 10.1002/tie thunderbird international Business review Vol. 51, No. 6 November/December 2009</p><p>successful private equity portfolio and should under no circumstances be sacrificed for allocation considerations. Figure 3 shows the impact on successful manager selec-tion on the basis of the same allocation.</p><p>Thus, all allocation targets need to be optimized and possibly adjusted in an iterative process depending on when quality managers become available (Figure 4).</p><p>A further topic that needs to be addressed is the timing of the market. It is impossible to elaborate all aspects of this topic in the scope of this article, but given the long-term nature of private equity, where each fund typically covers more than one economic cycle, it is al-most impossible to time the market. Therefore, market </p><p>fundraising periods, no money can be placed with these managers. Thus, it is critical to continuously evaluate and benchmark managers in the market to have transparency when top-quality opportunities are available. In order to do this adequately, a forward calendar covering rolling 24 to 36 months containing target managers should be maintained at all times. In addition, continuous market oversight and analysis is required, as there are always some top managers that lose their edge and experience changes that make a good future performance unlikely. These managers will need to be substituted by promis-ing emerging teams. It is critical to note at this stage that manager quality is the most important element of a </p><p>figure 2 portfolio Development Modeling</p><p>figure 3 impact of investment Selection</p></li><li><p> Quality of the team: The team needs to be experi-enced, cohesive, and have a balanced skill set that covers all and is relevant to the specific requirements from acquisition and structuring of the transactions to company management, as well as exit in the target market. </p><p> Strategy:Thestrategyofamanagershouldbestableand sustainable. It should also be consistent with the skills of the team as well as the market the team oper-ates in. </p><p> Market:Themanagerneedstobewellpositionedinthe market and have a good reputation. The market segment needs to provide sufficient deal flow and needs to hold future potential. As discussed earlier, it is impossible to time the market in private equity; however, it is of crucial importance to understand how markets are developing, to evaluate their future poten-tial, and to gain understanding if a given manager has the right strategy as well as the skill set to profitably capture the market opportunity. </p><p> Trackrecord:Theanalysisof thetrackrecordallowsa benchmarking of the fund with respect to its peers. It is equally important to evaluate past performance to verify the managers strategy as well as positioning in the market. The analysis of the track record should be used to raise questions about the future and the consis-tency of the story rather than as a basis for decision. </p><p>Overall, it can be said that when team, strategy, and market aspects integrate well into a consistent story, which can be substantiated through the analysis of the track rec ord, and the market shows attractive potential that can be captured by the team, the prerequisites for attractive future performance are met. </p><p>Moni tor ing</p><p>Monitoring needs to be an integral part of any privateequity portfolio and fulfills several purposes. First, it needs to provide transparency on the progress and the performance of each underlying investment to ensure that all contractual arrangements are correctly met and to assess all risk positions in the portfolio. Second, the overall portfolio development with respect to unfunded exposures, likely cash requirements, and investment level and value development need to be assessed. And lastly the performance of the overall portfolio with respect to public equity and other private equity portfolios needs to be monitored. </p><p>When monitoring individual funds, the following aspects need to be considered:</p><p>530 spEciAL sEction on privAtE Equity</p><p>thunderbird international Business review Vol. 51, No. 6 November/December 2009</p><p>timing should not be an element that influences private equity asset allocation. </p><p>select ion of opportuni t ies</p><p>Once the allocation has been established and availability of funds has been confirmed, it is important to engage in a detailed due diligence process in order to identify the best investment opportunities or to confirm the contin-ued quality of an existing relationship. The basis for each due diligence is a thorough and rigorous process that combines a qualitative as well as quantitative analysis to assess all aspects of the offering. The basic aim of due dili-gence is to look behind the marketing story of a manager and to identify the real qualities and drivers for success as well as the specific risk situations. </p><p>There are four main building blocks that need to be considered (see also Figure 5):</p><p>figure 4 asset allocation is an iterative process</p><p>figure 5 Selection Criteria</p></li><li><p>els to build successful portfolios. Its long-term nature and illiquidity also make it very distinct from investing in pub-lic markets. It is also unique in its requirements, which combine the use of sophisticated models to adequately manage it with the need to form and maintain personal and long-term relationships with the private equity man-agers to be able to invest in the asset class. </p><p>Lately, there has been much talk about how the continued weakness of the lending market will result in a continued low volume of transactions and a nega-tive impact on private equity in general. However, it is important to point out that the downward correction of prices will provide attractive entry multiples, and despite the current crisis we believe that debt markets as well as the economy will recover during the holding period of companies acquired today. Distressed and turnaround strategies will see increasing opportunity, and with lending markets fundamentally changed, mezzanine should provide interesting opportunities. Other strategies less hit by the downturn like energy and infrastructure remain attractive. Thus, private eq-uity is well positioned to achieve attractive returnsas has been seen in previous cycles. Generally, experi-enced managers have demonstrated that they are agile and creative and, therefore, more than able to adapt to changing market environments, generating attractive returns even in difficult times. For those investors new or experienced that focus on building well-diversified portfolios and on investing with top-quality managers, we have every reason to believe that private equity will generate an annual outperformance of 2% to 6% over public markets in the coming years.</p><p> analysisoffundandportfoliodataforthecurrentandprior periods;</p><p> reconciliationofcashflows;</p><p> benchmarking of fund customary industrymeasures(net IRR, TV/PI, D/PI, RV/PI) against peer groups (Figure 6A); </p><p> monitoring progress on issues (weaknesses andthreats) raised in due diligence and alignment against agreed fund strategies;</p><p> monitoringteamdevelopmentandstability;</p><p> monitoringanynewissuesthatemergeduringthelifeof a fund (special monitoring); and</p><p> rating each funds quarterly performance utilizing asimple numerical rating system.</p><p>Tracking the overall development, the same cash-flow forecasting models used during asset allocation can be applied. And, last but not least, the perfor-mance of a portfolio with respect to public equity can be assessed using the public market equivalent plus(PME+)approach,whileforthecomparisonwithprivate equity a method called portfolio replication (Figure 6B) should be used. Any insight gained during monitoring needs to flow back into asset allocation as well as investment selection in a quest to continuously improve the portfolio. </p><p>conclusion</p><p>Private equity is a resource-intensive asset class that re-quires specialist knowledge as well as sophisticated mod-</p><p>How to Build a Successful private equity portfolio 531</p><p>DOI: 10.1002/tie thunderbird international Business review Vol. 51, No. 6 November/December 2009</p><p>figure 6 fund and portfolio Benchmarking</p></li><li><p>532 spEciAL sEction on privAtE Equity</p><p>thunderbird international Business review Vol. 51, No. 6 November/December 2009</p><p>Katharina Lichtner is a managing director and heads research at Capital Dynamics. She has been instrumental in developing the investment and postinvestment monitoring skills of Capital Dynamics. She is a member of the board of directors of Capital Dynamics, as well as a member of the executive committee. She is also a member of the board of the ipev (international private equity and venture Capital valuation Guidelines), as one of the representatives of the european private equity &amp; venture Capital association. previously, she was a consultant at McKinsey &amp; Company. from 1992 through 1996, Lichtner worked in a research position at the Basel institute for immunology. She holds a phD in immunology and an MSc in molecular biology and biochemistry from the Biocenter Basel.</p></li></ul>