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Investing in private equity: the pros and cons Back  
Frank Kenny says that despite the bursting of the dot.com bubble, above average returns can be still be attained by investing in private equity, even in the early stage technology sector.
Given the bursting of the internet bubble over the past eighteen months it seems likely that the returns generated by many of the 1999/2000 vintage venture capital funds will be poor.
In such circumstances, why should an institutional investor allocate capital to private equity, and more particularly why the early stage technology sector?
In answering the above we need to consider the factors in play in any asset allocation decision, the equity risk premium and the time horizon of the investor.
Pension funds have long embraced the concept of high returns for high risk, with the majority committing around 70 per cent of their assets to public equities. They accept that while returns in any given year can be poor, over the longer term equities have consistently outperformed debt.
The main case made for investing in private equity is similarly that, over the longer term, the returns will be high enough to justify the risk.
So what are the levels of return generated by venture capital funds and how volatile or risky are they? While data on the actual returns provided by venture capital can be difficult to access, some information has emerged into the public domain.
In May 2001 the California Public Employees Retirement System (CalPERS) published on their internet site a list of the IRR’s generated on all venture capital funds it had invested in over the previous decadei. Overall they had seen a 17.0 per cent IRR from their programme as at March 2001, having invested a total of $13.5 billion of commitments in 169 limited partnerships. They experienced a wide divergence of results across the range of funds they invested in from -83.6 per cent at the low end to 109.9 per cent at the top. In monitoring the individual funds they tended, with a few exceptions, to classify any fund returning between 15 per cent and 25 per cent per annum as ‘meeting expectations’. Other information published on CalPERS site at the time indicated that their investment advisers expected the long-term return from the private equity asset class to be 13.5 per cent per annum.

A study by Ibbotson Research provided further insightii. To get around the problem of valuation bias in funds that were not yet fully liquidated, they studied only that subsection of venture funds which had completed the full cycle and which had been fully liquidated. They found almost no correlation between the timing of returns from fully liquidated venture capital funds and public equity.
This would make venture capital a suitable asset class for portfolio diversification enabling an investment manager to lessen the risk profile of his equity fund while maintaining the overall long-term return. The Ibbotson study argued for a weighting of between 2 and 9 per cent in an all-equity portfolio.
If some investment in venture capital as an asset class makes sense, the question remains as to whether, given the collapse in technology valuations of the past year, it still makes sense to invest in early stage technology.
There is no doubt that valuations were driven up to excessive levels in 1999 and 2000 as investors began to see the internet as a new business paradigm and a one-way bet. Some of this was driven by a high level of investment in early stage technology by private individuals and some by venture capital firms riding increasing valuations and short cycles from investment to exit. Now that expectations have returned to more ‘normal’ levels there is real value to be found in interesting deals and the ability of the venture capitalist to deliver a 10 X return on any individual deal has probably increased.
The venture capitalist, especially if playing in the early stage technology space, may be the ultimate ‘stock picker’. For every 100 business plans across his desk, he seeks to use his knowledge and skill in an imperfect market to pick those gems that will deliver a vastly superior return. If he finds a 10 X return in one in five investments he will deliver a good return for his investors. It is not surprising that in such an environment the variation on returns between different managers can be substantial. It is an area where experience counts and the ability to access a network of contacts and apply the lessons learned from previous similar companies can make the difference between success and failure in the early fragile years of a company’s life.

Implementing a private equity investment programme
It is clear that private equity as an asset class differs greatly from either public equity or debt. Once a decision is made to commit to a particular fund an investor has little control over liquidity. The general partner will determine when cash is drawn down, with subsequent returns being dependent on a trade sale or flotation. Although there are secondary markets for private equity, it is essentially an asset class that cannot be traded. You cannot be ‘in’ one moment and ‘out’ the next. So implementing a private equity programme requires careful thought and a planned approach as mistakes are not easily or quickly rectified.
Most venture capital funds are established with a life of ten years. In general they will draw down the greater part of their capital in the first half of the lifetime of the fund and make returns to investors from year four on. Because some returns will typically flow before all capital has been drawn down, an investor who commits a certain amount to the asset class will find that their total exposure to the class rarely reaches the level of their commitments. Co-operative Insurance (CIS) recently presented their experience of private equity investingiii. They described attempts at hitting a certain level of asset allocation as a bit like running uphill. So a manager may need to over-commit to reach his target asset allocation for the class.
Experienced investors also find that if they commit to a programme of investment over an extended period, across a number of different funds, the programme can become self financing, with cash flow from distributions equalling or exceeding amounts needed to meet capital calls in the newer funds.
Again CIS reported that their programme had become self-financing and they presented a model which illustrated how, at a 15 per cent IRR, a programme with consistent new commitments each year will become cash flow positive by year nine.
Perhaps the most important maxim is to allocate to the asset class over a period of time. Funds tend to be benchmarked against each other based on the year in which they were raised, their ‘vintage’ year. Much like wine, there are good years and bad years, as market forces and economic cycles play their part in entry and exit conditions. A manager would be wise to seek to reach a targeted asset allocation over an extended period to gain exposure to a full cycle.

Choosing a manager
Lastly it is important to choose only capable and experienced venture capital managers, who have experience of investing and exiting in good times and bad. In an asset class with a wide variation of results around the mean, accessing the top quartile of funds will be of crucial importance in meeting or exceeding your return expectations.

i Published papers for presentation at CalPERS Investment Committee meeting, May 2001.
ii Venture Capital and its Role in Strategic Asset Allocation, P Cheng, G Baierl, and P Kaplan, Ibbotson Research, June 2001.
iii Why Private Equity? Richard Hotchkis, Senior Investment Manager, CIS. 25 February 2002 AltAssets.net

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