By Prof. O. Gottschalg, HEC School of Management, Paris

Professor Oliver Gottschalg is speaking at this year’s SuperReturn U.S. event in Boston (5-8 June). He will be presenting new research on ‘Fundraising Performance – Insight Into New Approaches & Methods To Highlight True Outperformance & Help GPs Demonstrate Effectively & Objectively Their Strengths To LPs’. He has kindly shared this piece with us, given the great interest in fundraising-related topics and thought that the focus on advanced ways to achieve efficiencies in the fundraising process may be of interest to attendees and readers alike.

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As much as fundraising is far from easy for most GPs these days,  separating the real ‘outperformers’ from the ‘pretenders’ is one of the greatest challenges for LPs against a current backdrop of over 1,000 GPs looking to raise funds… In theory, an in-depth quantitative analysis of each GP’s track record could be useful in providing powerful guidance as to which group merits further commitments. But such a task is complicated in a world in which 75% of all GPs can claim ‘Top Quartile’ status for their funds as long as they exploit the available flexibility in defining both the vintage year and the relevant benchmark provider. Key performance metrics used are also open to question while the abundance of competing methods to calculate fundamental performance attributes in private equity (PE) may well lead to substantially different results. All these factors contribute to jokes favoured by placement agents that there are probably as many ways to calculate a ‘value driver bridge’ as there are GPs across the globe. (Footnotes to Top Quartile Study and IRR piece by Dr Oliver Gottschalg : http://www.peracs.com/report/Top%20Quartile.pdf and http://peracs.com/report/PERACS%20Research%20Brief%20April%202012.pdf)

A priori it is next to impossible for an LP to know if the method a particular GP has chosen is both an acceptable choice and well-suited to assess a  given track record or whether the choice of methodologies has been driven by a desire to present favourable data. Hence LPs have to spend enormous amounts of time trying to understand each method they come across, assess its relevance and redo their own analyses in order to achieve comparability across GPs. Many LPs simply do not have the resources to do all of this for 1,000 funds this year. For their part, GPs are constantly required to explain and defend their chosen method against the scepticism of their LPs.  All of this absorbs much of the available bandwidth between GPs and LPs, which could more effectively be used to discuss strategies to create future value.

It is clear that the establishment of superior quality standardized methods and benchmarks that are generally applicable and commonly understood would drive enormous benefits to the entire PE industry and to LPs in particular. Specialized advisory firm PERACS has recently launched a complementary analytics service providing conflict-free advanced and standardized track record analytics and certification services to GPs and LPs alike.

Drawing on a combination of decades of practical PE investment experience and over 10 years of leading academic research on PE performance measurement and benchmarking, PERACS has created five powerful metrics that capture key aspects of a GP’s absolute and relative performance, value drivers, strategic differentiators and risk attributes. The analyses are performed in several ways, including a comparison of gross and net returns, analyses at the deal-level, fund-level and portfolio-level, as well as with sensitivity checks regarding the NAVS of unrealized investments. All metrics are derived based on detailed information about a given GP and selectively draw on available benchmark data on comparable private equity and public market investments.

Performance, Value Drivers, Strategic Differentiators and Risk Attributes at a glance

METRIC 1:  The PERACS ALPHA

Using the PERACS  Rate of Return (PRR), a powerful performance measure that avoids the possible biases of standard IRR, we draw on leading academic research (see Acharya, Gottschalg et al. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1324016), it is possible to isolate the part of performance that is not attributable to broad market trends and quantify to what extent this outperformance is attribute to financial leverage, sector choices or operational outperformance, using a performance measure that avoids possible biases of standard IRR.

METRIC 2: The PERACS Relevant Competitor Benchmark

Moving away from the imprecise use of the ‘vintage year’ as the basis of benchmarking within PE, more accurate benchmarking can be performed against the empirically derived ‘relevant competitors’ for each PE Firm and fund. The basis for this benchmarking is the analysis of the characteristics of each fund’s underlying investments and the comparison of these with the investment choices of other PE funds.

This assessment of the degree of ‘competitive overlap’ between different PE funds makes it possible to (a) identify those funds that overlap with the a given GP’s funds in a significant way (the ‘relevant peers’) and (b) to benchmark that GP’s performance against the aggregate performance of those relevant competitors, using the degree of competitive overlap between different funds as the ‘weighting’ in the performance aggregation for the calculation of this ‘Relevant Competitor Benchmark’. This benchmark has been shown to be substantially more accurate and precise than the traditional vintage-year based benchmarking and more objective than a comparison with a set of peers that are self-selected by a GP.

METRIC 3: The PERACS Value Driver Bridge

A refinement of the widely used Value-Driver (or Value Attribution) analysis can break performance down into a component based on annualised performance measures which avoid the possible biases of IRR. It distinguished between revenue-based, margin-based, multiple-based, FX- based and deleverage-based components. In addition benchmarking within each of the value drivers can provide additional insights. This can reveal, for example, not only how much of absolute performance was due to revenue growth, but how much of a deal’s (or fund’s) outperformance over public market investments may be attributable  to the fact that a GP’s portfolio companies were able to consistently outperform public market companies over the relevant time period. The latter analysis also offers detailed and objective insights into the status and the value appreciation of unrealized investments relative to their industry peers.

METRIC 4: Identifying Strategic Distinctiveness

Leveraging the methodology behind the DowJones PE Rankings, it is possible to quantify key aspects of the empirically-validated strategic performance drivers of a GP. This includes the degree to which investments distinctly differ in terms of timing, size, geography, and industry from mainstream PE investments, evidence of stable and proprietary deal flow and consistency in investment strategy.

METRIC 5: The PERACS Risk Curve

Based on a detailed analysis of the return distribution of the deals in a PE Firm’s portfolio, it is possible to calculate an innovative measure of risk of PE portfolios that graphically illustrates the return distribution and expresses it in one simple figure, including the option to graphically and quantitatively benchmark a fund’s risk profile against other PE funds.

To ensure full transparency and guarantee objectivity, all such metrics have to be fully formulaic, exhaustively documented and deterministic.  They use given data provided by a client including the industry classification for each investment, NAVs of the unrealized portfolio and key accounting information (Revenues, EBITDA and Capital structure) for the time of entry and exit of each deal. As such, the results do not depend on any subjective assessment.

PERACS, together with HEC Paris will, in the next few months, publish a joint research report on the innovative risk and return characteristics of the PE asset class, leveraging the richness of the HEC Buyout database (with 18,000 individual PE investments worldwide, including detailed cash flows and deal characteristics) and the IP behind the PERACS Independent Track Record Analytics and Certification metrics.

In addition to the enormous efficiency gains in GP-LP information exchange thanks to the standardization of relevant metrics, standardized independent quantitative analytics bring tangible advantages to all parties of the PE industry:

• GPs provide ready-made advanced analytics to LPs, who will be able to consider them early on in the due diligence process, independent of the availability of in-house resources to perform such analytics, which increases efficiency in their fund selection process
• LPs are able to buttress and support documentation for investment recommendations
• The use of such metrics is consisting with ILPA Principles on Alignment, Governance and Performance Reporting Transparency
• LPs and GPs can use standardized independent quantitative analytics both for internal assessment of the quality of different parts of their portfolio, as well as for external communication about the risk and return of their portfolios
• LPs and GPs receive authoritative back up of marketing statements acceptable to regulators
• Standardized independent quantitative analytics enable users to (a) identify portfolio trends based on quarterly updates, (b) perform what-if analyses on how actions impact the reported statistics, (c) slice/dice and tailor portfolio to exclude obsolete sectors/geographies/departed professionals etc. and (d) provide data driven explanation of performance variation across portfolio.

Finally, and perhaps most significantly, the application of standardized advanced analytics to assess the calibre of fund managers will raise the bar in terms of the overall sophistication of this asset class. In doing so, it will be helping to build the case for private equity in the current political debate about its merits and the need to make it more attractive to outside investors.

As was mentioned recently by a senior partner at a leading GP:  “Today there is currently about 50 times more investable money available outside PE than is invested in PE. Everything the industry does to advance the level of analytics in Private Equity will be helpful to improve that ratio going forward.”

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