Private Equity Cash Flows and Performance Patterns

Private Equity Cash Flows and Performance PatternsBy Nik Morandi, Partner and Andrea Carnelli, Vice President

September 2014

in focus

2Private Equity Cash Flows and Performance Patterns

SUMMARY

In selecting a general partners (GP) latest fund and assessing whether the fund has the potential to be a top quartile performer, investors typically assess track record alongside more subjective elements, such as the purported strengths and experience of investment team members.

Pantheon has conducted a quantitative study to review whether there are characteristics of private equity funds, most of them cash flow-based, that certain quartile performers share in common. In particular, the study compared the patterns of cumulative calls, distributions, NAV uplifts and the J-curve in the first five years of a buyout funds life, and found that some of these signals were commonly shared by funds with top quartile performance versus bottom quartile performance1. Whilst it is not possible to predict future performance outcomes, our research has identified some statistically relevant factors that, although not deterministic, were associated with final fund quartile rankings.

The study highlights that funds that distributed or wrote-up portfolio company valuations more than their peers within the first few years from inception generally featured a substantially higher probability of ranking top quartile than bottom quartile. Conversely, a variable pace of capital deployment during the early years of a funds commitment period appears to carry no relevant or statistically significant information about future performance.

Monitoring certain data of private equity funds, including the pattern of cumulative calls, the amount of distributions, NAV uplifts and the depth of the J-curve, in the first few years of their investment cycles can help investors to actively manage portfolios, for example by retaining or increasing allocations to what the investors believe could be funds with the potential to perform well at the expense of positions indicating a higher probability of lower performance. In addition, judging that a general partners current fund is on track to be a top quartile performer, even when companies are immature and all capital is yet to be invested, may improve decision-making in secondary purchases of less mature portfolios. Finally, these datapoints can influence the due diligence process during subsequent fundraisings by the same GP2.

1 The methodology of the quantitative study is described in detail on page 6.2 Past performance is not indicative of future results. This material is not intended to be, and should not be perceived as, a belief that Panthe-on can project or predict potential fund or manager performance or potentially forecast investment results. This material is a quantitative study utilizing proprietary research into potential performance indicators that may further educate known, sophisticated private equity investors regarding active portfolio management.

KEY OBSERVATIONS

This study has found that funds that distributed more than their vintage peers during the first few years of their commitment period were more likely to be top quartile performers over the long term

High NAV uplifts relative to the vintage cohort also indicated a higher probability of future outperformance in the dataset

A deep J-curve, relative to vintage peers, signalled a significantly higher probability that a fund would end up bottom rather than top quartile

The level of cumulative calls appeared to carry no relevant information about future performance outcomes

3SEPTEMBER 2014

INTRODUCTION TO THE STUDY

This paper asks whether there are common characteristics among funds that have outperformed based on the analysis of cash flow patterns and other performance characteristics in the early stages of a funds life. This question finds no answer in academic literature3, which has mainly focused on the issue of performance persistence across funds managed by the same GP. There is clearly much to be gained from selecting top quartile funds, not least given the spread between top and bottom quartile performance (otherwise known as the inter-quartile range) in private equity: when looking at all private equity funds from 1979, the average IRR is 13.6% for upper quartile funds, but only -1.6% for lower quartile funds4.

In this study, Pantheon analyses cash flow and performance data from Preqin for vintages between 1992 and 20075. Performance is defined in terms of the common Total Value to Paid In (TVPI) return metric, but the results were also robust when using IRRs. (Please see the below section entitled Methodology for further details on the methodology and approach taken).

HIGH CALL RATE DID NOT SIGNAL OUTPERFORMANCE

Many investors take a higher-than-average rate of capital calls to be a hallmark of a confident general partner that is deploying capital from a new fund quickly and consistently because its investment team is finding a stream of attractive investments.

The findings do not support that hypothesis (see Figure 1 overleaf6). Our results showed that funds that called more than their peers (as a proportion of total fund size or aggregate commitments) in any given vintage did not have a higher probability of ranking top quartile. Indeed, funds that drew down a higher proportion of investor capital compared to vintage peers appeared more likely to end up in the bottom quartile. One explanation for any potential underperformance stemming from a high call rate is that GPs could tendentially increase the pace of investment when overall market conditions are more stable, when credit markets are at their most liquid and when confidence levels are rising exactly the sort of conditions often associated with a more expensive valuation environment. It is an area that merits further investigation, and Pantheon will be considering it in a coming study that looks at whether or not GPs investment and divestment patterns are generally pro-cyclical or anti-cyclical, and whether certain behavioural patterns can be identified.

With respect to the performance-related aspect of a GPs call rate, however, we were able to conclude that the call rate was not a reliable or meaningful indicator. The apparently higher probability of a high call rate fund ending up bottom rather than top quartile was not a statistically significant outcome.

3 See for instance: Harris, R.S., T. Jenkinson, S. N. Kaplan, and R. Stuecke. 2013. Has Persistence Persisted in Private Equity? Evidence from Buyout and Ven-ture Capital Funds. Darden Business School Working Paper No. 2304808. 4 Source: Thomson One and Bloomberg. All data to 30 September, 2013. Thomson Quartile data relates to all Private Equity across all regions from the Thom-son One database.5 Earlier vintages were excluded due to an insufficient number of available funds, while later vintages were excluded in order to ensure a sufficiently mature set of investments. Please see Methodology on page 6 for further information.6 Please see Methodology for an additional explanation on Figures 1 4.


HIGHER DISTRIBUTIONS AND NAV UPLIFTS SIGNALED OUTPERFORMANCE

Whilst the level of calls did not seem correlated to performance, the study indicates that distributions and uplift movements yielded more conclusive results. The study found that funds that distributed more than their vintage peers during a typical five-year commitment period were more likely to rank as top quartile in later years (see Figure 2). This effect is noticeable from the second year of a funds life, and is substantial and highly statistically significant by year five: funds that distributed more than their vintage peers (i.e. those that fall within the top 25% of their vintage cohort in terms of the level of distributions relative to total fund size), featured more than a 40% probability of eventually ranking top quartile.

Early distributions did not necessarily result from portfolio company exits during the early stages of a funds commitment period. These can also be generated through asset disposals of non-core operations, or refinancings where the GP increases the debt load on a particular asset in return for an equity distribution back to limited partners (commonly referred to as dividend recapitalizations). Taken together, these activities can be a reflection of a nimble GP, attuned to exit and credit market conditions, capable of taking advantage of attractive liquidity environments even in the very early stages of a fund. Irrespective of whether some of these distributions may be recallable by the GP for re-deployment into future investments, it could be argued that the link between GPs capable of acting in this manner and future fund outperformance seems intuitive.

Nevertheless, the results of our study did not simply corroborate what one might view as self-evident or tautological for three reasons, each suggesting that the relationship between high distributions and performance is mechanically not related. First, the analysis related final fund performance to early distributions: a fund that produced large distributions in the early stages did not necessarily keep up the pace as it matured. Second, the analysis employed TVPI as a performance metric, which did not overweight early distributions. Finally, this study concluded that funds that were top performers distributed the large part of their total distributions after the period that the relevant time frame measured.

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Please see "Methodology" for an explanation of Figure 1.

Figure 1: Cumulative Calls

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Figure 2: Cumulative Distributions

5SEPTEMBER 2014

In a similar vein, funds that wrote-up their assets more than their vintage peer group in their early years were more likely to go on to outperform. The results were apparent even earlier in the fund life than is the case for distributions. A fund that reported a high pace of valuation write-ups (in relative terms) in its first year was more likely to end up in the top quartile; by the second year, the relationship between the rate of NAV uplifts and final quartile ranking was very strong and highly statistically significant (see Figure 3).

It is worth noting that the study is based on fund vintages up until 2007, after which point the industry widely adopted FAS 157 fair valuation reporting. While it is impossible to say if different reporting standards would have influenced the findings of the study7 (this will become more apparent in the years to come), the shift did place an onus on GPs to record increased valuations more accurately and in a more timely fashion, thus improving overall clarity around company values.

Taken together, our research showed that a high rate of distributions and portfolio uplift can be signals of positive early momentum in funds. One view is that they can also be signs, or perhaps causes, of a positive mindset that can often be observed among certain GPs. In particular, one could suggest that early success and delivering capital back to investors can foster the confidence to take tougher decisions in later years, or assume more risk elsewhere in the portfolio with the objective of driving fund performance over the longer term.

In contrast, one can speculate that GPs that take early knocks to their portfolios or witness little early success may be inclined to hunker-down, and can lack the incentive or the confidence to make decisions and investments that could potentially lead to stronger performance in the long-run.

J-CURVE DEPTH AS A SIGNAL OF UNDERPERFORMANCE

Our study has so far demonstrated that the patterns of calls from the funds in the data set were not statistically significant to the future performance of a fund, but distributions (and the rate of valuation increases) could be. It is natural to ask whether a joint analysis of the combined impact of calls and distributions can provide some insight. The relationship between calls and distributions is reflected in the private equity J-curve the difference between the level of cumulative distributions and calls and how this relationship varies over time8. The study suggests that the deeper a funds J-curve (i.e. the more negative or less positive the net cash position of a fund at any given point in time), the lower the probability that the general partner was able to recover from this profile and generate

7 Our study included fund vintages between 1992 and 2007 but examined fund performance data up until 2013; as a result, the study included NAV informa-tion both pre and post the implementation of FAS 157.8 Note that for the purposes of our study, our definition of the J-curve only takes into account calls and distributions since we are seeking to isolate the net cash flow profile of a fund; we have therefore not included NAV in our J-curve definition.

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Figure 3: NAV Uplift Rate


eventual top quartile performance (see Figure 4 below). While the results were noticeable from year two of a funds life, by year three the effect on performance was marked and statistically significant. If an investors portfolio was still deep in J-curve territory by year five relative to vintage peers, this persistency was a very clear signal of potential underperformance in later years.

CONCLUSIONS

We believe the findings of the study have applications that can help investors both manage their primary portfolios and can help in the diligence of secondary investment opportunities.

The ability to analyze early cash flow and NAV uplift data can provide additional supporting information for an investor looking to manage out underperforming components of a private equity portfolio, and consider doing so at an earlier stage, before that underperformance is fully crystallized or becomes evident. Capital freed up in this way can then potentially be redeployed into other funds.

Analysis of current immature funds can also be invaluable when assessing new primary investments. The ability to evaluate patterns of calls, distributions and NAV uplifts of a GPs current fund can inform a decision when considering an investment in a subsequent fundraising.

The analysis of factors like calls, distributions, NAV uplifts and the depth of the J-curve during the early years of a funds term will not replace analysis of a GPs past performance, or assessments of the skills and stability of an investment team. But the results corroborate that they merit being considered by sophisticated private equity investors that want to improve fund and manager selection, and manage their portfolios more actively.

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Figure 4: J-Curve Depth

7SEPTEMBER 2014

METHODOLOGY

The data consisted of calls, distributions and interim valuations (NAV) for 322 US buyout funds (vintages: 1992-2007) based on fund performance data up to and including Q2 2013 as reported by Preqin. All data was standardized by fund size. We considered four types of performance metrics (described herein as cash flow or performance signals) at each fund age (years 1 to 5): level of cumulative calls, level of distributions, NAV uplift rate (average of value changes adjusted by lagged NAV), and depth of J-curve (total net cash flows, which is equal to cumulative distributions less cumulative calls). The relationship between cash flow patterns and final fund performance (TVPI) was investigated non-parametrically: we grouped funds based on their performance characteristics at a specific fund age, and then asked whether any group included a large number of top performing funds (based on TVPI). In order to ensure that results were comparable across vintages, we assigned fund quartiles for each performance metric. For each performance metric at each fund age (years 1 to 5), we calculated the distribution of performance across quartiles. In order to determine which performance metrics were statistically significant in our results, we tested the null hypothesis that performance is evenly distributed across quartiles via a Chi-squared test.

Figures 1 - 4 illustrate how the pattern of cash flows (and NAV) was tied to final fund performance at different stages of fund life (from year 1 to year 5). Blue and orange bars represent the probability that a fund ranked, by the end of its life or latest available data at Q2 2013, as top or bottom quartile, respectively. The performance metrics consist of top quartile cumulative calls (Figure 1), top quartile distributions (Figure 2), top quartile NAV uplift rate (Figure 3), and bottom quartile J-curve (Figure 4). Quartile classifications of cash flow and NAV signals are vintage-specific.


IMPORTANT DISCLOSURE

This publication has been prepared solely for illustration, educational and or discussion purposes only. Under no circumstances should the information contained herein be used or considered as an offer, inducement, invitation, solicitation or recommendation to buy or sell any security or financial instrument or to pursue any investment product or strategy or otherwise engage in any investment activity or as an expression of an opinion as to the present or future value or price of any such securities or instruments.

This publication may include forward-looking statements. All projections, forecasts or related statements or expressions of opinion are forward-looking statements. Although Pantheon believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to be correct, and such forward-looking statements should not be regarded as a guarantee, prediction or definitive statement of fact or probability. Pantheon has taken reasonable care to ensure that the information contained in this document is accurate at the date of publication. However, no warranty or guarantee (express or implied) is given by Pantheon as to the accuracy of the information in this document, and to the extent permitted by applicable law, Pantheon specifically disclaims any liability for errors, inaccuracies or omissions in this document and for any loss or damage resulting from its use. Unless stated otherwise, any opinions expressed herein are current as of the date hereof and are subject to change at any time. Unless stated otherwise all views expressed herein represent Pantheons opinion.

This document is distributed by Pantheon which is comprised of operating entities principally based in San Francisco, New York, London and Hong Kong. Pantheon Ventures Inc. and Pantheon Ventures (US) LP are registered as investment advisors with the U.S. Securities and Exchange Commission. Pantheon Ventures (UK) LLP is authorised and regulated by the Financial Conduct Authority (FCA) in the United Kingdom. Pantheon Ventures (HK) LLP is regulated by the Securities and Futures Commission in Hong Kong.

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Private Equity Cash Flows and Performance Patterns

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