Buyout performance: stage fright?

Does size matter? According to figures from Venture Economics, both in the US and Europe, mid-market buyout funds (under E1bn in assets) have outperformed larger buyout funds (over E1bn in assets) in both absolute performance and in the level of cash distributions back to investors. Also, since 1990 European buyout funds have outperformed US buyout funds. Why? Mainly because of the inefficiencies in European conglomerates that private equity players have been able to take advantage of and also because European buyout funds have traditionally used less leverage on buyout transactions than their US counterparts resulting in a better risk adjusted return profile of European buyout funds. But as always the key question for institutional investors is who the star buyout funds of tomorrow will be? Angela Sormani reports.

The 2003 preliminary performance figures for European buyout funds from Venture Economics indicate the downturn may finally be over, as the one-year horizon returns for European buyout funds improved from -3.2% to -1.8% over the preceding year. The gradual improvement in the IPO and M&A exit markets in the latter part of 2003 provided buyout funds with the opportunity to generate some distributions to limited partners, brightening the performance picture for investors after the past few difficult years. An improved liquidity in the public markets along with stabilization and improvement of portfolio company valuations in Q1 2004 also bodes well for future performance.

But one year performance figures are misleading. Private equity performance figures are only relevant over a period of ten years or more once the fund has started making realisations. Figures from Thomson Venture Economics for private equity funds formed between 1980 and 2003 show net IRRs to investors demonstrate a marked increase over a ten year period from -1.8% over one year, 0.5% over three years, 9.3% over five years and 12.5% over ten years.

Performance figures for the UK private equity industry tell a similar story. The UK private equity industry continues to perform robustly and outperforms all comparable asset classes over the medium to long term. The British Venture Capital Association’s Performance Measurement Survey shows UK private equity outperforming UK pension funds’ assets and all FTSE Indices over three, five and ten year periods.

The survey reveals net returns raised by private equity measured an impressive 12.3% during 2003; 2.6% over three years;10.2% over five years and 14.2% over a ten year period. The strongest performance of the UK private equity fund categories came from generalist and large MBO funds, which were the best performers in 2003 and over five and ten years.

But contrary to popular belief, an investment in private equity does not always mean performance will be impaired over the first three to five years, says Tycho Sneyers of LGT Capital Partners. A professionally-managed private equity programme with a significant allocation to secondary transactions can generate significant distributions in the first two to three years of a diversified portfolio. However, the limited liquidity in private equity still requires a long term investment horizon.

In private equity there is a significant performance gap between top and bottom quartile funds. While top quartile fund managers can achieve over 30% returns per annum, lower quartile managers may not even return the invested capital. This, says Sneyers, is primarily due to the wide differences in private equity fund manager experiences, breadth of networks to source the best investment opportunities, operational and financial value creation during the holding period and successful execution of a selective sales process in an inefficient market.

A fair assessment

Christophe Rouvinez of Capital Dynamics says: “Performance assessment is still challenging as many funds only report company valuations with little information about company specifics. The buyout sector is continually evolving and buyouts in Europe will require a lot of work even from skilled GPs in order to extract optimum performance from funds.”

Most GPs believe fund reporting is transparent enough and that further publicity of fund performance information would impact on the longer term focus of private equity investing. And some institutional investors experienced in the private equity asset class believe continual rating of private equity funds is not possible due to the long term nature of investments. In addition, the concept of fair value investment valuation for portfolio reviews is seen by the majority of institutional investors as an easily manipulated figure and therefore not satisfactory.

David Martin of Granville Baird Capital Partners, a prominent mid-market player, says: “We report quarterly and value half yearly as valuation is more an art than a science. Investors can be a little sceptical about valuations given that a high valuation will create more praise than low valuations. In the end the truth is in the cash realized and valuations are unreliable signposts. Our two recent portfolio company ( and Alukon) sales provided returns well in excess of our valuations as we like to be prudent. That is a reason for giving more information about the trading of portfolio companies in terms of sales and profits, and non financial key performance factors. Then investors can make their own judgment if they want to.”

The main issue in performance reporting is you never know how well a fund is going to perform until most of it has been invested, so the only way to mask returns is to put in valuations. But you can’t reveal the true performance of a fund until the exits start manifesting themselves. Once exits start happening it may be that a seemingly poor-performing fund will then have its performance boosted by a single exit.

But the main drawback in private equity is that the problem investments surface more immediately than the good ones, creating the inevitable effect of the J-curve, the early years of a fund’s life which produce negative returns. Mike Fell of Granville Baird Capital Partners says: “The problem with performance in this industry is that no one wants to provide figures to the marketplace. If you’re going out to fund raise, no one is going to admit their current fund isn’t performing well.”

Anthony Romanello of Venture Economics addresses this problem: “Realizations are great for window-dressing purposes. To a certain extent, exit activity by buyout groups is linked to the fund raising cycle as they try, as much as the market environment allows, to time liquidity events to coincide with their next-fund pre-marketing efforts.” A recent example he cites is MidOcean Partners, which is thought to be gearing up to raise a new fund and has demonstrated a flurry of portfolio company sales in the last year.

The key differences in performance, according to Christophe Rouvinez, is noted with the managers. It’s those managers with the track records that are expected to outperform. “As far as due diligence is concerned you don’t only look at the overall track record of the GPs and the performance of the individual funds compared to its peers, but also at the individual performance of companies within predecessor funds. It is important to verify that performance is due to a consistent tangible skill rather than a lucky home run,” says Rouvinez. He adds: “You want to be sure they have a strategy and the reason they have a higher return is because they followed their strategy and not just because of a single star performer in their portfolio. You have to look for consistency.”

Shahin Shojai, director of strategic research at Capco, asks how a private equity firm is able to discriminate between those MBO targets that fail and those that succeed?

He uses public-to-private transactions as an example and says that many of these transactions that fail do not underperform their industrial peers prior to being bought out, they are simply over-priced by the bidders. It is those management teams that win the bid at a high price who are faced with the winner’s curse. Many managers may overestimate their ability in bringing about substantial improvements within the management of the target and so fail to meet investors’ expectations.

Shojai concludes that if the main goal of a GP is to rectify managerial inefficiencies, the most suitable targets should be those that are underperforming their peers since they possess the greatest potential for improvement.

Where to invest?

According to the Goldman Sachs/Russell Alternative Investing Report 2003 private equity is on the radar screens of most European institutional investors with an estimated 58% of European pension funds participating in the asset class. The average strategic allocation of continental European and UK pension funds to private equity is 4.2% and 3.6% respectively. This is still significantly lower than the average strategic allocation of US pension funds to private equity of 7.5%.

Where can an investor expect to see the best buyout performance? The European market has outperformed the US over the last ten years, according to figures from Venture Economics. In Europe funds under €1bn with vintage years between 1990-1999 achieved a net IRR of 16.9% as of June 30, 2003. This was significantly higher than US funds in the same category and period, which achieved an IRR of 9%. With funds above €1bn, the differences between Europe and the US are less marked, but Europe has still achieved better returns.

Tycho Sneyers says: “In Europe there are still a lot of large conglomerate structures that are in the process of selling parts of their business to focus their business strategy on areas in which they have a clear competitive advantage and that process is lucrative for private equity houses and has created many opportunities. US companies have on average a much narrower business focus.”

James Pitt, managing director Axa Private Equity, adds: “There’s a good correlation between an increased volume in fund raising and a subsequent decline in returns. This is demonstrated by the increase in US buyout fund raising in the late 1980s and the subsequent decline in overall US buyout returns in the 1990s. Europe experienced the start of its buyout fund raising boom in the mid 1990s and, so, drawing conclusions from the US experience, we will probably see a broadly similar decline in overall European buyout returns this decade.”

Another issue relating to buyout performance is the mid-market versus mega fund debate. Views are mixed here. Figures from Venture Economics support the fact that buyout funds under €1bn have outperformed those buyout funds with over €1bn to invest. From a sample of European buyout funds with vintage years of between 1990 and 1999 the pooled average net IRR from a sample size of 163 funds was 16.9%. For those funds above €1bn the pooled average net IRR from a sample size of 14 was 6.4%.

Small versus large buyouts, asks Sneyers. “Smaller buyouts have on average performed better, both in Europe and the US. Mainly because there are more inefficiencies in the sales process [in the mid-market]. Full-blown auctions are rare and that allows buyout funds to buy companies cheaper. Companies at the smaller end of the market are often also less professionally managed or might need help with international expansion, areas in which private equity funds can add a lot of value.”

The reasoning seems clear. There are more opportunities for a private equity firm to add value at the smaller end of the buyout market. Chris Ward of Deloitte & Touche says: “The big debate at the moment is whether there are better opportunities to add value in the middle market as it is very much the area where private equity firms have the opportunity to influence management and bring a certain amount of strategic discipline to a business. The question is will this translate into better returns?”

He uses Graphite Capital’s pending flotation of Wagamama as an example. If the group gets its flotation price it will be significantly higher than what was originally paid for the business and that will mean an impressive return for Graphite Capital.

But both the mid-market and mega arena are attractive to institutional investors, says Anthony Romanello, director of investor services for Venture Economics. It is just a different approach that needs to be taken with both. “There are differences in the sense that in the mega fund arena there’s a great deal of manager selection risk. There can be tremendous returns for LPs in that sector as long as they exercise extraordinary care in selecting fund managers.”

The problem, he says is that there are not as many funds over the €1bn bracket in the market and so competition for the top performers is high. The Venture Economics data used in this article is proof of this with a sample size of 163 funds below €1bn compared to 14 funds in the above €1bn bracket.

He explains the attractions of mid-market funds and why the performance of these funds may outshine that of the mega funds. “In the mid-market area it’s less of an auction environment and so there are a lot more deals under the radar. A lot of the transactions are sourced by the GP and often there are no other GPs that know about the transactions so they are able to get the company at a low price.” This sort of proprietary deal flow is invaluable. And it is because the mid-market is less of an auction environment that the returns can be exceptional. So for this reason in the mid-market there isn’t as much pressure on selecting the top fund managers as there is in the mega fund arena.

In the US, the demand for mid-market European funds is strong. Chris Ward says: “Many LPs, especially in the US are keen to get exposure to the European mid-market because at the larger end it is very difficult to add value purely by playing the arbitrage game. The problem LPs have is finding the really outstanding mid-market private equity fund managers.”

He adds: “There is a lot of attention on the mid-market, but it will be a few years before anything definitive comes out in terms of performance figures to prove this area performs as well as the mega funds have in recent years.”

Stefan Hepp of SCM Strategic Capital Management agrees that there will always be conflicting views on the mega versus mid-market buyout fund performance issue. He questions whether an investor should demand higher returns from mid-market funds compared to large buyout funds. “Company statistics suggest that there is a higher rate of failure among smaller firms compared to larger ones and banks seem to be less keen to provide debt to the smaller deals. Both indicators can be interpreted to suggest higher risk that would command a higher return expectation.”

He adds that there is an assumption among investors that the mid-market funds are out-performing the mega funds at the moment, but this is not necessarily true. He says: “If you look at realisation activity the last two years have been characterised by larger realisations rather than smaller realisations and by this you would expect the larger funds to be outperforming.” This, he says, may just be a timing issue – it may be easier to sell a group such as Homebase than some mid-market car supplier at the moment.

Another complication is if you are looking back over a ten-year time frame, it is difficult to differentiate between a mid-market firm and a fund targeting the mega deals, says Hepp. Firms such as Candover and Permira for example were propelled into the big buyout league by track records that were generated through returns made in the mid-market.

Hepp says: “Size classifications change over time. How do you define the market across Europe? It is impossible. If you look at the Spanish mid-market and the UK mid-market, the size classifications are quite different. A larger deal in Spain would be an average mid-market deal in the UK. Some of the most successful track records in transactions that would today qualify as mid-market deals have been accomplished by the very firms that now focus on larger transactions. To use their investment history as a basis to allocate money to the mid-market somewhat misses the point as they are not doing many deals in the mid-market anymore. So what investors are really asking is not whether mid-market performance is better, but whether they should be giving the mid-market funds more money?”

Also where is the best place for mid-market buyout funds to generate their returns, asks Hepp? Is it in Spain or Italy or is it in the more mature markets such as the UK, France and Germany? Hepp recommends looking at how the likes of Candover, Cinven and Permira generated their returns in the mid-market and therein may lie the answer. He concludes: “The practical question for investors is whether firms such as Quadriga, Graphite, Mercapital, Granville Baird and CapVis, to mention just a few well-known players, outperform the funds of Permira, Candover or Cinven?”

The objective of private equity is to create an asset class which produces better returns than in bonds and the stock markets and by and large over the years the UK private equity market has certainly lived up those expectations. At the end of the day the proof of the pudding is in the cash. Investors want to see the returns. The internal rate of return of a fund is less of an importance to investors than how many times they get their money back. A good fund manager is supposed to return between 2.5 and three times their original investment. And so the main priority for an institutional investor is to select a fund that will meet those criteria and deliver those returns.