It’s All About Cash-On-Cash Returns

This asset class has a kimono made of lead.For the first five years a private equity fund’s performance is obscured by the J-curve effect, in which fees and the slow drawdown of capital render return figures meaningless. In the years after that, sponsors produce interim performance numbers.

Still, a big question mark hovers over the value of unrealized investments, since an arms-length transaction such as a sale to a third party is required to attach an incontrovertible value to a deal. Only after a portfolio is fully realized can we conclusively pinpoint how the fund performed.

By extension, we can’t really judge how the industry has performed as a whole until we have a sufficient sample of fully realized funds. I’m not convinced we quite have that, given the industry’s relatively short history. But early returns are encouraging—even taking into account the insane levels of debt (by today’s standards) buyout practitioners piled on companies in the 1980s, super-sizing their returns.

For this exercise I dove into the Buyouts Magazine database of 518 domestic buyout/corporate finance funds compiled last fall. Most of the data for the funds, including vintages up to 2006, was current as of March 31, 2011. Of those 518 domestic buyout funds, 66 appear to be fully realized, with known vintages ranging from 1981 to 2003. (For more on our methodology see the November 14 edition of Buyouts.)

The performance of domestic buyout funds that look to be fully realized (because the value of holdings is listed as zero in our database) is impressive. The median IRR is 15.6 percent, compared with 9.9 percent for the entire sample of domestic buyout funds. The median top-quartile demarcation for the fully realized sample is 25.1 percent, higher than the 18.8 percent comparable figure for the whole sample; the bottom-quartile demarcation is 6.1 percent, higher than 3.2 percent for the entire sample.

You find a similar story when you look at investment multiples for the 61 fully realized funds that provided them. The median investment multiple is 2.1x, top quartile 3.1x and bottom quartile 1.5x, far better than the 1.5x median, 1.9x top quartile and 1.1x bottom quartile marks achieved by the database as a whole.

What accounts for the superior performance of the fully realized funds? It would probably take the labor of a team of academic researchers to uncover the full truth. Two big factors are no doubt the higher leverage multiples and less competition for deals enjoyed by early practitioners in the asset class. A third factor could also be at play—a bias by today’s sponsors toward placing conservative valuations on unrealized investments.

The private equity industry has an obligation to provide fair and honest interim valuations to its investors (just ask anyone at the Securities and Exchange Commission). But, having so far failed to definitively prove it delivers returns superior to public markets, sponsors may secretly be hoping for bigger-than-expected windfalls at exit time.