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Transparency: can you handle it?

Transparency is a guaranteed talking point as far as the private equity industry is concerned. Until summer last year, the annual performance figures published by the National Venture Capital Association (NVCA) and the European Venture Capital & Private Equity Association (EVCA) were about as transparent as you were likely to get. And they are limited to offering aggregated fund performance rather than a break down of individual funds. Then, on its website, CalPERS, the State of California’s employee pension fund, published the IRRs of all the private equity funds it had ever invested in. The furore was swift and shortly afterwards the list disappeared from view. Just over a year later the debate has been re-ignited, again in the US. Lisa Bushrod reports.

That’s not to say the debate hasn’t been ongoing in the interim: on the contrary. Both the British Venture Capital Association (BVCA) and EVCA, in Europe, have made great strides toward improving the transparency of their universes and many of the smaller continental European associations are following suit. Transparency is, after all, often the quid-pro-quo when lobbying for legal and regulatory changes to promote private equity activity at a national level and indeed at the EU.

The touch paper this time was that several press and other sources had approached large US-based institutional investors and asked them to reveal the performance of the private equity funds in which they had invested. University of Texas Investment Management Company (UTIMCO) was first and it initially declined but under pressure in mid-September the board voted to comply. By end of October the word on the performance of UTIMCO’s private equity funds was out.

The press and others had put pressure on UTIMCO to reveal on the basis of the State of Texas’ Freedom of Information Act. Europe doesn’t have anything like this on its statue books so in one sense the issue would be unlikely to arise here but there is more to it than that.

“In the US there is nervousness about what happened in the public markets: for example, Enron was at $90 a share and that turned out to be an illusory value driven by unreliable accounting. Private equity does not have those issues because it is a totally different market. It has different corporate governance dynamics. Both the portfolio company and private equity funds managers have to invest their own funds, whereas in the public markets the managers get stock options,” explains Ivan Vercoutere at LGT Capital Partners.

Perhaps the most interesting thing about the UTIMCO disclosures (see table opposite which has been edited to include funds with a serious, rather than opportunistic, European investment focus) is that they have proved one side of the transparency debate right. That argument being that interim IRRs are neither particularly useful nor are they likely to complete a potential investors’ understanding of a fund manager, or for that matter a particular fund.

Vercoutere explains: “The whole issue is time frames, the timing of cash flows as well as the valuation methodologies applied. There is not a lot of information about these two critical elements: are the valuations within a tight range or widely dispersed? In UTIMCO’s case, it is highly unlikely that two firms have applied the same valuations methodology. That being said, cash in, cash out is the only thing that cannot be argued against.”

If you fall in with Vercoutere’s view of the limitations of interim IRRs of a private equity fund it’s harder to digest the arbitrage argument espoused by so many institutional investors. Their view is that with greater transparency their ability to benefit from arbitrage would be eroded. This argument looks stuck in a rut. Financial health warnings constantly serve to remind that past performance is not necessarily a guide to future performance, in which case surely the arbitrage doesn’t come from the fact of transparency, but rather how the information resulting from that transparency is interpreted and put to use in the context of present challenges in the market?

If this is true then transparency isn’t the end game. But it is an important part of private equity’s journey to becoming an internationally-recognised mainstream asset class.

Interestingly the European Investment Fund, one of Europe’s biggest institutional investors last year and this, is planning to publish detailed information on its investments next year. “For the time being we do not disclose the performance of funds, except if they are very good, nor do we disclose the performance of investee companies. We are reviewing this but we need to finalise our information system. The idea is to disclose information on the average performance of our investments in 2003; average returns per country, per stage and so on,” says Marc Schublin at the European Investment Fund (EIF).

EIF has in part gained its position as one of the largest institutional investors in Europe due to it deploying a large amount of money during 2001 and this year when the bottom has otherwise well and truly fallen out of the private equity fund raising market. This is partly the fault of poor private equity performance but it is as much a result of the weight of the problems being experienced in the more traditional asset classes meaning investors are seeking to put their house in order, especially with Basle II looming up ahead.

As for resistance of fund managers Schublin shrewdly notes that fund raising is a point of survival for the private equity industry, as such, if managers want funds they will have to take them on the rules and transparency terms offered. The EIF intends to publish a regular account of the performance of its private equity investing activities simply because it is useful rather than having come under pressure to do so, says Schublin.

Words of caution are offered. “It’s okay to have some disclosure like [UTIMCO], although a lot of GPs are not too pleased about it. The interpretation of the data is an issue. Additionally disclosure should not go beyond the fund level because then it’s damaging to the industry. That could potentially destroy the industry because it goes to core of the strategic focus of a private equity group. It would be like IBM having to disclose its acquisition strategy,” says Vercoutere.

Jeremy Golding, of Golding Capital Partners, agrees: “There is a big range between manic secrecy or manic opaqueness and perfect transparency and the industry has to find a reasonable compromise. The industry is treading along the path of needing more transparency but it needs to safeguard commercial interests.”

Transparency, if it were to come about, could be a good thing. To have a breakdown of the performance of every fund by vintage year should improve the reliability of data as the number of fund managers providing input grows. One of the accusations always levelled at performance figures is that only the best funds respond and so consequently the figures are skewed in the private equity industry’s favour rather than that of the investor. Until Europe follows the US lead and publishes the names of the private equity funds included in these annual surveys that’s an accusation that’s hard to convincingly lay to rest and even then it won’t disappear entirely. Many of the respondents are in fact institutional investors so they have little to gain from inflating figures.

This is the industry, after all, in which everyone claims to be in the top quartile of performers. Not for any other reason than if your fund isn’t in the top quartile institutional investors may as well have stuck with the bond markets and placed their riskier bets elsewhere.

For their part private equity fund mangers often hide behind the J-curve excuse worried that when potential future investors see minus figures they will close the door for good.

Others pooh-pooh this argument pointing out that institutional investors should be given a bit more credit. Time may, or may not, tell.