Headline numbers from the latest UK venture fund performance survey showed that these vehicles significantly outperformed UK pension fund assets over one, three, five and ten years. Venture funds also outperformed the FTSE All-Share Index and FTSE 100 Index over three and five years, according to the 1997 Performance Measurement Survey undertaken by the British Venture Capital Association (BVCA) in conjunction with performance measurement specialists WM Company and Crossroads Management (UK).
The 14.6% pooled IRR for venture funds over ten years compares with an increase of 13.3% in pension fund assets and a 15.7% increase in the FTSE All-Share Index. Over five years, the margin of outperformance is considerably greater: venture capital returned a pooled 29.3% IRR, compared with 13.7% from UK pension fund assets; 17.2% from the FTSE; and 16.6% from the FTSE All-Share Index. Comparison over three years also sees venture capital outstripping these benchmarks by a healthy margin. The pooled venture capital three-year return is 29.6%, compared with 15.5% for pension funds, 23.7% for the FTSE 100 and 21.3% for the FTSE All-Share Index.
The pooled one-year return for venture funds in 1997 was 21%, a dramatic decrease from the 42.9% achieved in 1996. However, one-year figures are notably volatile and can be strongly affected by a few very large realisations, as was the case in 1996. The exit climate in general was less benevolent in 1997 than in the previous year: although the stock market soared, increase in share prices was driven largely by enthusiasm for larger companies – particularly financial groups – rather than for small-cap stocks. To judge private equity as an asset class on the basis of one-year returns is as misleading as it is perverse.
By the end of 1997, funds raised between 1980 and 1993 had returned 142% of paid-in capital, while 33% of their original investment remained unrealised.
Last year alone, these funds returned more than GBP1 billion, or 29% of their paid-in capital, to investors.
Measured since inception, all categories of funds showed improved performance over time except large MBO funds, which nevertheless emerged again as the best long-term performers in this year’s survey.
Large MBOs Still Head the Field
Large MBO funds returned 25.4% per annum measured to December 1996, falling to 19.7% per annum to December 1997. WM attributes this decline largely to enhanced sample coverage in this year’s survey; the figure will also have been influenced by the substantial fall in one-year returns for large MBO funds recorded in 1997 after 1996’s atypically high figure, which was considerably beefed up by rapid exits from the rolling stock operating company privatisations.
Although their one-year returns dropped to 20.6% in 1997 from 56% in 1996, large buyout funds consistently outperformed the principal comparators over three, five and ten years. Measured since inception, larger MBO funds also produced the widest range of returns – between 35.6% and 7.2%, excluding the upper and lower deciles.
In the future, as a natural result of growing competition and rising prices, returns from larger buyouts are unlikely to continue at the high levels seen in recent years. The name of the game, however, is relative, rather than absolute, performance, and buyout returns would have to fall a long way before they underperform current UK pension fund assets.
Middle-market MBO Funds ranked second to large MBO Funds over five and ten years, and were beaten by a small margin into second place in the three-year line-up by generalist funds. (For this year’s survey, middle-market MBOs were classified as buyouts with GBP2 million to GBP10 million of equity rather than GBP2 million to GBP5 million as in previous years, while the minimum equity qualification for large MBOs increased to GBP10 million from GBP5 million. Earlier years’ data have not been restated). Middle-market MBO and large MBO funds showed the highest percentage of paid-in capital distributed to investors, 147% and 149% respectively, in line with the typically shorter holding period of buyouts compared with development or early-stage investments.
Measured over one year, development-stage funds substantially outperformed larger buyouts in 1997, turning in a 30.7% IRR. Their ten-year returns of 9.2% per annum are disappointing, but measured over three and five years, development funds perform comfortably better than the principal comparators. Measured since inception, development funds’ returns varied between 15.8% and -9.6%, excluding the top and bottom deciles.
In common with generalist and early-stage funds, the performance of development funds since inception has improved over previous years as portfolios have matured and investments realised. The performance of this fund category, in particular, is likely to have been depressed by a number of early vintage, poorly performing vehicles from management groups that have since dropped out of the market.
Early-stage funds, consistently the poorest performers since the BVCA began surveying performance in 1994, are now showing considerable uplift, particularly when measured over three and five years, where they outperform the main comparators by a substantial margin.
As one would expect, early-stage funds with their longer investment horizons have distributed a lower proportion (81%) of their paid-in capital than any other stage category of vehicle. However, this is counterbalanced by the level of residual value remaining in their portfolios (61%). In terms of total current value compared with paid-in capital, at 162% early-stage funds rank slightly ahead of development-stage vehicles. At 181% of paid-in capital, generalist funds head this ranking rather than the large MBO funds one might have expected to find in first place. However, the effect of the shorter exit horizons of large MBO funds has probably been outweighed by the typically earlier vintages of generalist funds (with one or two notable, and sizeable, exceptions). Generalist vehicles currently retain value equivalent to 49% of paid-in capital in their portfolios.
Early Vintages Disappoint,
More Recent Years Outperform
Measuring performance by vintage year, the BVCA/WM survey found that six of the 13 vintages outperformed the principal comparators in UK pension fund assets and five also outperformed the FTSE All-Share Index over one year. Over three years, 1991 was the best-performing vintage, returning 48.4% per annum, while 1985 was the worst, delivering just 2.7% per annum. Six of the 11 vintages analysed outperformed both UK pension fund comparators and the FTSE All-Share Index over three years.
Over five years, the outperformance of private equity funds is more marked, with only two of the nine vintages failing to outperform the comparators. Here, 1989 vintage funds excelled, delivering returns of 49.2% per annum.
The comparison over ten years shows private equity in a less flattering light. While 1985-vintage funds delivered 18.6% per annum over the period, more than the principal comparators, the other funds in the sample (representing 27% of the total number of funds analysed) turned in lacklustre performances considerably below the benchmark. This underperforming constituency, however, includes both funds raised when the UK private equity market was relatively under-developed and some vintages whose performance may have been severely affected when recession hit in the late 1980s.
Funds raised in 1991 are currently showing the best returns since inception, at 23.4% per annum. This vintage also produced strong returns in 1997 (35.4%) and ranked first over three years (48.4%). In the course of five years, 1991 funds returned 31.4% per annum, still a strong performance but ranking below the 49.2% returns from funds raised in 1989, the 35.2% from 1985 funds and the 33.2% achieved by the 1988 vintage. Compared with these three vintages, however, 1991 appears to offer the best overall potential for returns. The 1991 vintage funds have already distributed 121% of their paid-in capital to investors, while retaining a residual value of 61% of paid-in capital. Although the 1988 and 1989 fund populations have to date generated higher values in relation to their paid-in capital (182% and 199% respectively), the residual value remaining in these vehicles, and therefore their potential for further uplift, is proportionately less.
Pooled Figures Hide Wide Variation in Individual Fund Performance
Examination of the range of returns achieved by UK private equity funds, analysed either by category or by vintage year, confirms anecdotal evidence of the massive variation in performance achieved from investment in the sector.
Since inception, the entire population of funds surveyed shows a range of 29.4% between the 27% return achieved by the tenth percentile and the rather depressing -2.5% return from the 90th percentile. The tendency for all fund categories, not surprisingly, is for the range of returns to narrow over time; measured over three years, the range of returns for the entire population is 73.7%, narrowing to 25.3% over ten years. Early-stage funds show the widest variation over three years, with a 138.9% range. This short-term measurement, however, reflects little more than the impact that one or two successful early exits can have on the interim performance of a fund. Over ten years, the ranges of returns for the different categories of funds fall into a relatively narrow spectrum: early-stage vehicles showed a 28.3% range from the tenth to the 90th percentile, while generalist vehicles’ performance varied in a band of 18.7%.
The range of returns since inception for funds measured by vintage year covered a wider spread than when measured by fund type, from a 13.3% spread for 1992 vehicles to a 36.3% variation for their predecessors raised in 1991.
That the variation between category return ranges is narrower than for vintage return ranges is partly a function of the downward pressure on IRRs over time: each of the category samples of funds contains its share of more mature vehicles, and the range of returns for funds raised between 1980 and 1984 is particularly low, at 14.4%. However, the ranges of returns for individual vintage years look as if they might be influenced by the volume of funds raised in the year in question, as well as by the economic conditions prevailing during the fund’s investment and exit phases. The prolific 1990 vintage currently shows a variation of 44.9% between the tenth and 90th percentiles since inception. The figure for 1985’s population, which includes 12 separate vehicles, is 27.8%.
A particularly poor vintage, 1987, which delivered a return of 6.6% to investors over ten years, bore the full brunt of the recession: its range of returns, at 15.8% over ten years, is narrower than for any other vintage that has passed the ten-year mark. However, 1986, another poorly performing vintage that was subject to many of the same conditions, produced a greater amplitude of returns, with a range of 23.5% over ten years.
Since the UK’s population of mature fund vintages is still relatively restricted, it is hard to draw any concrete conclusions from ranges of returns, although in general, years when more funds are raised look likely to produce a broader spread of performance. It is too early yet to see any clear correlation between wide or narrow performance ranges (rather than overall pooled returns) and the prevailing economic conditions to which an individual vintage was subject.
Pick with Care – and Enjoy
The use of “vintage” to describe funds raised in a given year invites analogy, and it appears that investing in private equity has much in common with buying wine en primeur. Some vintages will be better than others, but at the time of purchase there is no reliable means of determining which these will be. Just as the quality of the wine is influenced by the weather in the growing season, so is the performance of the fund by the economic climate it encounters: investors in private equity can at least find comfort in the fact that economic trends can be predicted with considerably more certainty than the weather. In the end, however, the quality of the investment, in claret or in ten-year private equity funds, can be judged only with hindsight.
This is not to argue that private equity investment is a lottery: just as en primeur orders are placed based on the reputation of a particular grower and vineyard, private equity funds are – or should be – selected according to the strategy and track record of their managers. While not a sure-fire guarantee of exceptional results, this approach, if consistently adhered to over time, has every chance of providing better than average rewards.
However, meager allocations on the part of UK pension funds constrain the potential of private equity to enhance overall pension fund performance to a degree where its impact is all but imperceptible. In a presentation at the recent National Association of Pension Funds annual conference, BVCA chairman Clive Sherling observed that on average less than 0.75% of UK pension fund assets are invested in venture capital, compared with 5% in the US. Pointing to the “consistently superior returns” available from this asset class, he recommended that UK pension fund trustees should question why their consultants and actuaries have not recommended a more appropriate allocation to venture capital in recent years.
Table 1: UK Private Equity Percentage Return by Investment Stage
No. of funds 1997 3 years 5 years 10 years
Funds by specialisation surveyed (%) (%) (%) (%)
Early-Stage 17 14.5 22.9 21.3 8.2
Development 38 30.6 24.4 25.4 9.2
Middle-Market MBO 32 19.1 25.2 25.7 15.7
Large MBO 33 20.8 33.9 35.7 19.7
Generalist 32 20.6 25.6 20.9 10.2
Total 152 21.0 29.6 29.3 14.6
Source: WM Company
Table 2: Performance of Principal Comparispn
1997 (%) 3 years (%) 5 years(%) 10 years (%)
UK pension funds (total assets)* 16.8 15.5 13.7 13.3
FTSE All-Share 23.6 21.3 16.6 15.7
FTSE 100 28.7 23.7 17.2 16.7
FTSE SmallCap 9.1 13.4 14.8 12.4
FTSE Fledgling 6.1 11.4 n/a n/a
*From WM All Funds performance of over 1,600 pension funds with a value of GBP449
billion at 31/12/97, representing approximately three-quarters of the UK pension
Source: WM Company
Table 3: overall performance by Vintage Year
Vintage No. of Funds 1997 (%) 3 years (%) 5 years (%) 10 years (%)
1980- 84 11 38.7 12.7 13.7 3.2
1985 12 4.1 2.7 35.2 18.6
1986 7 13.1 10.9 14.0 8.1
1987 11 34.2 28.9 17.6 6.6
1988 17 28.8 20.8 33.2 n/a
189 16 28.8 40.5 49.2 n/a
1990 13 4.1 30.7 27.0 n/a
1991 10 35.4 48.4 31.4 n/a
1992 6 22.9 37.2 21.4 n/a
1993 8 7.2 12.5 n/a n/a
1994 16 37.4 37.6 n/a n/a
1995 9 6.4 n/a n/a n/a
1996 9 19.8 n/a n/a n/a
1997 7 n/a n/a n/a n/a
TOTAL 152 21.0 29.6 29.3 14.6
Source: WM Company
Table 4: Profile of Capital Raised and Realized by Investment Stage
Capital raised Paid-in
Funds by specialisation No. of Funds (GBPm) capital (GBPm)
Early-Stage 15 128 128
Development 30 461 448
Middle-Market MBO 22 671 618
Large MBO 17 1961 1861
Generalist 27 731 687
TOTAL 111 3,951 3,741
Distribution/ Residual Total
paid-in capital value/ paid-in value/paid in
(%) capital (%) capital (%)
81 59 162
126 31 158
147 30 177
149 26 175
131 49 181
142 33 174
Source: WM Company
Table 5: Ranges of Returns by Investment Stage since Inception
Total Early-Stage Development Mid MBO Large MBO Generalist
(%) (%) (%) (%) (%) (%)
Return 14.0 8.2 8.9 16.6 19.7 11.7
10th percentile 27.0 18.1 15.8 27.2 35.6 19.9
25th percentile 18.7 13.6 12.9 21.6 29.9 11.2
median 9.9 7.4 3.3 14.2 26.0 7.7
75th percentile 2.5 -5.6 -9.6 4.7 7.2 -3.3
Ranges of returns 29.4 23.7 25.4 22.4 28.4 23.2
Source: WM Company
Table 6: Ranges of Returns y vintage Year Ten years)
Total (%) 1980-84 1985 1986 1987
Return 14.6 3.2 18.65 8.1 6.6
10th percentile 20.8 12.9 28.4 17.9 16.3
25th percentile 13.6 11.31 25.2 13.6 11.4
median 6.8 1.2 11.6 4.1 7.6
75th percentile 0.7 -3.2 1.2 0.9 5.6
90th percentile 4.5 -8.6 -2.5 -5.5 0.5
Ranges of returns 25.3 21.6 30.9 23.5 15.8
Source: WM Company