The power of portfolio construction
Private equity firms are more likely to espouse the virtues of their deal-making than their talent for portfolio construction because it makes for a better story, according to David Robinson, co-author of Portfolio Management in Private Equity. “Buying a business at a good price, turning it around or growing it spectacularly, and then selling at a higher price is far easier to relate to potential investors than a narrative based on the judicial balancing of risk across a portfolio of investments,” he says.
Portfolio construction behaviour isn’t necessarily meant to be the headline, he adds, but rather, it is the product of the agency relationship between limited and general partners. “Ultimately, our findings are the result of the terms dictated in the limited partnership agreement (LPA),” he says. Put another way, many portfolio construction decisions stem from GP incentives and constraints that LPAs outline.
For example, the research findings first show that the biggest deals in a fund are typically the safest, and so offer the lowest levels of return. “When we ranked deals from the biggest down to the smallest, the smallest generally had the highest returns and also the greatest level of volatility,” Robinson explains. “Conversely, the biggest deals were safer, but had commensurately lower returns.” These findings are consistent with the idea that GPs are reluctant to “bet the farm” on riskier deals: they generally seek to balance generating returns with placing concentrated bets that might affect future fundraising.
Similarly, the paper shows that deals done early in a fund’s life tend to be very slightly riskier than later ones, but that if those early deals are successful, later transactions tend to be much safer and lower-returning bets. “The story appears to be that the GP doesn’t want to do things late in a fund’s life that undermine the early success they’ve generated,” says Robinson. “LPAs typically require GPs to hit a preferred return hurdle rate before carried interest kicks in. They also feature clawback provisions. This creates incentives for GPs to avoid taking risks on later deals if doing so might jeopardise early success.”
These behaviours have important implications for returns. The research explores the relative importance of deal-making skills compared with expertise in portfolio construction.
We clearly show that the portfolio management side of a PE firm’s behaviour improves the overall performance of a fund.
David Robinson
“Furthermore, when we tried to apportion skill versus luck at the individual investment level and for a fund as a whole, we found that the portfolio formation part of the job was actually more attributable to skill than was the case for isolated deals.”
He says that this is interesting because a behaviour primarily born from the need to solve an agency problem between LPs and GPs and that is played out in the details of an LPA ultimately impacts performance. “GPs that focus more on portfolio construction are the better GPs,” he says. “This is important because we haven’t always lived in a world where LPAs look like they do now.”
In particular, the research has implications for deal-by-deal carried interest structures, where portfolio construction is likely to be a lower priority. “Overall, the research highlights the LPA’s importance in determining investor behaviour,” says Robinson. “It also helps to put PE performance into context. We tend to read about the asset class’s colossal successes and failures, but it can be easy to lose sight of the complexities of managing a portfolio – of simultaneously managing a variety of different investments with the aim of achieving a specific risk-return objective.”
For Livingbridge partner Bevan Duncan, the finding that portfolio construction is a key facet of overall performance comes as no surprise. “Twice a year, we formally assess each of the assets in our funds against a set of criteria that we have developed, before pulling all that together to assess the performance and risk profile of the portfolio as a whole against the overall fund objectives,” he explains.
“Through this process, we are trying to identify the risk-reward dynamics on an individual asset basis, and then make trade-offs at the fund level in order to meet the fund’s goals. Those fund-level, risk-reward dynamics feed into decision-making about any new investments. Of course, each deal has to be approved based on its individual merits – there is a threshold that has to be met before we can underwrite the investment case. But we definitely look at investments through the lens of the existing portfolio.”
Considerations include concentration limits and diversification, both in terms of sector exposure and demand drivers. “We absolutely overlay a fund perspective when determining if we want to put more capital to work in a particular industry, business model or asset maturity,” Duncan says. He is less convinced about the concept of putting bigger cheques into safer investments, however. “Looking back across our track record, I don’t see that,” he says. “We may deploy further capital into a business where we have increasing levels of conviction in the investment case and the quality of the management team, meaning we build exposure over time, but I don’t think we would ever go into an investment thinking that the deal feels safe, so we are willing to invest more on day one.”
Equally, the findings that higher-risk investments are likely to take place earlier in the life of the fund do not resonate with Duncan.
When I look back at Livingbridge 5, one of the very best deals was the last to go into that fund. While you could argue that a manager might look to put money into a safe place and then close out the fund, if you have a high-performing fund, I would suggest that any new investment needs to be additive to the overall return.
Bevan Duncan
He agrees that portfolio construction skills are becoming increasingly important as the industry matures, however. “You have to get the deal selection and value creation side right, of course, but it is important to think proactively about the role each asset is going to play in the portfolio and the impact it will have on the overall risk-reward profile,” he says.
This may feed into decision-making around exits, in particular. “If an asset is constrained by its market size or if there are high levels of execution risk, for example, it may make sense to seek an earlier exit and bank a 2.5x return,” Duncan explains. “Delivering that liquidity back to investors may then allow you to hold on to a clearly differentiated business with good-quality earnings and a large addressable market for longer, driving an outsize return. Asset selection skills and portfolio construction skills go hand in hand.”