Private Capital Findings, Issue 21

The research finds that the impact of deployment pacing, subscription lines and recycle deal accounting methodologies strongly affect intermediate IRRs. Intermediate MOICs are affected weakly by subscription lines, but strongly affected by deployment pacing and capital recycling. Overall, the effect of these factors on interim valuations is significant, particularly early in a fund’s life, when the manager is likely to be fundraising, and LPs should therefore take this into account when undertaking their performance analysis.

In Interim Valuations, Predictability, and Outcomes in Private Equity, Ege Y. Ercan and Ilya A. Strebulaev (both Stanford University Graduate School of Business) and Steven N. Kaplan (The University of Chicago Booth School of Business) examine the link between interim valuation reports for portfolio companies and final outcomes. The study finds that a company’s valuation history is more informative than its most recent marks and holds a predictive power for future returns.

Using a novel dataset of US buyout and venture investments, the research concludes that companies with a history of staleness or frequent markdowns are more likely to perform poorly in the future. In addition, investments with larger reported interim marks tend to have lower future realised returns.

The combination of interim multiples, past staleness, and past markdown frequency can therefore help to predict whether an investment will end up among the best- or worst-performing deals at exit. Furthermore, these predictions are informative as early as the first year of the investment.

Finally, Loss Avoidance in Private Equity by Maria N. Borysoff (Costello College of Business at George Mason University) and Gregory Brown uncovers a disproportionately high frequency of exits achieving a MOIC of just over 1.0x and a disproportionately low frequency of exits achieving a MOIC of just under 1.0x, indicating that GPs are attempting to minimise their loss ratios, a metric widely used by LPs to assess the riskiness of funds.

Leveraging a dataset of almost 17,000 buyout investments made by more than 1,400 funds, the study suggests that managers may be focusing resources on boosting the performance of assets that are falling just short of breakeven. Methods including delaying an exit and the use of a rounding up technique, whereby employing the minimal effort required to increase a multiple of 0.94x to 0.95x, the reported multiple can then be rounded up to 1.0x.

The research further finds that GPs are most likely to engage in loss avoidance practices when fundraising and that loss avoidance correlates with a larger successor fund. It also finds that loss ratios are not correlated with the standard deviation of reported returns, suggesting that loss ratios are not an effective measure of risk.