Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Private Equity Primer (S1 E10)
Start down the road to unlocking the secrets of private equity investment with me, Edward Finley, your guide through the opaque world of non-public company ownership. As you tune into this episode, you're guaranteed an insider's perspective on how private equity stands in contrast to public markets, where the real opportunities for enhancing a company's value lie, and what it means to navigate the complex structures that are private equity funds. Learn about the distinct roles that limited and general partners play, their compensation, and the intricate dance of capital commitment and distribution that makes private equity a unique beast in the financial jungle.
We'll tackle the thorny issue of evaluating private equity returns, breaking down the limitations of conventional metrics like internal rate of return (IRR) and offering alternative methods for a more accurate assessment of financial performance. Join me for a masterclass in private equity that demystifies the jargon and lays bare the strategies used by the pros.
Notes - https://1drv.ms/p/s!AqjfuX3WVgp8uXJNaOZnGwR8KNz7?e=ASqZBq
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Hi, I'm Edward Finley, a Sum Time Professor at the University of Virginia and a Veteran Wall Street Investor, and you're listening to Not Another Investment Podcast. Here we explore topics in markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast. I'm Edward Finley.
Speaker 1:Well, last week we introduced the first of our asset class topics, namely equities, by trying to answer the question what do we think we own when we invest in equities? Or, to put it another way, when investors, providers of capital in capital markets, are choosing how to invest that capital, what risks do they think they own in order to make good decisions about those risks? And we discovered that it's a little more complicated than it might sound. Today, we're going to turn our attention to a related topic, but different in lots of different ways, and that is private equity. I think we're going to break this into two parts, and so today, in episode 10, we'll talk about some of the fundamentals, the structure, some additional definitions of private equity and some of the challenges in evaluating the risks that we own when we own private equity, and then, in the second part, we'll turn our attention to some of the research and the data to help us understand what private equity really is. Let's start off, as we did last time, with a definition, and this one is going to be a little bit, I hope, to put a smile on your face. So what do we buy as investors when we invest in private equity? Well, private equity is wait for it equity, so we just import the definition from last week. That is to say, private equity is no different in the sense that it's exposure to the productive economy, earning a premium for the uncertainty of bad times that might lie ahead. And, as we discussed last time, we're going to try to spend a little bit of time thinking about the risks that are present, that uncertainty risk that are present in private equity, that are also present in public equity. But we'll add some additional risks in private equity because, as I continue my definition, private equity is equity, of course, but it's equity in non-public companies with an expectation that the company's balance sheet and or its operations will be improved, and then the company sold to a strategic partner or taken public, in either case for a premium.
Speaker 1:Now, notice, there's a couple of important distinctions here. In the case of public equity, we really never spoke much about improving the operations or the balance sheet. We really talked about companies that were already on their way in a business venture. In private equity, we're going to find that there's either something about the current state of maturity of the company or something about the company's operations or balance sheet. That requires something more specific than just the regular operation of the business, and for that specific purpose the company requires capital. The structure of private equity is going to be an important part of understanding the risks.
Speaker 1:Private equity investments are made through what's called a limited partnership, and a limited partnership is used for a very important reason, and that is to separate economic ownership of the underlying investments from control of the underlying investments. This is not dissimilar from the kind of separation of ownership and control we saw in an ordinary company, where the shareholders own the company and are voting shareholders, but there are sometimes non-voting shareholders who have the economic ownership but no control. Very similar, but with a different objective. The objective here is that the limited partners are the investors. Those are the folks who are providing capital to invest in private companies. They own 100% of the economic interests in those companies. However, those limited partners have no control over what the partnership does. They own all the economic interests but they have no control. Limited partnerships have a general partner and the general partner has no economic interests in the underlying investments but has 100% of the control.
Speaker 1:Now you might think well, what kind of entity or person is a general partner of this kind of structure going to be? Those are the investment professionals who choose the companies to buy, that nurture and develop the companies that they buy and then ultimately sell them either to strategic partners or take them public. Those folks, of course, are not going to be doing that for free. If they don't have any economic interest in the underlying companies, how do they get paid? And the answer is that the general partners are paid contractually by the fund. The fund pays the general partner two ways. It pays it a percentage each year of the value of the fund's assets. That's known as the management fee. Typically it's 2%, plus the general partner is paid 20% of any realized profits. Just as an important word here, it means not the profits that we measure year to year. It means only the profits that are earned when a company is sold.
Speaker 1:At the outset of forming a fund to invest in private equity, the limited partners will commit a certain amount of capital for their partnership interest. Now that's important because it's very different from investing in public equities. In public equities, when we buy a share of stock and that's true whether we buy it on margin or we buy it in the spot market in either case, when we buy a share of stock, we provide the capital instantly and we own some interest in the company. In the case of private equity, limited partners make a commitment to provide a certain amount of capital and they're bound to do it. But they don't provide any money upfront. They only make that commitment Because the general partner finds investment opportunities for the fund. The general partner will quote, unquote, call capital from the limited partners. They'll make an announcement that they are going to call a million dollars from all limited partners, and limited partners will be required to send that money in proportion to their commitments to the partnership total. Likewise, as portfolio companies are sold, the general partner gets paid their 20% carried interest. It's called, and then the general partner might reinvest those proceeds in new companies. It might distribute some of those profits to the limited partners and invest the balance, or it might distribute all of it to the limited partners, and these capital distributions take place also at very non-typical intervals. Limited partners in private equity funds are rarely called on more than 75% to 90% of their commitments. Why I give you a range is that it depends on the type of private equity strategy, whether it's on the lower end of that percentage or the higher end. Now the point is that a commitment is usually not fully called.
Speaker 1:The funds themselves last typically seven to 10 years. They can sometimes last longer. In the early years of the fund there are mainly capital calls without any distributions and therefore very low annual returns, if you will, while in the later years, as distributions begin, returns slowly start to rise. And so in the private equity world this is sometimes referred to as the J-curve. You can kind of picture it If I were mapping on the x-axis time and on the y-axis my rate of return. My rate of return for the first few years might be negative and becoming more deeply negative as time goes. But then, as distributions start to happen, the curve forms its J shape and now my returns turn less negative, positive and then significantly positive. So the last of the portfolio companies is sold and the manager is paid, the limited partners receive their final distributions and the fund terminates. That's the general structure and operation of private equity funds.
Speaker 1:Some other definitions that we need to make sure that we have a handle on. First is something called vintage years. Others typically raise capital in new funds every few years. They don't raise funds every year. That's very atypical and they certainly don't wait until their current fund is finished and then raise a new fund. They balance somewhere between the two and it depends on a few things. The most important thing it depends on is the demand for investments that that manager makes. If there's very significant demand, the manager may launch a new fund earlier than might be typical. It also will depend a lot on the opportunities that are presented to the manager. If the manager senses that there are really interesting and important investment opportunities, they'll raise a fund more quickly. Each new fund that a manager raises is referred to by its quote unquote vintage year. People like Wines, that Wines have a year when they are bottled and come out of the cask. Likewise with private equity funds. So a manager, for example, that begins raising a fund now, in 2024, probably will close the fund raising this calendar year, maybe take six to 10 months to do it and that fund will have a name, but investors will typically want to identify the year in which the fund was raised. We'll talk more in a minute when we talk about risks, why that's so important to understand, but for the moment we just want to understand the term vintage years. We saw in public equities that returns time vary, and so it shouldn't be too much of a surprise that in private equity we would expect returns to time vary as well, and therefore we identify managers funds, by their vintage year in order to evaluate managers on the same basis, depending on the opportunity set that presents itself, comparing similar time periods of both investment and disinvestment.
Speaker 1:I'm going to now describe some of the strategies in private equity, but I want to sort of remind us that this is essentially a recapitulation of what we talked about when we discussed the equity market, so I'll do it a little bit more quickly, but it's important, I think, to sort of understand the strategies. Private equity is the large umbrella. It's the umbrella category that encompasses venture capital, growth, equity and buyout. Those are the three primary strategies. There are many others nuances on these things, but in the main those are the three categories, and so when we say private equity, we mean all three categories. We mean venture capital, growth, equity and buyout. It can be a little confusing because sometimes in the press private equity is the word used to refer specifically to buyout, and venture capital and growth equity are used to refer to those strategies. But I'm going to refer to all of them as private equity, that is, equity in non-public companies with the expectation that the company's balance sheet under operations will be improved and then sold for a premium.
Speaker 1:So let's start with the earliest in the life cycle of a company, and that is venture capital. So venture capital investors target private companies these are companies that are not yet public in order to provide capital for their growth. The first stage and funds are often raised in stages and managers focus and specialize in stages. The earliest stage is sometimes called pre-seed stage. Here the founder has an exciting business idea and is just getting the company off the ground. There are typically not going to be strangers who invest in the pre-seed stage. This is funded primarily from credit cards, family and friends. Seed capital is where we begin to see investors that are strangers to the founders. At the seed capital stage, the company is ready to prepare for market, to take their product or their service to the market. They have their competitor research. They have their product development, they've got their target demographics. They've hired a founding operating team. There is still a great deal of funding that comes from family and friends, but now we see the introduction of investors that are professional investors, sometimes called incubators, sometimes called angel investors or sometimes just called seed stage investors the kinds of companies that these investors are investing in in 2023, the median enterprise value that is what they estimate, because, of course, there are no market prices, so they have to estimate what they think these companies are worth. The median enterprise value in 2023 was about $13 million, so these are very early in their development. The median amount raised by a company at this stage from venture capital seed investors is about $3 million at the end of 2023. Pretty small fund raises in that level and pretty small enterprise values.
Speaker 1:Next up comes the early stage, or sometimes known as Series A. Here the company now has a user base. They've taken their product or their service to market. They've got some key performance indicators. They've got some revenue, some consistent revenue, and what they're planning on doing now is scaling the product across different markets or even complimentary products. They've got a good management team in place that's executing on the plan and here they are going to now begin to take much more capital to grow the company and they're going to take this capital from venture capital investors. Usually, there will be an anchor investor. A venture capital fund that specializes in the early stage will be chosen by the company, not just on the basis of who's interested in investing capital there will likely be many interested in investing but that anchor investor is going to be chosen on the basis of the other things that they bring to the table in addition to capital Things like network expertise in their business experience with other companies that have been in the same line of business, that they've invested in complimentary companies and can bring that kind of expertise. It's a much more nuanced decision than just who's got money to invest in my company. At this stage, the median enterprise value for companies raising early stage capital has gone up to almost $45 million at the end of 2023. And the median fund raise was about $11 million at the end of 2023. So they've increased in value significantly from that seed stage about three times in value and they've likewise increased the amount they raised by three times. This capital is crucial capital to take the company to the next level.
Speaker 1:Next we have mid-stage, or sometimes what's called Series B. Here, the company has now some really solid evidence on the demand for their product or service and they're ready to take their business to a much larger scale. Their focus here is on business development advertising technology, investment technology, support Companies here are pretty fairly well established, but they aren't really yet household names. Again, they're going to be funded by venture capital funds those that specialize in mid-stage investing or Series B investing and usually it's going to be led by the investors who were the Series A investors in what's sometimes called follow-on rounds. Those investors that were Series A investors, if they haven't lost confidence in the ability of the company to grow, want to keep investing more. They want to be a part of that growth story. Here the companies are starting to get material in size. So at the end of 2023, the median enterprise value for a mid-stage company was about $100 million and the median raise was about $20 million.
Speaker 1:Last but not least is what's called late stage, and that's anything from Series C to beyond. Increasingly, companies are staying private longer, but private equity funds, as I mentioned last, only seven to 10 years, and so if your company is going to remain in late stage private mode for more than 10 years, you will probably not just raise a Series C round. You'll likely have to raise a Series D or Series E round. These are successful companies that are looking to scale, either by entering new markets, developing new products. It might be a strategic acquisition, or more than one strategic acquisition, because what they're doing is they're now preparing the company for size and competitive advantages to raise capital in the public markets and, as you'll recall, the public markets are massively bigger than private markets in equities massively bigger and so when a company can get to that stage of development, they can raise a tremendous amount of capital to really boost the growth and the value of their company. The investors of late stage include venture capital investors who have been, who are specialized venture capital investors in late stage companies, who bring different skills and different networks to the table in addition to capital. They will also typically be follow on investors that's also going to be true. So investors who invested in Series B or in Series A. And the median enterprise value now here is at least at the end of 2023, it was about $173 million and the median fundraise was about $23 million. So the size is not getting much bigger, the raises are not getting much bigger, but the company is itself becoming more now focused on entering new markets, creating new products, doing new acquisitions to ready itself for public markets. Okay, that's venture capital.
Speaker 1:Second is growth equity. Growth equity also focuses on private companies, but in the case of growth equity, these are private companies that are not yet ready to go public but have pretty much exhausted the interest and appetite of providers of capital in the venture capital market, and so if a company needs more time to develop after venture capital, before it goes public, they reach out to growth equity. Growth equity is still quite small relatively speaking to the other categories. It's been growing larger and larger lately for the reason, as I mentioned, that private companies are remaining private for longer and longer times.
Speaker 1:Third buyout here the investors are targeting undervalued or underperforming public companies, and they're doing so by taking control of the company and delisting it from public markets. That is, taking the company private. So they target undervalued or underperforming public companies by taking control of the company and they delisted from public markets. The ordinarily will do that with some mixture of capital and debt, so there is going to be some debt involved when they acquire, in contrast to growth equity and venture capital, in which there's no debt involved. It's also going to differ depending on the kind of buyout strategy, and so the question there is whether it's a leveraged buyout or whether it's a traditional buyout.
Speaker 1:Leveraged buyout targets mature companies in which the investors believe that the company does not have sufficient debt on its balance sheet to be efficient, and so, by taking the company private, they're able to then increase the amount of debt in the company and either sell it to a strategic buyer or take it public again. And in traditional buyout, the investor is focused on likewise mature public companies in which they believe that the company's operations have, for some reason, not kept pace. It may be that they didn't keep pace with competitive pressures, they didn't enter new markets when they should have, they didn't innovate when they should have, and for those reasons, the public markets are no longer treating that company very well. They think the company has problems. A traditional buyout manager will typically add some debt, because these are mature companies that may not have as much debt as they could have, but the focus is less on debt and less on the balance sheet and much more on improving the operations of the company, and after some number of years, the operation and business improvements take place. Then the company is taken public or is sold to a strategic buyer.
Speaker 1:All of those types of investing happen through the vehicle of a private equity fund, this limited partnership, in which the limited partners are the investors. They provide all the capital and have none of the control. And it's run by a general partner who are staffed by the investment specialists who make all of the decisions and have all the control over which companies to invest in, how much to invest, what improvements to make, et cetera, until it's time to sell it. And they don't have any interest economic interest in the underlying companies that they invest in. Instead, they're paid contractually, with a 2% management fee to just pay them for keeping their business open and paying their employees and doing the work that they're supposed to do, and then a 20% carried interest after they sell a company for a profit. We refer to all of the companies inside the fund that they buy as portfolio companies and recall the portfolio companies are, by definition, all private.
Speaker 1:Okay, so with that understanding of the structure and strategies in private equity, let's turn our attention to some of the problems and challenges in evaluating risk and returns, say, in contrast to public equity. Well, the biggest and the most obvious is that there's no reliable market value for these companies. They're private. Now, venture capital companies are going to be the most speculative in terms of what their value might be. Growth equity might be speculative, but not nearly a speculative. Buyout will be speculative, but it was recently public and so people had some idea what it used to be worth. But, in any event, when you're an investor in private equity, there isn't a price. The general partner of the firm will, and is required to periodically hire appraisers to appraise the portfolio companies and estimate their value, but that's a very different enterprise than a market that trades and that seeks to incorporate all information into price.
Speaker 1:In addition, those valuations that I mentioned are performed only quarterly, and the valuations themselves are based on business data that's a quarter old. So think about it If I'm going to value my companies every quarter, and so I need a value as of December 31st, I'm not going to be able to report the value on December 31st, because why I need to compute its value? I don't have the data on December 31st, so I spend January, february and March collecting the data. Great Well, what data do I collect? It's not the data for October, november and December. It's the data for August, september and October, and so when values are reported quarterly, their quarterly data is lagged by a quarter.
Speaker 1:And so the result here is that, even though we have valuations, these valuations don't allow us to compute things like volatility like we did in public markets. And the reason could be pretty obvious. If you think about looking at the price of public equities in a chart, you'll see that there's constant price discovery, people are buying and selling, reevaluating information and the price is moving around quite a lot. So the standard deviation tells us something about the dispersion in price and something about the uncertainty of the value of the firm. In private markets, where you have valuations performed by a professional appraiser and they're performed quarterly and on quarterly lag, you can imagine that now those price movements and they will move, but they move much more smoothly. They're not as jagged, and so this process of smoothing makes computing standard deviation almost useless in terms of understanding the risks of uncertainty in investing in private equity.
Speaker 1:To make matters even worse, private equity funds, as I mentioned, aren't fully invested at one time. The general partners make capital calls from the limited partners, they make distributions to the limited partners. They sometimes mix them at the same time. They might, in one moment, call 100X in capital and announce a 20X distribution, and they're not going to take 100 and give back 20. They're just going to expect the investors to give them 80, the net amount. And they do this periodically, making it absolutely difficult to compute compound returns like we would in public equity markets. If I buy a share of Apple today, I can compute my compound return. Why? Because I own that share of Apple starting today, and I can evaluate my return by computing it of the movements in its price. Last but not least, we have a problem with private equity in that it's very difficult to evaluate the returns because it's very difficult to understand exactly what risks we own and by having difficulty in evaluating the risks we own makes it nearly impossible to have an appropriate benchmark.
Speaker 1:Okay, so private equity we understand as a broad category that includes venture capital, growth, equity and buyout. What these investors all have in common is a structure in which they're not fully invested all at once. Limited partners get called and they get distributions periodically. The general partners are specialists making choices about buying companies. All of the companies are private means that there are no reliable market prices. The valuations come quarterly on a quarterly lag. It makes the computation of volatility very difficult. Because of smoothing and because the capital flows go in and out, it's really very complicated to know exactly what my compound return is.
Speaker 1:So what have been the solutions typically? Well, one solution that was developed early on is a computation known as internal rate of return, or IRR. Well, what's the idea? Well, here's a very dorky answer. The internal rate of return measures the return for each marginal dollar invested, and it does that by finding the rate at which, when applied to a series of cash flows, makes the net present value zero. Okay, so if you don't have a background in statistics, what are we really saying? Internal rate of return is a statistical method by which we can estimate what the compound growth rate of an investment is by taking into account the cash flows. Well, it's true that internal rate of return is a compound rate of return, there's no two ways about it but it's not true that it is your compound rate of return. And so when a private equity fund reports for its last fund or for its current fund, its internal rate of return, it's awfully misleading, and I'll give you an illustration to show you what I mean.
Speaker 1:So let's say that we have this hypothetical private equity fund and it has two cash flows, one cash flow in and one cash flow out, so sort of a little like just buying public equities. So let's say, in January of year one we invest $100,000 in this fund and in January of year five we get back $161,051. Why such a strange number is because I wanted the IRR to be 10%. Well, in that case the IRR is your compound growth rate. There's no light between the two ideas. It's because there was just one cash flow. There weren't multiple cash flows. All right. Well, what if we make it look a little more like a private equity fund? Not entirely, but let's say that we invest $100,000 in year one, but the distributions come out little by little until in year five we get the last of the distributions.
Speaker 1:Okay, well, in that case I can create a series of cash flows so that the IRR is 10%, and so I could do that. I put $100,000 in the first year and then in the second year I get $15,000, again $15,000, again $15,000, again $15,000, and finally $84,475. Well, the IRR of those cash flows is the same 10% as my first model. Well, if I add up the cash flows in my second example, I get a total of $144,475, which is a lot less than the $161,051 in the first example. Yet they have exactly the same IRR. And therein lies the problem that the IRR doesn't really tell us what your compound growth rate will be. It tells us a compound growth rate. How do I know it? Because it can't possibly have the same compound growth rate if the total amount that I get back is different.
Speaker 1:All right, let's take another example that's even a little bit more realistic. Let's say that I don't invest all of the money right away. I invest $50,000 in the first year. In the second year I get $19,000 back and then I put another $50,000 in and the following year I get $25,000 back, $25,000 back again, and then $75,000, $475,000 at the end. How I picked those numbers was to make the total flows the same as my last example $144,000, $475,000. And you'll remember, in my last example, where there was just one inflow and all outflows, the IRR was 10% and the total was $144,475. In my second example, the total is $144,475, but I have both inflows and outflows at different times. Here my IRR is 13.6%.
Speaker 1:So again, what I want to illustrate here is the idea that IRR does tell us a compound rate of return and when we see it reported in the newspaper, et cetera, it is a compound rate of return. It's just not the compound rate of return. The most egregious example of this that I see is typically when reading the newspaper and you're reading an article about a private equity manager's most recent fund, the reporter will say that on the private equity manager's most recent fund they had a 24% IRR and then they'll compare it to the return on the S&P 500 for that period. And I hope you'll understand by this little example that I just gave you that's really not a fair comparison, because the IRR is the object of inflows and outflows and while it is a compound rate of return, it is not your compound rate of return and so we don't have a real apples to apples comparison. Well, how did we try to solve that problem?
Speaker 1:Well, we tried to solve that problem by looking at a different measure called multiple uninvested capital. So the idea here is all right IRR isn't my compound growth rate. Well, what if I just forget the compound growth rate part and say I know how much I invested total and I know how much I received in distributions? What if I just create a fraction, that is, the distributions divided by the investment, and I get a multiple uninvested capital. The idea there is that if I look at multiple uninvested capital, it's going to account for the fact that not all of the dollars are invested at once, and we can see that. So in my very first example with a single flow, I invest 100,000 in the first year and I get back 161,051 in year five. My multiple uninvested capital is 1.61.
Speaker 1:When I look at my second example, with one investment and then lots of outflows, my multiple uninvested capital is 1.45. Well, that's very useful, isn't it? Because you'll recall, my IRR for those two examples were both the same 10% and we said that was very misleading. But the multiple uninvested capital is not misleading. Likewise, in my more advanced example, where I have inflows and outflows and my IRRs were different, my multiple uninvested capital is the same 1.45. And so you see, the multiple uninvested capital has accomplished something.
Speaker 1:It takes into account the fact that not all of the dollars are invested at once, but what it doesn't take into account is how long the manager took to earn those returns. My examples are very easy. But imagine a manager that says my latest fund, I returned three times investor's capital. Well, that sounds terrific, doesn't it? Three times is great. Well, what you don't know is whether the manager did that in five years outstanding or in 20 years. Really not very impressive at all. So multiple uninvested capital leaves us wanting more, because it doesn't take into account how long it took. It does take into account the differing cash flows. It also isn't a compound rate of return, so it makes it really hard for me to compare it to other similar investments, particularly public investments. Public investments are going to have compound rates of return. What did the S&P earn, for example?
Speaker 1:Last but not least, both IRR and multiple uninvested capital suffer from one common problem which neither of them takes into account the risk we own, and you'll recall from our discussion of equities, there are different kinds of risks, and arbitrage pricing theory has taught us that those different risks have different compensations for those risks, and so it seems rather heedless to compare, say, what we're looking at in a venture capital fund, which are the tiniest companies at the earliest stage of the development. Compare that to, say, the S&P 500, which are the largest, most mature global public companies. Very different risks, and so if we want to have a benchmark, like we have for public equities, we have to come up somehow with a way of not just computing the compound, the compound growth rate, but also to do so with respect to the particular risks that the fund invests in. And here the industry has come up with another solution, and this solution is called the public market equivalent. Now, public market equivalents appear in lots and lots of different formats. I'm going to describe them generically and then later describe a very specific kind of public market equivalent, but there are all kinds of public market equivalents that you can compute. What's common among them is that a public market equivalent will measure the average annual excess return in private equity over a benchmark rate of return, which represents the risks, taking into account the amount and the timing of flows. So I'll repeat it A public market equivalent will measure the average annual excess return for private equity over a benchmark rate of return representing its risks and taking into account the timing and the amount of flows. In order to compute a public market equivalent, what we have to do essentially again, there are many different versions of this, but what they all have in common is what we have to do is we have to calculate the future value of each cash flow using a discount rate that matches the risk exposures in the private equity investment.
Speaker 1:Let me first just give a very simple numeric example. Let's take our most recent example of multiple inflows and outflows. We invest 50,000 in the first year, we get 19,000 in the second, and so on. Instead of just computing the IRR here, what we might do is we might say well, let's imagine we know the risks that are inherent in this strategy and we have a public market benchmark that is a fairly good measure of those risks. Let's further say that during the period of our investment, the compound rate of return was 10% per year. What we would do then is we would take our initial investment in the first year $50,000, and we would say well, what would that $50,000 be worth in the last year at a 10% rate of return? Likewise, we received a distribution in the second year. What would that distribution be worth in the last year, using a 10% compound rate of return? And so on and so on.
Speaker 1:We compute those values and we put all of the cash flows in final year dollars. Once we have them all in final year dollars, then we compute the IRR of those future values, and now what we have is a computation that takes into account the inflows and outflows, both their size and their timing, and takes into account what the risks inherent in the investment are, and is the compound excess return not a compound excess return? And so in my example that I gave you, where I say the risk rate is 10%, let's say that means that my public market equivalent is an excess return of 3.2%. What does that mean? How do we translate that? It means, on average, this fund earned 3% more than its public market equivalent. So by using a benchmark rate of return as the discount rate, we take into account the risks that the investment is invested in. By computing the value of the flows in future year dollars, we take into account the timing and the size of the investments, and then we're able to correct for the problem of multiple uninvested capital, because it's a compound rate of return and I can compare it to other risks, and then I can also compare to other managers of similar vintages.
Speaker 1:So what's the catch? Well, the catch is simply what's the right benchmark rate of return? What should we use when we're computing this public market equivalent return for investments in private equity? And the answer here is that it will kind of differ depending on whether we're talking about venture capital or buyout. So I'm going to stop there and let all of that sink in. Next week we'll come back to part two of private equity and we'll take a look at some of the research that tells us what are the risk exposures in buyout and venture capital and growth, and we'll take a look at some of the observed risk premia that we see earned in the market. And we'll also ask a very, very important question, which is is there any evidence to suggest that private equity managers have skill and therefore can earn better returns than the risks they're invested in? So thanks again for listening and I look forward to seeing you again next time.
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