Alternative Investment Vehicles: Issues in Private Equity Management - PowerPoint PPT Presentation

Alternative Investment Vehicles: Issues in Private Equity Management Axel Buchner and Niklas Wagner University of Passau, Germany EUROPEAN INVESTMENT BANK, Luxembourg, January 30, 2014 Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 1 / 49

Agenda 1 Modeling the Cash Flow Dynamics of Private Equity Funds 2 The Value of Private Equity Fund Fees and Managerial Incentives 3 The Abnormal Performance and Systematic Risk of Private Equity Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 2 / 49

Agenda 1 Modeling the Cash Flow Dynamics of Private Equity Funds Motivation Model Empirical Evidence Risk Management Application 2 The Value of Private Equity Fund Fees and Managerial Incentives 3 The Abnormal Performance and Systematic Risk of Private Equity Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 3 / 49

Motivation The uncertain timing of capital drawdowns and proceeds poses a challenge to the management of future investment cash flows. We proposes a novel stochastic model on the typical cash flow dynamics of private equity funds. The model is easy to implement and it can be used in various directions: Liquidity planning Risk management Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 4 / 49

Institutional Framework and Notation The modeled fund is organized as a limited partnership with private equity firms being general partners (GPs) and investors being limited partners (LPs). The fund has a total (legal) maturity T l and a commitment period T c , where T l ≥ T c must hold. The fund has a total (initial) commitments denoted by C . Cumulated capital drawdowns up to t are denoted D t , undrawn committed amounts up to time t are U t , i.e., D t = C − U t . Cumulated capital distributions up to t are denoted P t and p t = dP t /dt denotes the instantaneous capital distributions. Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 5 / 49

Capital Drawdowns Capital Drawdowns: The dynamics of the cumulated capital drawdowns D t can be described by: dD t = δ t U t 1 { 0 ≤ t ≤ T c } dt Drawdown Rate: The drawdown rate δ t is modeled by a CIR process: √ dδ t = κ ( θ − δ t ) dt + σ δ δ t dB δ,t where θ > 0 is the long-run mean, κ > 0 is the mean-reversion speed, and σ δ > 0 is the volatility. B δ,t is a Brownian motion. Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 6 / 49

Capital Distributions Capital Distributions: Instantaneous capital distributions p t are assumed to be log-normally distributed according to: d ln p t = µ t dt + σ P dB P,t Drift: The funds expected multiple E [ M t ] is assumed to follow the ordinary differential equation: E s [ dM t ] = αt ( m − E s [ M t ]) dt, 0 ≤ s ≤ t, where m is the multiple’s long-run mean and α is the constant speed of reversion to this mean. Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 7 / 49

Capital Distributions The stochastic process for the instantaneous capital distributions at some time t ≥ s is given by: � � √ − 1 2[ α ( t 2 − s 2 ) + σ 2 p t = αt ( mC − P s ) exp P ( t − s )] + σ P ǫ t t − s with ǫ t ∼ N (0 , 1). Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 8 / 49

Data Use a dataset of European private equity funds that has been provided by Thomson Venture Economics (TVE). The dataset contains a total of 777 funds over the period from 01/1980 through 06/2003. 95 of these funds are fully liquidated. Increase data universe by adding funds that have small net asset values compared to their realized cash flows at the end of the observation period. This gives an extended sample of mature funds that consists of a total of 203 funds and comprises 102 venture capital funds and 101 buyout funds. Calibrate the model to the sample cash flows by using the method of conditional least squares (CLS) Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 9 / 49

Goodness-of-Fit I 0.5 Cumulated Capital Drawdowns Yearly Capital Drawdowns 1 0.4 0.8 0.3 0.6 0.2 0.4 0.1 0.2 0 0 0 5 10 15 20 0 5 10 15 20 Lifetime of the Fund (in Years) Lifetime of the Fund (in Years) Figure: Annual Capital Drawdowns (Left) and Cumulated Capital Drawdowns (Right); Solid Lines represent Model Expectations; Dotted Lines represent Historical Data. Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 10 / 49

Goodness-of-Fit II 2 1.8 0.25 1.6 Cumulated Capital Distributions Yearly Capital Distributions 1.4 0.2 1.2 0.15 1 0.8 0.1 0.6 0.4 0.05 0.2 0 0 0 5 10 15 20 0 5 10 15 20 Lifetime of the Fund (in Years) Lifetime of the Fund (in Years) Figure: Annual Capital Distributions (Left) and Cumulated Capital Distributions (Right); Solid Lines represent Model Expectations; Dotted Lines represent Historical Data. Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 11 / 49

Goodness-of-Fit III 0.3 1 0.8 0.2 0.6 0.1 Cumulated Net Cash Flows Yearly Net Cash Flows 0.4 0 0.2 −0.1 0 −0.2 −0.2 −0.3 −0.4 −0.4 −0.6 −0.5 −0.8 0 5 10 15 20 0 5 10 15 20 Lifetime of the Fund (in Years) Lifetime of the Fund (in Years) Figure: Annual Net Fund Cash Flows (Left) and Cumulated Net Fund Cash Flows (Right); Solid Lines represent Model Expectations; Dotted Lines represent Historical Data. Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 12 / 49

Risk Management Application Table: Sensitivity Analysis for the Risk Profile of a Private Equity Fund This table illustrates the risk profile of the private equity fund and provides a sensitivity analysis. The base case in column 1 is constructed by using the estimated model parameters for the sample liquidated funds. Columns 2-5 show how the results change by altering the long-run multiple m and the long-run drawdown rate θ . High Dist. (Low Dist.) corresponds to the case when m is equal to the base case parameter plus (minus) two times the standard error of the estimator. Similarly, Fast Draw. (Slow Draw.) corresponds to the case when θ is equal to the base case parameter plus (minus) two times the standard error of the estimator. All calculations are based on quarterly simulated fund cash flows. Internal Rate of Return (in % p.a.) Base Case High Dist. Low Dist. Fast Draw. Slow Draw. Mean 8.94% 13.04% 4.72% 8.67% 9.42% Median 6.66% 10.12% 2.81% 6.53% 6.82% Std. 13.84% 20.06% 12.09% 13.01% 16.34% Lower 99th Quantile -4.52% -2.01% -7.16% -4.47% -4.66% Lower 95th Quantile -1.88% 0.68% -4.89% -1.87% -2.05% Probability of a Loss 11.65% 3.55% 30.43% 11.65% 11.78% (Prob(IRR < 0%)) Average IRR given a -2.00% -1.54% -2.81% -1.97% -2.09% Loss Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 13 / 49

Agenda 1 Modeling the Cash Flow Dynamics of Private Equity Funds 2 The Value of Private Equity Fund Fees and Managerial Incentives Motivation Model Fee Valuation Numerical Analysis 3 The Abnormal Performance and Systematic Risk of Private Equity Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 14 / 49

Motivation The goal is to introduce a risk-neutral option-pricing approach to the valuation of private equity fund fees. We model cash flow dynamics in the spirit of part 1 (drawdowns and distribbutions) to derive the value of private equity funds fees in an equilibrium framework. Approach allows us to study determinants of private equity fund fee value and to analyze incentives generated by the standard compensation schemes. Related literature includes Sahlman (1990), Fenn et al. (1997), Gompers and Lerner (1999), and Metrick and Yasuda (2010). Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 15 / 49

Private Equity Fund Fee Components Following the typical structure of private equity funds GPs receive two types of compensation for managing the investments: a fixed component called “management fee” and a performance related component called “carried interest” or simply “carry”. Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 16 / 49

Management Fees Let MF t denote cumulated management fees up to some time t ∈ [0 , T l ]. Management Fees: If management fees are defined as a percentage c mf of the committed capital C and are paid continuously, the dynamics are given by: dMF t = c mf Cdt Axel Buchner and Niklas Wagner Alternative Investment Vehicles: Issues in Private Equity Management 17 / 49