Achieving Private Equity Allocation Goals

By M. Isi Eromosele

A commitment strategy that allows an investor to consistently achieve and maintain a specific, targeted private equity exposure can be just as important as deciding on the initial allocation.

Optimized private equity target allocations are designed to reduce portfolio risk through diversification and boost performance. But if these allocations are not achieved and maintained, investors may not fully realize the benefits of adding private equity to a portfolio.

There are three central questions commonly faced by new and experienced private equity investors alike:

• As a new private equity investor, how should I size and pace my commitments to reach my target allocation?
• What future commitments will I need to make to maintain my proportional private equity exposure over time?
• How should I manage my long-term private equity commitments in the face of short-term market volatility across the rest of my portfolio?

Commitment Strategy

Institutional investors in search of improved returns and greater diversification are increasingly turning to private equity investments as they shuffle and refine their portfolio allocations.

Once the decision to invest in private equity is made, investors need to develop an appropriate target allocation based on their liquidity, risk tolerance and performance needs.

Estimating the future exposure or net asset value (NAV) of private equity investments continues to be very difficult. That’s because investors have no control over the timing of the contributions towards their commitment that will build NAV. Nor can they control distributions from underlying investments that will reduce NAV.

This lack of control results from private equity funds typically calling capital from investors as portfolio company acquisitions are made, and then distributing capital back to investors as investments are exited.

The majority of capital calls occur early in the life of a fund (typically years one through three), while most distributions occur later in the fund’s life (typically years four through ten). Over time, these cash flows form a pattern that is often referred to as the “J-curve.

An investor seeking to reach or maintain a specified allocation to private equity needs to understand exactly where their portfolio sits on the J-curve. In other words, the investor must understand the maturity of the portfolio relative to its overall lifecycle. Only if investors are armed with this essential information can they make effective future commitment decisions.

Commitment decisions are important in an effort to achieve strategic targeted private equity exposure. This could mean reducing that exposure by liquidating private equity interests on the secondary market, or increasing it by ramping up commitments (potentially via a secondary purchase).

Estimating Future Exposure

There are many critical factors that affect the unpredictable nature of private equity cash flows. These include:

Market Conditions 

Cash flows may be influenced by the market for private equity transactions in general. If markets are strong, and deals can be exited quickly, private equity investors may experience sooner-than-expected capital calls and distributions, while sluggish markets may delay portfolio company investments and/or require managers to hold portfolio companies for longer than expected time periods. This can delay both capital calls and distributions.

Strategy Considerations 

The strategy of a private equity fund may also affect cash-flow timing. For example, venture capital managers often must put substantial time into their portfolio companies over a series of investment rounds. Consequently, these investments often have longer lives and a greater time horizon from capital calls to distribution than their buyout counterparts.

Fundraising Cycles 

The timing of fundraising cycles for individual managers and the market as a whole,

can also impact when private equity investors have the ability to make commitments. This can affect the overall timing of future cash flows.

Manager-Specific Factors 

Each manager and each fund are impacted by numerous market and transaction-specific variables that impact cash-flow timing. This idiosyncratic element leads to different cash-flow patterns among funds, even for the same or similar managers.

These and other variables make predicting individual private-equity-fund cash flows a difficult task. Unfortunately, investors’ commitment-planning efforts can stall as a result.

Projecting Private Equity Cash Flows

• Having a private equity commitment strategy designed to achieve a target allocation is critical to sound portfolio management.
• In developing a new private equity program, capital commitments to private equity must be “upsized” to achieve a targeted exposure. In addition, frontloading commitments and/or making a secondary investment can help to reach an allocation target much faster.
• Maintaining a target private equity allocation is not simply a matter of increasing commitments at the growth rate of an investor’s broader asset base.
• An ongoing assessment of the composition, maturity and performance expectations of the underlying private equity assets is required to develop an appropriate commitment plan.
• Adjusting a private equity commitment strategy on the basis of short-term market movements has consequences for investors. Inconsistency in commitments can lead to both greater volatility of projected exposure and potential performance losses.

Private equity investors need to consider a strategic commitment plan to achieve allocation targets as much as they consider setting the targets themselves.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group

Impact Of Private Equity On The Global Economy

By M. Isi Eromosele

The past year has seen unprecedented turmoil in the markets, resulting in a fundamental restructuring of the global financial landscape. As the magnitude of the turmoil and its consequences has become clear, there has been a natural desire on the part of political leaders to closely examine the role of financial intermediaries.

These have not only included traditional financial institutions such as banks and investment companies, but also alternative investment asset classes such as private equity, which in many nations have remained largely outside the purview of regulators.

As such, in an era when global financial regulation is rapidly evolving, understanding the role and consequences of private equity has never been more important. Yet the systematic knowledge that can be drawn upon about these institutions is surprisingly limited.

In the last few decades, private equity has emerged as an important class of investment within the financial system and has evolved beyond the US and UK. Today, private equity transactions span different geographies and influence employment, productivity, corporate governance, management practices and broader economies. But global understanding of the impact of the modern private equity industry remains at a relatively low level.

A detailed analysis of the Global Private Equity Industry by Oseme Finance addressed the evolution of the sector during the past decade by including sample studies that covered the following broad topics:

• The demography of private equity investments,
• The willingness of private equity-backed firms to make long-term investments
• The impact of private equity activity on employment  
• The post-acquisition governance practices utilized by private equity firms

The research team complemented these studies with a variety of case studies, which examined these issues and others across a variety of geographies, with a particular emphasis on Germany, the UK and emerging private equity markets such as China and India.

The main goal of the study was to determine whether private equity ownership is a way to achieve improved management practices within firms through the introduction of new managers and better management practices.

Among the key findings are the following:

• Private equity-owned firms are on average the best managed ownership group. Private equity-owned firms are significantly better managed across a wide range of management practices than government-, family- and privately owned firms.  
• Often private equity owned firms are particularly strong at operational management practices, such as the adoption of modern ‘lean manufacturing’ practices, using continuous improvements and a comprehensive performance documentation process.
• Private equity-owned firms have strong operational management practices. Private equity-owned firms have strong people management practices in that they adopt merit-based hiring, firing, pay and promotions practices. Relative to other firms, they are even better at target management practices, in that private equity-owned firms tend to have tough evaluation metrics, which are well understood by the employees and linked to firm performance.
• Firms acquired by private equity groups experience productivity growth in the two-year period after the transaction; that is on average two percentage points more than at controls. About 72% of this out-performance differential reflects more effective management of existing facilities, including gains from accelerated reallocation of activities among the continuing establishments of target firms.
• The probability of establishment shut-down is less likely for more productive facilities for both private equity targets and comparable firms, but the relationship is much stronger for private equity-backed firms. In other words, private equity investors are much more likely to close underperforming establishments at the firms they back, as measured by labor productivity.

 Key findings: Emerging markets study

The Oseme Finance Report examines the rapid increase of private equity investment in emerging markets. During the past decade, the dollars raised by funds investing in the emerging economies of Asia, Russia and the former Soviet Union, Latin America, the Middle East and Africa has increased exponentially.

This report aims to understand the private and social returns of private equity investments in emerging economies by looking at the nature and outcomes of  these private equity deals across nations that differ in the development of their financial sectors, governance, regulatory systems and operational infrastructures.

Key findings are as follows:

• Emerging markets account for an overall modest share of private equity activity over the past decade. This share has grown in recent years, particularly in the growth equity category. Private equity represents a greater share of the gross domestic product (GDP) in nations that are wealthier and whose per capita GDP is growing more quickly.
• Only equity market development matters for the development of private equity, not the provision of debt and the effects are particularly strong for venture capitalists. One interpretation is that exiting through public offerings is particularly important for these firms.
• The measures of operational engineering appear to be particularly important for buyout activity. In particular, the presence of barriers to free trade, greater complexity in establishing new entities and greater corruption are associated with fewer LBOs.
• Minority transactions are associated with faster-growing countries. The presence of syndicated investments is associated with larger deals and with less favorable fundraising environments, which may be attributable to liquidity constraints.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group