Ecole de Management de Lyon (WHU Koblenz)
MSc Program  Master Thesis (PFE)

Performance of Private Equity Funds - Theories, Results, Implications -

Written by  Taro Niggemann
2005

Table of Contents

Abstract ... 4

1. Introduction  ... 5
1.1. Motivation  ... 5
1.2. Objectives  ... 6

2. Private Equity – An Overview  ... 8
2.1. What is Private Equity? ...  8
2.2. What is a Leveraged Buyout? ...  10
2.3. Limited Partner  ... 12
2.4. General Partner  ... 14
2.5. Target Company  ... 15
2.6. Financing of Leveraged Buyouts ...  16
2.6.1. Equity  ... 17
2.6.2. Debt  ... 18
2.6.3. Mezzanine  ... 19
2.7. Exit Channels  ... 20
2.8. The Three Levers for Value Creation in Leveraged Buyouts ...  21
2.8.1 Financial Leverage  ... 22
2.8.2. Operating Leverage ...  23
2.8.3. Market Timing / Exit Multiple ...  24

3. Performance Measurement of Private Equity ...  25
3.1. General Financial Performance Measurement Theory  ... 25
3.2. Performance of the Asset Class Private Equity ...  27
3.2.1. Performance Measurement Theory ...  27
3.2.2. Performance Measurement Practice ...  34
3.2.3. Recent Study Results ...  36
3.2.4. Implications  ... 48
3.3. Performance of Individual Private Equity Funds  ... 50
3.3.1. Performance Measurement Theory  ... 50
3.3.2. Recent Study Results ...  51
3.3.3. Implications  ... 57

4. Macroeconomic Environment for Private Equity in Germany and France  ... 61
4.1. History of the Private Equity Markets ...  61
4.2. Legal and Fiscal Environment  ... 62
4.3. Fund Raising  ... 64
4.4. Debt Financing ...  66
4.5. Investment Opportunities ...  67
4.6. Competition within Private Equity  ... 69
4.7. Business Markets and Perspectives  ... 70
4.8. Exit Channels ...  71
4.9. Conclusion – Exploitability of the Three Value-Creating Levers ...  72

5. Conclusion  ... 75
5.1. Performance of Private Equity Funds  ... 75
5.2. Outlook on the Perspectives of Private Equity Performance  ... 76
5.3. Hypotheses and Recommendations for Further Research  ... 77

Glossary of Terms ...  80

Bibliography  ... 83

Webliography ...  89

Appendix ...  90

Abstract

Private equity is currently replacing hedge funds as the most observed asset class. And while mutual funds experience a decline of assets under management, buyout funds break all records as far as fund raising is concerned. The attractiveness of buyout funds among investors is often attributed to superior returns and to an allegedly lower correlation with other asset classes. However, buyout fund returns also show superior volatility. In addition to that risk factor, investors must face liquidity and transparency risk. It is common agreement that investors are compensated for the elevated risk through a return premium. This and the cited lower correlation prompt more and more investors to add private equity into their portfolios.

The wide-spread opinion of superior private equity performance is backed by several studies. But the analysis of these studies reveal that a number of them employ methodologies which are disapproved of by experts on theoretical private equity performance measurement. Furthermore, some have a one-sided notion of financial performance. Benchmarking, risk and correlation data which are crucial for an overall performance assessment often lack.

The analysis of a series of technically appropriate, objective studies shows that private equity has historically outperformed public equity with regard to returns, in Europe more than in the United States (US). What remains unsolved is to which extent this return premium rewards the inherent, additional risk of private equity investments. And what is more certain: the prevalent view on correlation seems to be wrong. Empirical evidence and qualitative analysis speak for high correlation between private equity and the major asset classes.

The most important driver for individual fund performance appears to be the quality of fund management. Thereby, specialized teams outperform others. Moreover, specialized funds provide investors better opportunity to diversify their private equity portfolio.

Fundraising and investment conditions for private equity funds in France and Germany are favorable, but the accomplishment of superior performance will become harder in the future. The rules of the private equity business are changing as operating leverage has replaced financial leverage as the essential value driver. Whereas triggering the operating lever will become more difficult, exit conditions continue to improve. Selection of top-performing funds becomes even more crucial for investors due to an expected widening of the performance gap.

1. Introduction

1.1. Motivation

Most people will agree that „private“ is more attractive than „public“. The use of private jets is more convenient than flying public airlines, private parties are more promising than public parties, private health insurance provides better service than public healthcare and private schools often open up more opportunities than public schools. Observing the financial world, the impression is received that the same holds true for equity.

Public equity has gambled away a lot of trust in the eyes of the investor community since the crash of the new-economy-boom in 2001. Although stock markets have partially recovered, certain suspiciousness has remained, indicated by the ongoing difficulty that investment banks face when they attempt to execute initial public offerings.

Private equity, in contrast, enjoys great popularity.¹ New funds are being established, more and more US funds arrive on the European scene, fund-raising even for multi-billion funds is completed in minimum time, debt is cheap and financing alternatives are abundant, many graduates and young professionals wish to pursue a career in private equity and aversion to leveraged buyouts in the public has been diminishing.²

Private equity shares this favorable fate with other alternative asset classes like hedge funds. Low correlation of performance with other asset classes such as stocks and bonds as well as superior returns are most often cited as reasons for this run on alternative investments. However, return is only one side of the medal; the second component of performance is risk. And risk is difficult to measure in markets where liquidity is low and information scarce.

The following questions arise: How is overall performance of private equity to be measured? Which insights has research yielded on past performance? Which factors drive private equity returns and explain performance differences amongst funds? What are the prospects for the future? Is the macroeconomic environment favoring success? Can practical recommendations be deduced for private equity executives?

1.2. Objectives

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1 According to The Economist (2005) in the Wall Street Journal, New York Times and Financial Times, the use of the term "private equity" this year is up by around 60% compared with just two years ago, and by over 3,000% in the past ten years.
2 Very recent approaches against financial investors by some left-wing politicians who occasionally revive class conflict resentments constitute a newer trend.