Investors in alternative investments, like their mutual fund counterparts, are often accused of chasing performance. In the world of hedge funds, this means that managers are often thought to focus too much on monthly performance. And why not? Since most hedge funds are open-ended, they are always trying to impress potential investors. Positive monthly returns are music to a hedge fund marketer’s ears.

But what if the marketing process only happens once every three or four years?  That’s the world faced by most private equity and real estate funds.  Due to the illiquid nature of their holdings, these alternative investments need to open, raise capital, and close to new investments often within a few months. As you can imagine, this makes the performance of previous funds critical in the marketing of new funds.

You can almost say that an extra percent return for a private equity manager has a twofold effect on her compensation. One is direct, while the other (the ability to raise additional assets for future funds) is indirect.  This is the premise behind a paper by Ji-Woong Chung, Berk Sensoy, Lea Stern, and Michael Weisbach of Ohio State University (“Incentives of Private Equity General Partners from Future Fundraising”).

According to the quartet, these indirect incentives are as large – sometimes even larger – than the much-heralded incentive fee itself (a.k.a. carried interest).  So in a way, the incentives faced by private equity managers are actually twice as large as you think – especially for younger managers who often “give up promising careers in other fields such as investment banking to manage a relatively small fund.”

Previous studies have confirmed the axiom that fundraising success is related to historical performance. But according to the authors of this paper, none has reversed this equation and examined the effect of potential future funds on the incentives faced by PE managers right now.

But posting stellar returns doesn’t always help, according to the researchers. In fact, it only helps under two conditions: One is that the fund management company must be young (i.e. new). This makes intuitive sense. Investors have very little information on new managers, so the performance of their first or second fund really sets the tone for the marketing of future offerings.

The other condition under which a stellar first-fund return can drive future asset-raising success is scalability. The paper indicates that successful scalable strategies such as buyout funds are more likely to raise a ton of assets for a second fund than a less-scalable strategy such as venture capital.

To prove the point, Chung, Sensoy, Stern, and Weisbach look at nearly 10,000 private equity funds tracked by research firm Preqin (representing “70% of all capital ever raised by the private equity industry”). They extract about 1,700 buyout, VC and real estate funds for their study.

The chart below (created with data from the paper) confirms the assumption that buyout funds are more scalable than VC or real estate – regardless of the performance (which was pegged at around 16% p.a. for all three categories).

But once you add in the effect of performance on initial and secondary attempts at starting funds, future fund raising potential can change significantly.

The chart below from the paper shows that the ratio of “indirect incentives” (future fundraising) to “direct incentives” (carried interest on current fund) can be as high as 1.2 for rookie managers who plan to stay in the game for the long haul (defined as eventually launching another 4 funds).

The horizontal axis of this chart represents the current fund (first through fifth) while “N” represents the number of future funds still to be raised. So, if a manger is on their fourth fund and plans 5 more, then there is little future benefit from hitting the lights out on the current fund. For better or for worse, investors have already developed an opinion of the manager. So there is little incremental respect the manager can earn by producing good returns in the current period.

So the bottom line is that while the private equity portfolio manager might get excited about the carried interest when returns are good, the fund’s marketer can be equally as excited about the potential to raise assets down the line a little.

By: Konstantin Danilov, CAIA, AllAboutAlpha.com Editorial Board

There has been a lot of debate about the social and economic impact of private equity in recent years.  For example, the third paper in the World Economic Forum’s Globalization of Alternative Investments working paper series provides some interesting insights into the macroeconomic impact of private equity. The project – launched in 2007 to provide a “fact-based look” at the global impact of private equity – brought together a team of international scholars to conduct extensive research on the subject.

The paper sets out to answer the following question: does the presence of private equity investment affect the growth rate and cyclicality of the industry where the investment is made? The research focuses specifically on private equity’s impact on productivity, employment and capital formation growth in the industry. The findings are positive, which is good news as private equity continues to face heavy scrutiny from public officials and regulators. More…

With the dust still settling after World War II, British policymakers began to turn their attention to what had been called “a chronic shortage of long-term investment capital for small and medium-sized businesses.”  The result was the Industrial and Commercial Financial Corporation (ICFC), a pool of capital funded by major British banks.  Fast forward to July 1994, and the successor to the ICFC – now known as “3i” became one of the first private equity funds to be listed on an exchange.

Since then, many other private equity funds have listed themselves – most notably in the UK.  In fact, one might even say that listed private equity funds have blazed a trail for the recent wave of hedge fund ETFs. More…

By: Konstantin Danilov, AllAboutAlpha.com Editorial Board.

The secondary market for private equity interests has received lots of attention over the past year, but according to Michael Pugatch Vice President at HarbourVest Partners (writing in the Guest Column of the latest Debevoise & Plimpton Private Equity Report), the long-awaited “golden age” for secondaries did not transpire in 2009. However, the market has evolved and signs are pointing to an increase in transactions in 2010.

Sellers Remorse?

Historically, only large financial institutions and corporations have participated in the secondary market. Pugatch states that as a direct result of the financial crisis, several endowments and publicly traded private equity funds also entered the market in early 2009 (mostly as sellers).

For endowments, the need for current or future liquidity and the desire to reduce private equity allocations are the top reasons for wanting to sell. The latter is due to both the decrease in the valuation of public assets in 2008 and Q1 09, and the increase in risk aversion following the crisis. Last week’s post provides an overview of the Coller Capital private equity investor survey, which reaches a similar conclusion. For publicly traded funds, leveraged over-investment in private partnerships – a winning strategy during the 07-08 heyday – backfired when distributions ceased and liquidity became nonexistent.

Buyers Market

Buyers of secondary interests have traditionally been specialized firms that actively acquire private equity stakes, such as secondary private equity funds. Most recently, non-traditional buyers like insurance companies, pension funds and some endowments have entered the market as buyers to opportunistically increase their stakes in certain partnerships at an attractive price.

Active buyers of secondary interests dramatically scaled back their purchases in the second half of 2008 and the first half of 2009. Market uncertainty was obviously a factor, and a general lack of confidence in the valuation of private equity portfolio assets compounded the problem. Secondary bids dropped dramatically, falling as low as 30% of NAV for some partnerships, which in turn further decreased the number of secondary deals . Even the most cash-strapped investors were understandably reluctant to part with their private equity stakes for pennies on the dollar.

The Great Flood

HarbourVest expects that and increase in deal activity and the resulting increase in capital calls should spark the long awaited secondary market flood. Since capital calls have been minimal in the first half of 2009 (see chart below), and have picked up as the recovery has gained momentum, he speculates that some investors will face immediate liquidity concerns and will be forced to sell on the secondary market.

Last Resort

Will 2010 be the year that the private equity secondary market finally becomes a viable portfolio management tool? It will likely take longer than most had hoped. The reason is the level of complexity involved when valuing a private equity portfolio.

To keep things relatively simple, assume that the fund is fully invested. The first step is to value each individual company in the portfolio. Since the financials are not publicly available, the only option is to try to guess or take the FAS157 valuation as a fact. Unless of course, you either already own a stake in this particular fund or have a great relationship with the GP, in which case you can probably get a pretty good sense of how things are going.

Even if you were able to get a relatively accurate valuation of the portfolio assets, you are not done. Unlike a mutual fund manager, the GP has an active role in each portfolio company, which needs to be factored into the calculation (perhaps you already factored it into the discount rate for each company, but that is a longer discussion). Next, adjust for the vintage year (a proxy for purchase price for each company), already paid-out distributions, the fee structure, and any other factors that could affect the future distributions from the fund.

The level of complexity that is involved in valuing a secondary market portfolio favors buyers with lots of money already invested in private equity partnerships, lots of experience and many good relationships with GPs. Average sized pension funds, endowments, MFOs and individual investors are clearly at an informational disadvantage relative to secondary funds and large private equity investors. Until the information gap is narrowed, the private equity secondary market will continue to be viewed as a last resort for most investors.

Last summer, we reported on the changing face of private equity, as reflected in a nifty semi-annual publication from private equity firm Coller Capital.  The firm recently published its winter edition showing that much has changed in the world of private equity in a relatively short amount of time.

For starters, return expectations have taken a hit.  The proportion of survey respondents that expected 16%+ annual returns in the mid-term (3-5 years) has fallen by a quarter (see chart below from report). More…

Apparently it’s not just hedge funds that are now being held to a much higher standard when it comes to demands for transparency by institutional investors.

According to a recent survey published by SEI (downloadable with free registration here), financial advisors and other investors, private equity (PE) shops are also under increasing pressure to provide higher quality reporting and more “look-through” ability to their existing and potential investors. More…