Performance is king when it comes to LPs choosing their private equity fund commitments – but can those figures be trusted? Pavilion Alternatives Group managing director Richard Pugmire looks into the reasons behind return-rate contradictions.
Assessing the performance of a GP’s past funds is an essential part of the investor due diligence process. A common characteristic of these vehicles is that generally all LPs have the same exposure to the investments made by the fund. However, despite the common exposure, in practice LP returns can vary, raising questions of both the reasons behind the variance and the ‘true’ performance of the fund.
As part of our standard due diligence process, we review gross and net cash flows and recalculate performance for prior closed-end funds. Through our experience, we have identified several common reasons for performance differences, which include market forces, LPs opt-ins and GP marketing. Understanding these reasons is critical for LPs to get a true understanding of the fund, and tell the difference between investment flair and accounting gimmick.
Looking first at market forces. In these cases, LPs distributions are identical, but are quantified differently according to external factors such as exchange rates or onward sales. The lesson for investors in these instances is to consider their own circumstances and any risks that must be factored into their investment decisions.
In-kind distributions: Although most fund distributions are in cash, fund managers can make an in-kind distribution of company shares, typically of publicly-traded stock. As defined in the fund’s Limited Partnership Agreement, the fund will record the cash flow on the date and typically at the value it was distributed. However, an LP may record the cash flow as the value they received on the date the shares are sold. Thus, there can be a substantial difference between cash flows reported by the fund and the LP, particularly for volatile stocks.
Fund currency differences: An LP whose base currency is not the fund’s primary currency may convert cash outflows and inflows to their base currency. This can add or detract from the fund performance due to currency fluctuations. In the case of a U.S.-based LP investing in a euro-denominated fund, if capital calls are made when the euro is weak relative to the U.S. dollar and distributions are made when the euro has strengthened against the U.S. dollar, the LP will benefit from a positive currency fluctuation. The reverse can be true and a strengthened U.S. dollar can have a negative impact on funds denominated in foreign currencies. Thus, it is important to consider a fund manager’s performance in both its home currency as well as the LP’s base currency.
The next set of reasons for varying returns are attributable to LP opt-ins. In such cases, LPs themselves may choose to participate in a closed-end fund under different terms to their peers, either through timing, investment terms or exclusions. Investors in these cases must establish the precise circumstances for a stated return, and compare to their own investment process and criteria.
LPs commit in different “closes”: While some funds hold a single close, many will hold more than one with as much as a year separating the first and last close. Not unexpectedly, the magnitude of the performance differences can be larger for funds with longer fundraising periods, especially if the fund is making investments after its early closes. As the fund has subsequent closes, capital is reallocated from the early LPs to the new LPs, basically diluting the early LPs’ ownership interest in the fund’s first investments. Additionally, LPs participating in later closes are typically assessed a “late charge” that is passed on to the early LPs as they essentially financed the later LPs’ interest in the fund. Thus, early LPs will have a cash inflow while later LPs will have a cash outflow.
This difference in cash flows as well as the timing of the cash flows can create a difference in performance. Furthermore, if the fund has written up any of its investments, the later LPs will benefit since they receive the same valuation as the early LPs but their capital was contributed later. However, the increased use of capital call credit lines at the beginning of a fund somewhat mitigates performance differences caused by LPs participating in different closes. If the first capital call to LPs occurs after the final close, both early and later LPs will have the same performance.
Different parallel funds / fund terms: Funds can have different structures that generate dissimilar cash flows. For example, some fund managers are offering LPs options regarding what terms LPs would like to receive as investors in the fund. To illustrate, one class of shares will pay a higher management fee and lower carried interest percentage whereas a second class of shares will pay a lower management fee and higher carried interest percentage. Although LPs in these two classes will have exposure to the same investments, the difference in terms can lead to performance variations.
Opting out of investments: Some fund managers allow LPs to “opt-out” of participating in certain investments, such as for socially conscious reasons (e.g., gambling companies). LPs that opt out will have a different exposure to the fund’s investments than other LPs and, therefore, potentially a different return. Depending on the performance of the opt-out investments relative to the remainder of the portfolio, this could impart either a positive or negative bias to performance.
The final set of reasons for LP variance are controlled by the GP, and therefore are where would-be LPs must exercise the most caution. In these cases, GPs adjust their reported figures to better represent the ‘true’ performance of the fund. Whether these adjustments are justified or not must be carefully considered.
Inclusion of the General Partner (GP) commitment: The fund manager may include the GP commitment when reporting net cash flows. While the LPs of a fund pay management fees and carried interest, the GP commitment typically does not pay either. A larger GP commitment being included in the net cash flows will bias performance upwards. Thus, it is important to read the performance disclosures as well as to ask the fund manager for a full accounting of what is included in the reported fund performance.
Fund manager excludes certain investments: As part of their marketing materials, fund managers may exclude certain investments for a variety of reasons. For example, the partner leading the deal may have left the firm or that type of investment is no longer part of the fund manager’s core strategy. For example, a buyout firm may exclude venture capital investments made in previous funds as it no longer focuses on this area. When investments are excluded, further due diligence should be undertaken to understand what the fund performance was with these investments and if excluding them is justifiable.
When it comes to measuring fund performance between different LPs, the devil is most certainly in the detail. As the industry continues to evolve and fund managers offer more variety in a single vehicle, such as different terms and opt-out provisions, performance differences are likely to continue to propagate. As a general rule, reading the footnotes that accompany a performance presentation is helpful to provide insight into some potential sources of these differences. Doing so also demonstrates the importance of thoroughly researching fund managers to differentiate between those that generate their returns from their investment acumen and those that do so through accounting gimmicks.
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