Beyond the J Curve Managing a Portfolio of Venture Capital and Private Equity Funds The Wiley Finance Series

Beyond the J Curve provides the answers to key questions, including:

• Why 'top-quartile' promises should be taken with a huge pinch of salt and what it takes to select superior fund managers?
• What do limited partners need to consider when designing and managing portfolios?
• How one can determine the funds' economic value to help addressing the questions of 'fair value' under IAS 39 and 'risk' under Basel II or Solvency II?
• Why is monitoring important, and how does a limited partner manage his portfolio?
• How the portfolio's returns can be improved through proper liquidity management and what to consider when over-committing?
• And, why uncertainty rather than risk is an issue and how a limited partner can address and benefit from the fast changing private equity environment?

Beyond the J Curve takes the practitioner's view and offers private equity and venture capital professionals a comprehensive guide making high return targets more realistic and sustainable. This book is a must have for all parties involved in this market, as well as academic and students.

List of Boxes xv

Acknowledgements xvii

Disclaimer xviii

Part I Private Equity Environment 1

1 Introduction 3

1.1 Routes into private equity 3

1.2 The limited partner's viewpoint 4

1.3 The challenge of venture capital fund valuation 4

1.4 Hard figures or gut instinct? 5

1.5 Managing with fuzzy figures 5

1.6 Making the grades 5

1.7 Outline 7

2 Private Equity Market 9

2.1 Funds as intermediaries 10

2.2 The problem of predicting success 15

2.3 Broad segmentation of investment universe 18

2.4 Private equity market dynamics 22

2.5 Conclusion 26

3 Private Equity Fund Structure 27

3.1 Key features 29

3.2 Conflicts of interest 38

3.3 Finding the balance 38

4 Buyout and Venture Capital Fund Differences 41

4.1 Valuation 43

4.2 Business model 44

4.3 Deal structuring 45

4.4 Role of general partners 45

5 Funds-of-funds 47

5.1 Structure 47

5.2 Value added 48

5.3 Costs 51

5.4 Private equity investment programme 52

Part II Investment Process 57

6 Investment Process 59

6.1 Key performance drivers 59

6.2 Process description 61

6.3 Risk management 65

6.4 Tackling uncertainty 68

7 Risk Framework 73

7.1 Market value 75

7.2 Market or credit risk? 77

7.3 Conclusion 78

8 Portfolio Design 81

8.1 Portfolio design framework 81

8.2 Portfolio construction techniques 83

8.3 Risk–return management approaches 88

9 Case Study 95

9.1 Looking for the optimal programme size 95

9.2 Overcoming entry barriers: long-term strategies 104

10 The Management of Liquidity 115

10.1 Liquidity management problem 115

10.2 Liquidity management approaches 123

10.3 Investment strategies for undrawn capital 130

10.4 Cash flow projections 133

10.5 Conclusion 145

Part III Design Tools 151

11 Established Approaches to Fund Valuation 153

11.1 Bottom-up approach to private equity fund valuation 154

11.2 Inconsistency of valuations 157

11.3 NAVs do not tell the full picture 157

11.4 Portfolio companies cannot be valued in isolation 159

11.5 Conclusion 162

12 Benchmarking 165

12.1 Specific issues 165

12.2 Individual funds 166

12.3 Portfolio of funds 170

13 A Prototype Internal Grading System 173

13.1 Grading of private equity funds 173

13.2 The NAV is not enough 174

13.3 Existing approaches 176

13.4 New approach to internal fund-grading system 180

13.5 Summary—NAV- and grading-based valuation 188

13.6 Conclusion 189

14 Fund Manager Selection Process 193

14.1 Relevance of fund manager selection 193

14.2 Why due diligence? 194

14.3 The due diligence process 195

14.4 Fund manager selection process 197

14.5 Decision and commitment 201

15 Qualitative Fund Scoring 219

15.1 Scoring approach 219

15.2 Scoring dimensions 221

16 Grading-based Economic Model 233

16.1 Approach 233

16.2 Internal age adjustment 237

16.3 Private equity fund IRR projections 238

16.4 Expected portfolio returns 239

16.5 Discussion 241

16.6 Conclusion 242

17 Private Equity Fund Discount Rate 253

17.1 The capital asset pricing model 253

17.2 Private equity fund betas 257

17.3 The alternatives to the capital asset pricing model 264

17.4 Summary and conclusion 266

Part IV Management Tools 269

18 Monitoring 271

18.1 Approach to monitoring 272

18.2 The monitoring objectives 273

18.3 Information gathering 276

18.4 Evaluation 282

18.5 Actions 285

19 Case Study: Saving Your Investments—Approaches to Restructuring 287

19.1 The valley of tears 288

19.2 The report to the board 289

19.3 The terms of the restructuring 291

19.4 Epilogue 293

20 Secondary Transactions 297

20.1 Sellers and their motivations 297

20.2 Buyers and their motivations 299

20.3 Secondary market prices 300

20.4 Transactional issues 307

20.5 The fund manager perspective 308

Part V Embracing Uncertainty 311

21 Deviating from Top Funds 313

21.1 Strategic investments 313

21.2 Policy objectives 314

22 Real Options 319

22.1 Real options in private equity 319

22.2 Real option analysis 321

22.3 An expanded strategy and decision framework 322

23 Beyond the J-curve 327

23.1 Some do it better 327

23.2 Deadly sins 327

23.3 Structure instead of "gut instinct" 328

23.4 Patience is a virtue 328

23.5 Turning water into wine 329

Glossary 331

Bibliography 341

Abbreviations 351

Index 353

About the authors

DR THOMAS MEYER studied computer science at the Bundeswehr Universität in Munich followed by doctoral studies at the University of Trier. He also holds an MBA from the London Business School. After 12 years in the German Air Force he worked for the German insurance group Allianz AG in Corporate Finance and M&A with particular focus on Japan, and as the regional Chief Financial Officer of Allianz Asia Pacific in Singapore.

Over the last years Thomas has been responsible for the creation of the European Investment Fund's risk management function. The focus of his work is the development of valuation and risk management models and investment strategies for venture capital fund-of-funds.

tmeyer.mba33@london.edu

PIERRE–YVES MATHONET holds a Master of Science cum laude in Finance from London Business School and a Master of Science magna cum laude in Management from Solvay Business School, Brussels. He is also a Certified European Financial Analyst.

He worked as an investment banker in the technology groups of Donaldson, Lufkin & Jenrette (DLJ) and Credit Suisse First Boston, and previously, for the audit and consulting departments of PricewaterhouseCoopers.

He is currently heading the venture capital activities within the Risk Management and Monitoring division of the European Investment Fund.

pmathonet.mifft2000@london.edu

Together, as risk managers, the authors are responsible for a portfolio of nearly two hundred private equity funds with more than €2.5 billion committed and almost €5 billion under management.