The Evolution of Private Equity Fund Value

Private Equity:

Private equity is an integral part of an institutional portfolio’s alternative asset allocation. This is owing to the fact that private equity is complementary to traditional asset classes and has been demonstrated to be accretive to total returns while providing significant diversity from public equities and fixed income markets. When private equity is integrated into a standard portfolio, however, several distinctive characteristics can provide major hurdles to asset allocation decisions.

The projected return and risk of an asset class are two important factors to consider when making asset allocation decisions. Time-weighted returns are used in public markets for a certain holding term, with the premise that no transactions occur throughout the investment period. Private equity investment performance, on the other hand, is generally calculated using an internal rate of return, which accounts for all cash flows from the venture’s start. This may result in a misalignment in the evaluation time horizon between a private equity investment and more traditional assets for an investor. Using interim period volatility to assess the risk of private equity, as it is for other liquid or market-traded assets, can also be problematic. Because its performance is based in part on the values of underlying firms, which tend to respond slowly to market information and can be artificially smoothed, the private equity market may look less volatile than the public market for a short period of time.

Several approaches for estimating private equity volatility have been created by “unsmoothing” appraisal-based returns utilizing a large pool of assets representing various private equity strategies or subclasses. Despite the fact that various methodologies may provide somewhat different estimates, they all provide useful information about how different sectors of the private equity markets fluctuate over time and their short-term risk characteristics. Due to the lack of a broad-based private equity benchmark, an individual investor’s private equity portfolio is likely to differ from the market in terms of the subclass, geography, fund size, sector exposure, vintage year, and other factors, and they would each face different investment opportunity sets when making a new capital commitment. Investors in private equity typically cannot move in and out of their stakes regularly without incurring considerable transaction expenses after they have made a commitment. As a result, investment and allocation decisions must increasingly be based on the economic worth of the investor’s existing private equity obligations, as well as the dispersion of their end outcomes once these commitments have been held to maturity or fully liquidated.

Despite the high cost of purchasing and selling pre-existing private equity assets, secondary market transactions have increased significantly, owing to investors’ increasingly active attitude to managing their private equity portfolios.

 LPs may utilize the secondary market to:

  1. Increase or reduce exposure to certain market sectors as a result of a change in their investment strategy or economic condition.
  2. Manage unforeseen risks as their holdings develop.
  3. Simply obtain liquidity from their existing assets. Secondary sales, which can include a huge portfolio of assets, are another way for private equity asset managers to generate liquidity, return cash to clients sooner, and maximize portfolio performance.

We’ve seen an increase in GP-led transactions that are driven by a desire to not only provide liquidity to existing LPs, but also to realign the interests of various stakeholders, bring in new capital, and allow the sponsor to manage selected assets for longer periods of time in order to create more value. Whatever the incentive for secondary market participants, the capacity to pick transaction assets and the ability to evaluate their risk-adjusted return potential during the ensuing holding term are key to success.

Fund performance tends to rise, not reduce, for funds older than five years.

The cross-section variation of funds is used to estimate the factors of future fund performance. Future fund performance is predicted by a number of market-wide and fund-specific characteristics, including liquidity created to date, prior fund performance, dry powder (at both the fund and market-level), public market returns, credit spreads, and so on. However, the key parameters differ for buyout and venture capital funds, and they might change throughout the course of a fund’s existence.

by Rachel Buscall

by Rachel Buscall

Co-Founder & Managing Director at New Capital Link. Having started her career in the financial sector, Rachel demonstrated a natural flair for entrepreneurship.

New Capital Link

Alternative investment specialists offering structured opportunities across the UK & Overseas.

New Capital Link is a boutique London-based introducer that offers unique UK & global investment opportunities worldwide.

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Due to the potential for losses, the Financial Conduct Authority (FCA) considers this investment to be very complex and high risk.

What are the key risks?

1. You could lose all the money you invest

If the business offering this investment fails, there is a high risk that you will lose all your money. Businesses like this often fail as they usually use risky investment strategies. 

Advertised rates of return aren’t guaranteed. This is not a savings account. If the issuer doesn’t pay you back as agreed, you could earn less money than expected or nothing at all. A higher advertised rate of return means a higher risk of losing your money. If it looks too good to be true, it probably is.

These investments are sometimes held in an Innovative Finance ISA (IFISA). While any potential gains from your investment will be tax free, you can still lose all your money. An IFISA does not reduce the risk of the investment or protect you from losses.

2. You are unlikely to be protected if something goes wrong

The business offering this investment is not regulated by the FCA. Protection from the Financial Services Compensation Scheme (FSCS) only considers claims against failed regulated firms. Learn more about FSCS protection here. https://www.fscs.org.uk/what-we-cover/investments/ or

Protection from the Financial Services Compensation Scheme (FSCS), in relation to claims against failed regulated firms, does not cover poor investment performance. Try the FSCS investment protection checker here. https://www.fscs.org.uk/check/investment-protection-checker/

The Financial Ombudsman Service (FOS) will not be able to consider complaints related to this firm or Protection from the Financial Ombudsman Service (FOS) does not cover poor investment performance. If you have a complaint against an FCA-regulated firm, FOS may be able to consider it. Learn more about FOS protection here. https://www.financial-ombudsman.org.uk/consumers

3. You are unlikely to get your money back quickly

This type of business could face cash-flow problems that delay interest payments. It could also fail altogether and be unable to repay investors their money. 

You are unlikely to be able to cash in your investment early by selling it. You are usually locked in until the business has paid you back over the period agreed. In the rare circumstances where it is possible to sell your investment in a ‘secondary market’, you may not find a buyer at the price you are willing to sell.

4. This is a complex investment

This investment has a complex structure based on other risky investments. A business that raises money like this lends it to, or invests it in, other businesses or property. This makes it difficult for the investor to know where their money is going.

This makes it difficult to predict how risky the investment is, but it will most likely be high.

You may wish to get financial advice before deciding to invest.

5. Don’t put all your eggs in one basket

Putting all your money into a single business or type of investment for example, is risky. Spreading your money across different investments makes you less dependent on any one to do well. 

A good rule of thumb is not to invest more than 10% of your money in high-risk investments. https://www.fca.org.uk/investsmart/5-questions-ask-you-invest

If you are interested in learning more about how to protect yourself, visit the FCA’s website here: https://www.fca.org.uk/investsmart

For further information about minibonds, visit the FCA’s website here.https://www.fca.org.uk/consumers/mini-bonds