It’s said that the most meaningless number in sports is the score at the end of the first quarter of a football game; so much will happen before the final whistle sounds, that the first quarter score is a specious predictor at best. Lately, I’ve been feeling that the private equity equivalent of that oft-misleading tally is Total Value to Paid In Capital (TVPI). I get it . . . we have to gesture in the direction of a comprehensive interim measure of performance, but look folks (and I’m talking to you, GPs): all we LPs really care about is cash in cash out, moolah in da coolah, ducats in the buckets, and pennies in the piggies.
Now it’s always been clear that interim valuations are prone to tinkering, throwing TVPIs into question. No surprise there. But such shenanigans seem to be most frequent as fundraises approach. We didn’t need academic studies to confirm our suspicions, but they’re out there. And even if we’re feeling charitable, the vagaries of subsequent financing rounds and the occasional undulations that all business experience can send NAVs gyrating. No matter what the fair value police (thank you, Accountants and Auditors Full Employment Act of 2002) have to say about it, it’s an incredibly imprecise science.
Advocates of TVPI sometimes say that it’s one of the least-worst quantifications of performance. And indeed, the perfect may be the enemy of the very good. Yet TVPI has been feeling pretty useless as a predictor of final performance unless the D(distributions relative to)PI quotient is pretty high.
So what’s a poor LP to do? How might we think about the success (or lack thereof) of a particular fund? Setting aside the fact that performance is a lagging indicator, not a leading one, how do we institutional private equity portfolio managers show our face in our Monday meetings when the hedge fund cats speak in tongues, regularly dropping Greek, Sanskrit, and Cuneiform in their discourses on performance? We need to bring something more compelling to the table than: “check out this new new thing . . .”
To be sure, there are some nifty performance measures that have gained some currency, including public market equivalent and real time discounting analyses, but most are subject to the appraisal effects that can be so confounding. So here’s my simple proposal: rather than looking at what a portfolio might be worth by guessing at current (or future) company valuations and summing them, what if we instead asked how large an exit each and every investment needed to achieve to return a certain meaningful portion of the fund and then reality checking those putative outcomes? What if we were to turn the coin on its head?
In venture world, one might ask, how big a company needs to be created in order to return half the fund? One times the fund? Those may seem like high hurdles for any one company, but given the high expected loss rates endemic to VC such a discontinuous outcome — or several such big exits — has historically been a prerequisite of generating the types of returns we LPs crave. My buddy, Brad Svrluga, calls this hurdle the "RTFE," or "Return The Fund Exit.") In buyout world, one might ask: how big a return do we need for each of our, say, 10-15 portfolio companies to each return twenty to thirty percent of the fund?
By way of example, here’s what such a table might look like for a $150 million VC fund that wants each company to return half the fund:
Amt Invested Stake Valuation Required Exit
Company A $3,000,000 13.4% $22.5M $562.5M
Company B $1,000,000 3.1% $32.3M $2.4B
Company X $1,500,000 26.0% $5.8M $290.0M
Now Company B might seem like a sporty play, but such an outcome might be in the realm of possible given its progress and potential while Company X may have already seen the market for its new fangled rotary-dial telephone pass it by . . . You see where I’m going with this. (Of course, dilution needs to be considered in due course, although ownership percentage is one lever that can be pulled; he who owns most of the pot of gold at the lowest basis is the King of the Leprechauns.)
Indeed, one of the side-benefits of these analyses has been that GPs are forced to think about their underwriting of deals. An occasional outcome I've experienced on asking GPs to perform this analysis is something along the lines of, “yikes! Our most exciting company is only poised to return a quarter of the fund using reasonable exit assumptions! The rest of the portfolio has to work pretty darn hard for us to get a carry-generating return!”
Now, I’m not hoping (although secretly maybe I am) that thinking rigorously and systematically about exits and fund arithmetic will introduce a value (or at least a GARP) perspective to private investing, but at the very least, I’m hoping we can start to reframe the conversation from what LPs currently are thinking (i.e. “how are you trying to pull the wool over my eyes?”) into a real discussion that starts to unpack assumptions and drive the intimacy and engagement that is so sorely lacking in today’s LP-GP relationship.
Not sure if it’s a norm, but it’d surely surprise me if the GP takes an investment call in a particular portfolio company without as much as doing a cursory review of its exit potential & potential exit valuation – they probably do too, but don’t necessarily assign a value, given the magnitude of arbitrariness in doing so. It hence is somewhat ironic that the exit valuation in this model is a merely a derivative of the overall size/ value of the fund raised by the VC and doesn’t factor-in anything that’d determine the potential of an individual investee enterprise – confounding this further is the VC having to justify this derived value.
So while the proposed analysis does sound like a non-nonsense approach to assessing the fund performance, that part about “reality checking those putative outcomes” would still remain the single most challenging & expectedly the most contentious aspect even as LP-GP engage with an intent to cracking the funding arithmetic.
Nonetheless, it’s good to be reminded that for all practical reasons the sum of individual valuations of portfolio companies in a particular fund is but an unexciting statistic to the PE Portfolio manager in the LP organization keen on showcasing something akin to the promise of an ‘absolute return’ his hedge-fund counterpart typically presents 🙂
[…] At the end of the day all that matters is Moolah in da Coolah – the distributed to paid-in-capital multiple that a fund ultimately achieves. Here was my effort at thinking about some of these portfolio construction issues in the context of valuation environment: All About the Benjamins. […]