Beyond the J Curve

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.

• List of Boxes xvAcknowledgements xviiDisclaimer xviiiPart I Private Equity Environment 11 Introduction 31.1 Routes into private equity 31.2 The limited partner's viewpoint 41.3 The challenge of venture capital fund valuation 41.4 Hard figures or gut instinct? 51.5 Managing with fuzzy figures 51.6 Making the grades 51.7 Outline 72 Private Equity Market 92.1 Funds as intermediaries 102.2 The problem of predicting success 152.3 Broad segmentation of investment universe 182.4 Private equity market dynamics 222.5 Conclusion 263 Private Equity Fund Structure 273.1 Key features 293.2 Conflicts of interest 383.3 Finding the balance 384 Buyout and Venture Capital Fund Differences 414.1 Valuation 434.2 Business model 444.3 Deal structuring 454.4 Role of general partners 455 Funds-of-funds 475.1 Structure 475.2 Value added 485.3 Costs 515.4 Private equity investment programme 52Part II Investment Process 576 Investment Process 596.1 Key performance drivers 596.2 Process description 616.3 Risk management 656.4 Tackling uncertainty 687 Risk Framework 737.1 Market value 757.2 Market or credit risk? 777.3 Conclusion 788 Portfolio Design 818.1 Portfolio design framework 818.2 Portfolio construction techniques 838.3 Risk–return management approaches 889 Case Study 959.1 Looking for the optimal programme size 959.2 Overcoming entry barriers: long-term strategies 10410 The Management of Liquidity 11510.1 Liquidity management problem 11510.2 Liquidity management approaches 12310.3 Investment strategies for undrawn capital 13010.4 Cash flow projections 13310.5 Conclusion 145Part III Design Tools 15111 Established Approaches to Fund Valuation 15311.1 Bottom-up approach to private equity fund valuation 15411.2 Inconsistency of valuations 15711.3 NAVs do not tell the full picture 15711.4 Portfolio companies cannot be valued in isolation 15911.5 Conclusion 16212 Benchmarking 16512.1 Specific issues 16512.2 Individual funds 16612.3 Portfolio of funds 17013 A Prototype Internal Grading System 17313.1 Grading of private equity funds 17313.2 The NAV is not enough 17413.3 Existing approaches 17613.4 New approach to internal fund-grading system 18013.5 Summary—NAV- and grading-based valuation 18813.6 Conclusion 18914 Fund Manager Selection Process 19314.1 Relevance of fund manager selection 19314.2 Why due diligence? 19414.3 The due diligence process 19514.4 Fund manager selection process 19714.5 Decision and commitment 20115 Qualitative Fund Scoring 21915.1 Scoring approach 21915.2 Scoring dimensions 22116 Grading-based Economic Model 23316.1 Approach 23316.2 Internal age adjustment 23716.3 Private equity fund IRR projections 23816.4 Expected portfolio returns 23916.5 Discussion 24116.6 Conclusion 24217 Private Equity Fund Discount Rate 25317.1 The capital asset pricing model 25317.2 Private equity fund betas 25717.3 The alternatives to the capital asset pricing model 26417.4 Summary and conclusion 266Part IV Management Tools 26918 Monitoring 27118.1 Approach to monitoring 27218.2 The monitoring objectives 27318.3 Information gathering 27618.4 Evaluation 28218.5 Actions 28519 Case Study: Saving Your Investments—Approaches to Restructuring 28719.1 The valley of tears 28819.2 The report to the board 28919.3 The terms of the restructuring 29119.4 Epilogue 29320 Secondary Transactions 29720.1 Sellers and their motivations 29720.2 Buyers and their motivations 29920.3 Secondary market prices 30020.4 Transactional issues 30720.5 The fund manager perspective 308Part V Embracing Uncertainty 31121 Deviating from Top Funds 31321.1 Strategic investments 31321.2 Policy objectives 31422 Real Options 31922.1 Real options in private equity 31922.2 Real option analysis 32122.3 An expanded strategy and decision framework 32223 Beyond the J-curve 32723.1 Some do it better 32723.2 Deadly sins 32723.3 Structure instead of "gut instinct" 32823.4 Patience is a virtue 32823.5 Turning water into wine 329Glossary 331Bibliography 341Abbreviations 351Index 353

"...highlights why limited partners are bad performers and provides guidance for investments..." (Financial Times, 1st August 05) "...an interesting book on a fascinating subject" (Professional Investor, Dec/Jan 05/06)