CEO Middle East - - CONTENTS - Sean Daykin Prin­ci­ple, Mercer Fi­nan­cial Ser­vices

In light of the re­cent in­ten­si­fied eco­nomic di­ver­si­fi­ca­tion and de­vel­op­ment ef­forts in the GCC, pri­vate eq­uity (PE) is emerg­ing as a rel­a­tively new as­set class in the re­gion. In­ter­est in ‘growth cap­i­tal’ rather than the more tra­di­tional ‘buy out’ PE can be seen in the de­vel­oped mar­kets of the UAE and Western Europe, with ven­ture cap­i­tal (VC) see­ing a a surge fol­low­ing the suc­cess of VC uni­corns such as Ca­reem and the pur­chase of by Ama­zon.

How­ever, the highly-pub­li­cised case of the Abraaj Group’s col­lase has the in­dus­try call­ing for more ro­bust cor­po­rate gov­er­nance in the re­gion. Lo­cal PE man­agers are fac­ing far greater scru­tiny as in­vestors are be­gin­ning to pay more at­ten­tion to how funds are be­ing han­dled. Buy­ers and in­vestors in­creas­ingly want to base their de­ci­sions to en­ter the PE mar­ket through proven and tested in­for­ma­tion, con­sid­er­ing fac­tors such as past per­for­mance, and also due dili­gence on in­vest­ment and op­er­a­tions.

While mea­sur­ing the ab­so­lute and rel­a­tive per­for­mance of pri­vate mar­kets is crit­i­cal, it is sig­nif­i­cantly nu­anced. ‘Value cre­ation is an im­por­tant as­pect in the PE story, and its mea­sure­ment should be ac­cu­rate and mean­ing­ful. Eval­u­at­ing past per­for­mance is al­ways a fac­tor when de­cid­ing whether or not to in­clude PE within the over­all as­set al­lo­ca­tion of a port­fo­lio. How­ever, in­vestors must dive deeper to de­ter­mine a fund’s true per­for­mance, through rig­or­ous due dili­gence. A com­bi­na­tion of met­rics and qual­i­ta­tive mea­sures are im­por­tant for pro­vid­ing a holis­tic un­der­stand­ing of a fund’s track record and its fu­ture po­ten­tial.

In terms of quan­ti­ta­tive met­rics, the three most com­monly used ones are in­ter­nal rate of re­turn (IRR), to­tal value to paid-in (TVPI) ra­tio and dis­trib­uted to paid-in (DPI) ra­tio.

The in­ter­nal rate of re­turn (IRR) is the most widely cited met­ric for mea­sur­ing the per­for­mance of pri­vate mar­ket in­vest­ments. This is a time­based mea­sure­ment which takes into ac­count the in­vest­ment made and ac­quired over a pe­riod of time. The longer an in­vest­ment takes to ma­ture (or sell at a given price), the lower an an­nu­alised IRR.

The sec­ond ra­tio, to­tal value to paid-in (TVPI), con­sid­ers how the sum value re­ceived from in­vest­ments (through div­i­dends and a sale at the end) com­pares to the ini­tial in­vest­ment made.

The fi­nal mea­sure is the dis­trib­uted to paid in (DPI) ra­tio. Again, in sim­ple terms it mea­sures how much of the ini­tial cap­i­tal is re­turned (though div­i­dends or other pay­ments) com­pared to how much was in­vested ini­tially. DPI is a barom­e­ter of re­alised value, not to­tal value.

All three met­rics play an im­por­tant role in help­ing in­vestors eval­u­ate a pri­vate eq­uity fund’s his­tor­i­cal per­for­mance. No sin­gle met­ric can ac­cu­rately as­sess the per­for­mance of a fund, but when em­ployed al­to­gether, they can help paint a more com­pre­hen­sive pic­ture.

Gaug­ing a fund’s past per­for­mance doesn’t re­veal much about the per­for­mance of the next PE fund; long in­vest­ment timescales make it nec­es­sary to con­sider other in­vest­ment re­lated fac­tors as well, in­clud­ing how in­vest­ment teams source deals, how they create value at their port­fo­lio com­pa­nies, and the sta­bil­ity of the team it­self. Fol­low­ing the Abraaj case, as­sess­ing man­agers and back of­fice op­er­a­tions have be­come an es­sen­tial mea­sure of due dili­gence. Ef­fec­tive in­ter­nal con­trols, strong sys­tems and a well-staffed op­er­a­tions team are crit­i­cal for a pri­vate eq­uity fund to suc­ceed.

Mea­sur­ing pri­vate mar­ket per­for­mance is com­pli­cated. It needs a clear view of rel­e­vant met­rics, is in­formed through mul­ti­ple per­spec­tives, and de­mands speci­ficity of anal­y­sis. Ad­di­tion­ally, it can be sub­jec­tive, prone to ma­nip­u­la­tion and rep­re­sent an im­per­fect as­sess­ment of the suc­cess of a pri­vate mar­ket in­vest­ment.

How­ever, pri­vate mar­ket per­for­mance mea­sure­ment will evolve and im­prove on its cur­rent short­com­ings. The key for in­vestors is to iden­tify in­vest­ment tal­ent that can gen­er­ate strong re­turns sus­tain­ably, and un­der­take deep ‘qual­i­ta­tive’ mea­sure­ments with op­er­a­tional due dili­gence to as­sess the like­li­hood of fu­ture in­vest­ment suc­cess.

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