Beyond the J Curve

"...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)

About the authors DR THOMAS MEYER studied computer science at the Bundeswehr Universitt 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 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 Riskreturn 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 SummaryNAV- 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 InvestmentsApproaches 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 op