Not-So-Private Equity

08-19-2003 | Source: Institutional Investor Magazine, Americas and International Editions

IN THE FALL OF 2001, THE CALIFORNIA PUBLIC EMPLOYEES' RETIREMENT SYSTEM BEGAN fielding calls and letters from Matt Marshall, a journalist at the San Jose Mercury News. The reporter wanted information on the performance of CalPERS's private equity investments, including details on companies owned by funds in its portfolio.

The nation's biggest pension fund, citing nondisclosure clauses in its investment partnership agreements, refused to comply. The Mercury News turned up the heat with letters from its lawyers, arguing that a state agency is obliged to make such disclosures and noting that CalPERS had previously published selective private equity performance data in brochures and on its Web site. CalPERS continued to demur.

Then the newspaper tried another route. It filed a request under California's Public Records Act, the state's version of the federal Freedom of Information Act, which limits government agencies' ability to withhold data except when it pertains to sensitive matters of security, law enforcement and trade secrets. CalPERS argued that performance data are trade secrets, and thus exempt, but the fund's previous disclosures undermined its defense, and last December it agreed to a settlement. CalPERS would reveal how much it had earned or lost in each of the private equity funds it invests in, but it wouldn't disclose the identities or valuations of individual companies in the portfolios.

The settlement, consistent with -- and spurred by -- a November ruling by San Francisco Superior Court Judge James Robertson, was a landmark, a clear sign that the private equity asset class had grown too big and prominent to maintain its clubby and secretive ways.

"The people of California are entitled to know how their retirement money is being invested and what kind of performance they're getting," reasons David Yarnold, who was executive editor of the Mercury News when it was pursuing CalPERS and who now oversees the paper's editorial and opinion pages. "It's the height of arrogance to say to the people whose money you're investing that they're not smart enough to understand performance results."

A similar demand from the Houston Chronicle forced the University of Texas Investment Management Co. to disclose its private equity fund performance in October. In December the California State Teachers' Retirement System and the Oregon Public Employees Retirement System both agreed to disclose their investments' internal rates of return. And in March the University of Michigan decided to disclose its private equity results.

The pressure for disclosure isn't coming only from news organizations. Student groups and labor unions have gotten in on the act, pushing for transparency from private endowments, such as those of Harvard University and Yale University, which are exempt from open-records laws. Mark O'Hare, co-founder of Private Equity Intelligence, an online information service, is using open-records laws in Massachusetts, Texas and elsewhere to collect data on state agencies' holdings in more than 1,500 private equity funds and resell information about those funds to investors, private equity firms and financial advisers. Freedom-of-information principles, says O'Hare, "make it impossible to stop disclosure."

The private equity industry -- limited liability partnerships making investments primarily in private companies, including the relatively high-risk start-ups that receive venture capital funding -- has long defended its selective disclosure practices. Discretion traditionally ensured a level of comfort between fund managers and their investors. If public pension funds have to disclose too much, so the logic goes, private equity partnerships might be less willing to invite them in.

Under normal contractual arrangements only general and limited partners are privy to the financials. But the industry has grown too big, important and international to maintain its veil of secrecy, especially at a time when public markets have tumbled and fraud has been exposed in other corners of the financial world.

"It illustrates a fundamental tension," says Joseph Dear, executive director of the Washington State Investment Board, which has released private equity performance data upon request since 1998 in accordance with a state public records law. "A public agency must be transparent and accountable and at the same time carry out the functions of a major investment management organization, for which privacy is necessary in extremely competitive financial markets." The board now earmarks 12 percent of its $51.8 billion portfolio for private equity.

Demands for accountability are also coming from large limited-partner investors, who are pushing for more timeliness and transparency in the way private equity and venture capital firms' portfolio holdings are valued. Although the buy-side investors can get thorough reports from their general partners, they often invest in so many private equity funds -- 350 in CalPERS's case -- that it is virtually impossible to keep close tabs on the individual companies held in those portfolios. Further complicating their task is the fact that different funds may ascribe different valuations to the same company. Such imprecision might have been acceptable during the market bubble of the 1990s, when everybody was getting rich, but the sharp decline in public markets (and hence private equity valuations) has put a far higher premium on precision in reporting.

Just ask William Franklin, managing director of Bank of America Capital Corp., who oversees the private equity portion of the Bank of America Corp. subsidiary's $5 billion in investment funds, distributed among 200 venture and buyout firms. Franklin is chairman of the Private Equity Industry Guidelines Group, a consortium of investors that is exploring ways to standardize valuation and reporting methods for its own purposes -- and perhaps for eventual public consumption. "I can get all the information if I ask, but how much time do I want to spend doing that?" Franklin says. "To answer questions from my management intelligently, I need to know what's going on in the underlying companies. I want more consistency in valuation methodologies and consistency in the level of data that's exchanged."

UNTIL THE EARLY 1990S, PRIVATE EQUITY WAS A cliquish cottage industry that attracted at most a few billion dollars in a typical year -- mainly from well-heeled investors who understood and accepted the risks of these relatively high-stake bets. No more. In 2000, the year the technology boom peaked, venture capitalists raised $107 billion, and other private equity funds -- including those investing in buyouts and mezzanine stages -- rang up $87 billion more, according to Thomson Venture Economics and the National Venture Capital Association. Net new venture capital fundraising plunged to about $2 billion in 2002, with other private equity at $32 billion, but the cumulative flood of liquidity into nonpublic investments has spawned an ever-expanding circle of interested parties -- among them, public pension funds seeking to diversify their portfolios. In 2002 these institutions were responsible for slightly more than 20 percent of venture capital investments and perhaps as much as 30 percent or more of buyout funds.

CalPERS, for example, says that it has committed to invest $19.6 billion in its alternative-investment management program, but as of the end of April, it had deployed only $6.7 billion, 4.9 percent of CalPERS's total portfolio of $137.8 billion. The annual internal rate of return on those private equity investments as of December 31, was 8.8 percent. (The pension fund's top executives declined to be interviewed for this article.)

"The scale of some of the funds, and the multiple sources from which they collect their funds, requires that they behave as large institutions to some degree, with some standard procedures that they can point to and that investors rely upon," says Colin Blaydon, a director and former dean of the Foster Center for Private Equity at Dartmouth University's Tuck School of Business.

Ted Dintersmith, a partner at Charles River Ventures in Waltham, Massachusetts, and a director of the National Venture Capital Association, says that although general partners may agree in principle on the need for better disclosure, that doesn't mean that they are eager to oblige -- especially after two consecutive years in which venture capital losses exceeded 20 percent.

General partners' biggest worry is that revealing internal rates of return, the common benchmark for private equity performance during the life of a fund, would put them on a slippery slope that could lead to the exposure of confidential data that might cause damage to companies in their portfolios. They fear that financial or qualitative information could tip off outsiders about a strategic breakthrough or competitive weakness. Poor performance of a venture fund could hinder its ability to raise additional capital.

Moreover, public plans and general partners alike fret that the lay observer will not appreciate the long-term nature of these investments and will misinterpret performance numbers that are grounded in the highly subjective process of valuing illiquid entities.

Funds typically post sharp declines in their first few years -- a phenomenon known as the J-curve -- when management fees pile up and portfolio companies aren't ready for the initial public offerings or mergers that provide the greatest returns to investors. Industry experts maintain that internal rates of return have little significance until at least midway through a fund's typical ten-to-12-year life span and that the only measure that really counts is the money returned when a fund reaches the end of its term.

Sanjay Subhedar, a founding partner at Storm Ventures in Palo Alto, California, dismisses interim IRRs as "absolutely meaningless. Disclosing IRRs on a quarterly basis is like taking the score every two seconds in a basketball game." Of course, basketball fans do exactly that -- and private equity investors get their scores on a quarterly basis.

Instead of remaining reactive and defensive in response to public requests, private equity players are moving to improve the way portfolio companies are valued, which is the basis for the funds' performance numbers. The nearly two-year-old Private Equity Industry Guidelines Group is at the forefront of this trend. PEIGG has 18 member companies, including General Motors Investment Management Corp., Grove Street Advisors, HarbourVest Partners, J.P. Morgan Chase & Co. and Financial Technologies, provider of the Investran accounting system used by many private equity firms.

PEIGG aims to complete a first draft later this year of recommended guidelines for portfolio valuation and performance reporting -- a document that it hopes will preempt formal government intervention. Although there have been no statements to suggest that private equity is in its sights, the Securities and Exchange Commission is bearing down on the lightly regulated hedge fund sector, and venture capitalists fear they might be its next target. "We believe we should self-police and not let the government come in and drive regulation," says PEIGG's Franklin.

As recently as a year ago, there was little to indicate that the private equity disclosure issue would create such excitement. For years a handful of states, including Alaska and Washington, had been disclosing private equity performance data, consistent with their interpretation of local open-records laws. Doing so became routine and was little noticed except by interested parties like labor unions and researchers.

But disclosure became a cause célèbre after the collapse of the stock market bubble and the corporate scandals that ensued. The reporting by the San Jose Mercury News attracted the most attention because it went after the biggest fund of all, CalPERS.

The Mercury News wasn't the first newspaper to confront a state pension agency. In 1999 the Houston Chronicle investigated the University of Texas Investment Management Co.'s private equity portfolio. The paper reported that almost a third of the investments made between 1995 and 1998 -- totaling $1.7 billion -- were in firms having political or personal ties to either Utimco's then-chairman, Thomas Hicks, the founder of buyout shop Hicks, Muse, Tate & Furst, or to then- governor George W. Bush. Last year the Chronicle filed an open-records request that, as in the California case, resulted in a settlement. In September the Utimco board, pushed by a decision from then­state attorney general John Cornyn, decided to release IRRs and cash-in and cash-out totals for 149 completed and active funds worth a combined $1.8 billion.

Freedom-of-information-style requests from newspapers and other entities across the country have multiplied. But general partners at private equity shops appear to be winning their argument against pension funds and other disclosure advocates who have called for specific information about portfolio companies. Says Charles River's Dintersmith: "We give a fair amount of information about the status of our current portfolio companies to limited partners. We'll fight to the death to prevent that from reaching the public. It would be incredibly detrimental."

Even disclosure of aggregate IRRs could cramp portfolio managers' investment styles. "Imagine that a guy reading the paper sees that Utimco's pension funds have been losing money," says Jonathan Silver, a general partner at Core Capital Partners in Washington, D.C. "Then he calls the union guy, who calls the limited partners. You can then imagine the pressure about what kinds of investments the funds are making. That could make it very hard to manage a ten-year fund."

On the flip side, more public awareness of IRR data could bring more questioning of the accuracy of portfolio company valuations and an improvement in transparency that many investors would welcome. Determining a private company's worth involves a lot of guesswork. It requires general partners to make judgments about the unrealized value of portfolio companies -- estimates that in turn must account for intangibles like the state of technology and the quality of management.

Aware of these pitfalls, CalPERS and others have added sections to their published reports and Web sites, explaining the valuation difficulties, the long-term nature of these investments and the J-curve effect (see box).

Ironically, the push toward greater transparency could narrow the range of information that general partners are willing to share with limited partners, such as public pension funds, that are exposed to state open-records requirements. "We're beginning to see some GPs restricting the information that they're providing to us, which either necessitates an on-site visit to inspect financial data or a dialogue about how to protect information necessary for proper oversight," says Washington State's Dear.

The consequences of disclosure by public agencies -- intended or otherwise -- will become apparent over the next year, when many private equity firms are expected to try to raise new funds to succeed those that they raised at the height of the dot-com boom. Because these new funds are likely to be smaller, in keeping with the more constrained investment climate, the funds raising money can afford to be choosier.

Clint Harris, co-founder and managing partner of Wellesley, Massachusetts­based Grove Street Advisors, which oversees CalPERS's private equity portfolio, reckons that 20 to 40 venture shops could choose not to take capital from public pension funds. "We've got two in our portfolio that care about having their performance data disclosed, and access will be limited next time," Harris says, adding that he thinks the impact on CalPERS's financial performance will not be material.

"Access is a major concern," says Dear. "If we can't do business with the best investment organizations, it limits our ability to generate returns for the beneficiaries."

HOWEVER THE PRIVATE EQUITY INDUSTRY navigates the battleground over public disclosure, it will have to come to grips with valuation standards. Valuation questions caused plenty of headaches during the market downturn as institutional investors struggled to get a good read on how their private equity investments were faring.

More than half of the private equity funds in the U.S. base their valuation methodology on proposals issued, but never officially adopted, by the National Venture Capital Association in 1990, according to a survey of 288 venture firms conducted last fall by the Foster Center at Dartmouth. When the bubble was inflating, these guidelines yielded conservative results: They prescribe that investments in portfolio companies be carried at cost until a new round of financing or material change indicates a different value. Therefore, valuation increases generally lagged behind fair market values.

That worked well when times were good; everyone likes good news. But as the market turned bearish, the NVCA method often overestimated portfolio company valuations. And because subjective judgments play a big role in assessments, different venture capital firms often attach different valuations to the same portfolio company. That can make it difficult for institutional investors to monitor their private equity performance and make accurate reports to their boards.

"We have various GPs reporting portfolio companies differently," says BofA's Franklin. "The more standardization, the easier it would be for us to assess our portfolio."

The pending guidelines from the Franklin-led PEIGG are meant to supersede the de facto NVCA standards, applying to interim valuations in venture capital and, unlike the NVCA's, also to buyout funds. Whereas the NVCA rules rely mainly on "liquidity events" such as new investment rounds to calculate a valuation, the PEIGG will likely encourage general partners to factor in more subjective variables to get timelier fair-value estimates consistent with international accounting conventions. For instance, general partners could be pushed to explain and measure how a company is executing against its business plan as well as account for the movement of public market indexes.

Most limited partners are not big fans of this modification, because it would result in increased volatility and less consistency in funds' portfolio company valuations and because it doesn't fully reflect the long-term speculative nature of venture investments. But it is favored by public companies that must mark their private equity investments to market on a quarterly basis and by public pension funds whose (now public) quarterly performance data will be scrutinized by beneficiaries. For public companies that have sharply curtailed their private equity portfolios since the market peak, the benefits of greater transparency and accuracy in valuations would more than offset any increase in volatility. "We're part of a bank with $769 billion in assets," says BofA's Franklin. "My portfolio is not material."

Kevin Delbridge, a managing director at private equity firm HarbourVest Partners in Boston and head of PEIGG's valuation subcommittee, believes that the group is taking a conservative approach that will make interim valuation changes less abrupt.

"We need to move up to the next level in terms of professionalizing reporting and value," declares Delbridge, who estimates that current venture capital valuations are overstated and could fall 20 percent this year. "We need to reduce the amount of wiggle room," he says, in part by encouraging closer consultations between limited and general partners. "We'd like to see greater transparency for the LPs and give them the opportunity to give advice and guidance to the GPs."

Adds PEIGG chairman Franklin: "Fair market value is in the eye of the beholder, so we suggest that there be interaction between general partners and the investors in the fund. At least there should be an acceptance by LPs that this is an acceptable set of valuation policies."

The British Venture Capital Association, the other major industry body working to codify standards, issued a set of reporting and valuation guidelines on July 7. Consistent with international accounting norms, they endorse greater use of rigorous fair-value assessments and timely reporting practices.

"There may be a compromise approach that appeals to the underlying principle of fair value but still recognizes the nature of this asset class -- and to which people in the accounting profession would say, 'All right,'" says Dartmouth's Blaydon. "We're at least six months away from knowing, but there needs to be a resolution within the next year. There's still a lot of bad news to come out, and otherwise things will be seen as secret and nontransparent."

Battered by market volatility, targeted by the press and wary of government regulation, the private equity business is coming out in the open, and its principal players must get accustomed to the glare. 

Pressed for the first time to disclose details of their private equity investments, public pension plans may be throwing their members a curve -- literally.

The institutions are prefacing their disclosures with detailed disclaimers that provide, in essence, a crash course on the J-curve. That's the figure that illustrates the propensity of private equity funds to post negative returns in their early years -- when portfolio companies are burning cash -- before delivering sharply higher returns as they climb to profitability or are sold or taken public.

Readers must plow through these disclaimers before getting to the bottom-line internal rates of return. The University of Texas Investment Management Co. puts its 149-word disclaimer on every page of its report, beginning with "WARNING: Due to a number of factors, including most importantly a lack of valuation standards in the private equity industry, differences in the pace of investments across partnerships and the understatement of returns in the early years of a partnership life, the IRR information in this report DOES NOT accurately reflect the current or expected future returns of the partnerships."

Besides educating plan participants, such wording provides cover for the pension funds' wretched results from investments made in 1999, 2000 and 2001, while not offending general partners who prefer not to bring too much attention to their poor early-stage performance.

Consider the 1999 fund Telecom Partners III, into which the Washington State Investment Board had sunk $46.3 million as of year-end 2002. Since inception the value of the investment had shrunk to $4.7 million, for an annualized internal rate of return of ­64.2 percent.

In 2001 the California Public Employees' Retirement System committed $325 million to Lombard Pacific III but only got around to investing $1.4 million. As of the end of last December, the value had shriveled to $14,000 as the fund had lost more than 99 percent of its value.

It's hard to do worse than that, but CalPERS tags all of its alternative-investment returns on 1998-vintage-and-later funds "not meaningful." As its Web site explains it, "Industry practice dictates that these funds are in the early stages of their investment life cycle, and any performance analysis done on these funds would not generate meaningful results as private equity funds are understood to be long-term investments."

Still, there is an upside, which explains why public pension funds continue to allocate portions of their portfolios to private equity.

Despite a recent string of duds, the University of Michigan has enjoyed a slew of home-run investments, including Matrix Partners IV, a 1995 fund that had a net annual IRR of 223 percent as of the end of June 2002, and Kleiner Perkins Caufield & Byers III, launched in 1996, which posted a net IRR of 287 percent.

Utimco says its private equity returns have outperformed the Standard & Poor's 500 index on a one-, three-, five- and ten-year basis. CalPERS reports that its currently active investments of $10.8 billion in 350 funds had a net annualized IRR of 8.8 percent as of year-end 2002. That's impressive, considering that the weighted average age of CalPERS's portfolio is 3.7 years. Going forward, the J-curve should make it even better. -- S.B.