How to screen private equity funds?

Hello, everyone. In this lesson, we will talk about how to screen private equity funds that are suitable for you. In order to allocate private equity funds in their own portfolio, we should first need its income characteristics, and then we should be familiar with the evaluation methods of private equity funds in order to match their own private equity funds.

1. The income characteristics of private equity funds.

Compared with the traditional large types of assets, the returns of private equity funds obviously show a "J curve effect" (J-curve Effect).

J curve is a curve drawn with time as the horizontal axis and the rate of return of private equity funds as the vertical axis. The trajectory is similar to the letter J, which reflects the phenomenon that the return of private equity funds is negative in the early stage and becomes positive gradually in the later stage, which is vividly called the J curve effect.

Through this phenomenon, it is not difficult to see the two major characteristics of private equity fund returns: first, private equity investment is a long-term investment. The investment period of general equity investment funds is 7-9 years, and in the first 2-3 years, it is mainly difficult to obtain income, and the income will not increase significantly until the investment is effective. Second, the liquidity risk is prominent, the entry and exit of private equity investment is not easy, when the market deteriorates or there are better investment opportunities, it may not be able to exit.

Therefore, in asset allocation, private equity funds belong to the asset class of high growth and low liquidity. Investors should fully consider their own risk tolerance and allocation needs to judge whether private equity funds are suitable for them. At the same time, pay attention to the diversification of investment risk, control the proportion of private equity funds in asset allocation, usually 5% of 10% is reasonable.

2. Evaluation methods of private equity funds.

Different from other financial investments, the private equity industry has the characteristics of strong data privacy, uneven distribution of returns and long investment cycle, so the factors considered in its evaluation are more diversified. We can adopt a combination of quantitative and qualitative methods to evaluate private equity funds, mainly using quantitative indicators for long-term evaluation, while qualitative factors can be used for short-term evaluation.

Quantitative analysis is to judge the ability of funds to create returns from the perspective of risk and return. The commonly used performance indicators to evaluate private equity funds are IRR, MOIC, DPI, RVPI, TVPI and so on.

Internal rate of return IRR (Internal Rate Of Return)

The internal rate of return is the discount rate at which the total present value of capital inflow is equal to the total present value of capital outflow and the net present value is equal to 00:00. This index takes full account of the time value of money and is widely used at present. The higher the IRR, the earlier or more the investment will be returned.

However, it should be noted that in the stage of continuous investment in private equity funds, high IRR does not mean that the fund is better. Because in the process of IRR calculation, the IRR of small projects in the short term is often on the high side, but they may not actually make much money. Because of the long investment cycle and large investment in the early stage, the calculated IRR of large projects that really make money is often on the low side. Therefore, when using IRR, we should pay special attention to the time point of cash flow in and out of the fund during the existence of the fund, and avoid simply looking at the IRR value to measure the performance of the fund.

In fact, because fund managers need to balance the length of investment time and the level of investment returns, the rhythm of capital inflows and outflows of each private equity fund is different, so it is not meaningful to look at IRR in the pre-investment of private equity funds. On the contrary, it will have more reference significance to observe the IRR when withdrawing from the fund or the fund withdrawing from the project. Because at this time IRR is already a definite number, there will be no change, and it can better represent the investment ability of the manager. In addition, IRR can also be used in the withdrawal period to do horizontal comparison with other funds issued in the same period to evaluate the performance of funds in the industry.

Return on Capital multiple MOIC (Multiple Of Invested Capital)

The multiple of capital return is the ratio of the investment return of the equity investment fund to the initial investment, which reflects the increase of the absolute value of the capital invested by the fund. If the MOIC of a private equity fund is 2 times, there is no other special mark, which means that the principal invested by the fund has increased by 100%.

There are two types of MOIC: realized return multiple (Realized MOIC) and unrealized return multiple (Unrealized MOIC). When the project does not exit, MOIC refers to the multiple of unrealized return, using the current fair value of the project to compare the investment cost. When the project cost withdraws and the investment return of the fund is secure, MOIC is the multiple of the realized return, which is equal to the actual investment return than the investment cost.

Usually, a private equity fund will invest in multiple projects. Investors can directly understand the situation of each project invested by the fund by looking at the MOIC of the project or portfolio invested by the fund. These MOIC values are generally marked in the fund's post-investment report. When analyzing this, investors should note that if the project with high MOIC has never been withdrawn and the valuation is high, the exit time should be carefully evaluated; if the duration of the project MOIC is less than or equal to 1 for a long time, the possibility of cost recovery in the future is low, and necessary measures should be taken as soon as possible.

Generally speaking, the advantage of MOIC is that it directly reflects the growth of the value of the fund, while the disadvantage is that it does not take into account the time required to complete this growth. For example, the same 10-fold return, whether realized in 8 years or 10 years, cannot be reflected through MOIC. Therefore, when evaluating private equity funds, MOIC should be used together with IRR. There are special quick check tables for MOC and IRR in the industry, which can easily find out IRR according to MOC and investment time. In addition, MOIC is also suitable for horizontal comparisons between private equity funds established in the same period to see who has a higher return on capital at the same time.

Invested capital dividend rate DPI (Distribution over Paid-In)

The dividend rate of the invested capital is equal to the ratio of the cash dividend of the fund to the capital paid by the investor. DPI equals 1 is the break-even point, which means that investors have fully recovered their invested capital. The shorter the time for DPI to reach 1, the faster the return on investment. In practical application, DPI is an indicator that investors pay close attention to, because it represents the return of investors' income, excluding the "rich on paper" part.

Multiple of residual value of invested capital RVPI (Residual Value to Paid-In)

The multiple of the surplus value of the invested capital is equal to the unrealized return than the capital paid by the investor. Used to measure the outstanding return of investors, the unrealized return is the book value of the assets held by the fund. In contrast to DPI, RVPI measures the return of the rich part of paper, which tends to vary and differ from the final return.

Multiple of invested capital TVPI (Total Value to Paid-In)

The multiple of the total invested capital measures the multiple of the expected return of the investor, which is the ratio of the expected total value of the fund to the paid-up capital of the investor. Note here to distinguish from MOIC, MOIC is the return multiple of the fund, and the denominator is the amount invested by the fund (investment cost). TVPI=DPI+RVPI, the expected total value in the early period of the fund refers to the valuation of the investment portfolio. When all the investments of the fund are completely withdrawn, the expected total value is the final return of the fund.

Qualitative analysis is mainly to evaluate the brand, management team, competitive advantage, internal control management, investment strategy and other aspects of private equity funds.

Fund brand

Mainly focus on the brand recognition of fund companies, credit status, ranking in the investment industry, financing capacity analysis, the composition of fund investors and so on. Among them, in terms of credit status, we should adopt the strategy of "once there is a default or veto". In addition, for various rankings, we should also pay attention to the selection and ranking rules, not just look at the ranking figures.

Management team

Investors should evaluate the fund manager team as comprehensively as possible, not only from the aspects of educational background, professional experience, investment characteristics, personal investment performance and social resources, but also comprehensive evaluation of team culture, complementarity of team capabilities, team stability, team cooperation and other core personnel, such as fund partners, VP (vice president), investment managers, analysts and other core personnel from the aspects of educational background, professional experience, investment characteristics, personal investment performance and social resources.

advantage in competition

In the accumulation of long-term investment experience, different private equity foundations form different competitive advantages, such as professional advantage, channel advantage, capital market advantage, enterprise operation advantage and so on. No matter what kind of advantages, as long as the formation of outstanding characteristics, it is possible to create differential opportunities to obtain more effective investment and better returns. Therefore, it is necessary to examine the fund manager's investment experience, enterprise operation experience, industry status, industry resources, social resources and other advantages of the candidate funds.

Internal control management

Investors should pay attention to whether the candidate fund manager's organizational structure, mode of operation, decision-making mechanism, decision-making process, internal distribution mechanism and other aspects are scientific and risk can be controlled.

Investment strategy

Investors should inspect the fund development strategy and investment planning. First of all, from the macro level, we should see whether the investment direction of the fund is in line with the development policy and the trend of economic development. Secondly, we should pay attention to observe whether the fund has a clear strategic goal and scientific investment concept. Finally, we should pay attention to the investment mode, field, stage, region, project selection, project investment, post-investment management, project exit and other strategies of the fund.

In addition to quantitative and qualitative analysis, investors can also observe the proposed investment funds from the perspective of evaluation of third parties, such as evaluation of project parties, evaluation of investors, evaluation of other funds under the same brand, and so on.

All right, that's all for today. There are many contents, if you have any questions, you are welcome to leave a message for us to communicate and discuss. I believe that at present, we have a better understanding of private equity funds, and we will talk about the subscription practice of private equity funds in the next class.