Understanding and Evaluating Buyout Portfolio Risks

Konstantin Danilov The purpose of the paper will be to understand and evaluate portfolio level risk from the perspective of an investor (LP) whose portfolio contains one or more Buyout funds. For the purposes of this paper, risk will be defined as the increased probability of a loss of capital that would result in a return that is less than the median LBO return for a given year. It is the intent of the paper to acknowledge the limits of statistical analysis and focus on a logical measure of relative risk by creating a risk spectrum for each of what I believe to be the fundamental risk drivers within a fund. Further, I will try to establish a framework for monitoring risk on an ongoing basis, as it will likely change during the funds life. The assumptions that I will make are that: 1. The investments in the specific funds have already been made (i.e. many of the factors are only visible after the positions in portfolio companies have been established by the GP). 2. The investor is able to get access to certain financial and otherwise material information from the GP (or from elsewhere) regarding the portfolio companies. The first part of the paper will discuss the reasons why variance is at best a meaningless proxy for evaluating the risk of a PE investment. Next, I will present the risk drivers, the concentration of which within a given fund, I believe to be indicative of increased risk. Returns Distribution LBO returns tend to exhibit a fat-tailed distribution, with a kurtosis of 3.38 (relative to a normal distribution). Also, managed pricing issues and self-selection bias further prevent accurate performance measurement and benchmarking of fund returns.1 Given that the returns distribution is, at best, highly fat-tailed, the use of any normal distribution based statistics to measure risk is highly misleading. Thus, I believe that a blend of logically based qualitative and quantitative factors will be the best proxy for the inherent future risk of capital loss associated with Buyout investing, regardless of past volatility. Most of the factors are specific to portfolio companies will have to be aggregated at the fund level, and evaluated on a relative basis, requiring a certain amount of analysis and subjective estimation on the part of the investor. In fact, Froland (2008) estimates that 56% and 79% of returns on above-average and top buyout deals come from companyspecific factors, with the remainder resulting from market and sector appreciation.2 Valuation Risk Due to the wide variety of valuation methodologies used by GPs to value portfolio companies, the investor can be exposed to significant uncertainty as to the true residual value of the fund. Highly subjective valuation practices that require significant assumptions and long-term projections can result in an overvalued portfolio, which will

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result in a significant loss of capital once true values are recognized upon exit. Phalippou and Gottschlag (2006) show that some poorly performing funds may delay markdowns on poorly performing investments in order to mask interim underperformance, thereby maximizing their fundraising efforts.3 More importantly, funds that use more-aggressive residual values4, as defined by relatively high values despite an extended period during which no investments or distributions are made, have lower fund performance.5 The Private Equity Industry Guidelines Group (PEIGG) defines fair value as the amount at which an investment could be exchanged in a current transaction between willing parties, other than a forced liquidation or sale.6 PEIGG and AIMR provide the following valuation hierarchy and guidelines: Valuation Hierarchy and Guidelines (PEIGG)7: 1. Comparable Company Transactions: examination of third-party investments or transactions in comparable equity securities. 2. Performance Multiples: application of most appropriate and reasonable multiple derived from market-based or recent private transactions; the method that involves the least number of estimates is preferred. (Portfolio company must have positive and maintainable operating performance). 3. Other: DCF, NAV and Industry-Specific Benchmark methodologies may also be appropriate in certain circumstances. The most objective measures of value are preferred over less objective methods the former pose the least amount of valuation risk. Discounted Cash Flow techniques are considered the least objective, and therefore, the least preferable method of obtaining fair value; forward-looking estimates and projections expose investors to significant valuation uncertainty.8 Investors must then assign a risk score to each portfolio based on the percentage of the fund valued at each level of the valuation hierarchy. (This is similar to the Basel Accords risk capital requirements for banks; in this case, the fund is penalized with a higher risk factor score, rather than a higher capital requirement). The optimal level of capital assigned to each valuation bucket is not easily established and will require significant research and, ultimately, an industry consensus. (Alternatively, and LP may assign their own levels based on what they believe to be the optimal levels.) Sample Valuation Risk Spectrum Table: Risk Level Risk Score Percentage of Fund Assets in Level 3 Lowest 1-2 0-20% Moderate 3 20-60% Highest 4-5 60%-100%

Investors must revisit valuation practices repeatedly, as changing market conditions (e.g. the lack of availability of comparable transactions) will increase or decrease the valuation risk over time.

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Purchase Multiple Risk A high purchase multiple (Enterprise Value to EBITDA) paid for a portfolio company increases the investors risk of loss, as it increases the chances that the company is overvalued at purchase. Aigner, Albercht et al. (2008) show that performance is negatively influenced by GDP growth and MSCI returns during a funds vintage year, which serve as a proxy for purchase multiple levels.9 The idea is that when the economy is doing well, GPs must pay higher prices for portfolio companies, which leads to lower fund returns. Higher multiples also increase the stress placed on the capital structure of a company, which is also increases the overall risk of capital loss.10 This anecdotal evidence is supported by Albercht et al. (2008), who find that vintage year MSCI growth has a significant positive impact on the percentage of portfolio companies with a negative IRR.11 A quick and simple way to evaluate a funds level of PM risk is to use the average multiple levels for buyouts in the funds vintage year. A rolling 10 year ranking (assuming the LP does not own a significant amount of funds that are over 10 years old) of the vintages based on average multiple levels can be used as a framework for establishing the relative level of risk for each fund in the portfolio. (This assumes that the average multiple level will be representative of the funds multiple level; the accuracy of the analysis increases with the number of funds in the investors portfolio). Sample Simple Purchase Multiple Risk Spectrum Table (1997-2007) Risk Level Risk Score Vintage Lowest 1 2001, 2000 Moderate 3 2004 Highest 5 2007, 1998

2 2002, 2003

4 2006, 1997, 1999

A less simplified approach would entail calculating the actual average purchase multiple for each fund, and additionally penalizing (rewarding) the fund if multiple levels are higher (lower) than the averages for a particular vintage year. The risk score for the factor would be based on a) vintage and b) actual multiple level: Sample Detailed Purchase Multiple Risk Spectrum (1997-2007) Risk Level Risk Score Vintage Fund PM Level Lowest 1 2001, 2000 Lower Moderate 3 2004 Highest 5 2007, 1998 Higher

2 2002, 2003 Higher

4 2006, 1997, 1999 Lower

This would also allow for a more robust analysis of funds that have the same vintage year: for example, a 2007 fund with a multiple that is higher-than-average would score worse than a 2007 fund with a lower-than-average multiple level. Leverage Risk Financial leverage amplifies gains and losses on portfolio investments, and should therefore be viewed as a risk factor at the fund level. Leverage in the form of debt creates an obligation that the firm must pay regardless of revenues, and the failure to do so can result in a loss of control of the company. The use of debt has two main benefits: the tax-deductibility of interest payments and its use as a disciplining tool for company management. (That is, failed projects financed by debt will receive more scrutiny than those that are not. Also, fixed debt interest payments will force managers to be more risk averse, because of the aforementioned risk of distress or bankruptcy.)12 The disadvantages of using debt are: an increase in the probability of bankruptcy; agency costs resulting from the differing interests of lenders and equity investors; and the loss of future borrowing ability. Due to the existence of these tangible and intangible costs and benefits of using debt, there clearly exists an optimal mix of debt and equity in a capital structure.13 The increased use of debt will initially decrease the cost of capital, as more expensive equity financing is replaced by cheaper debt. However, as more debt is added to the capital structure, the equity of the firm becomes riskier (due to the fact that interest payments now represent a fixed obligation on earnings), and begins to put upward pressure on the cost of capital. Further upward pressure results from the rising cost of debt due to the increased risk of default as more and more debt is added to the capital structure.14 Damodaran (2008) also points out that indirect bankruptcy costs should also be reflected in operating income, as customers, suppliers and investors will react adversely to increasing levels of debt and the resulting decrease in bond ratings. In the case of buyouts, total-debt-to-EBITDA is more relevant than the overall debt-to-capital ratio because cash-flow coverage determines the ability of the GP to pay down the companys debt an essential component of a successful LBO. Because buyout firms tend to focus on companies with high, stable cash-flows, debt-to-EBITDA levels tend be significantly lower than public companies, while overall debt-to-capital ratios are higher.15 The stability and predictability of cash flows, and their magnitude relative to enterprise value, will determine the optimal debt levels for portfolio companies. Because of the unique attributes of LBO companies, an optimal leverage ratio cannot be determined by using public market averages specific buyout leverage levels for establishing relative risk must be derived. Historically, total-debt-to-EBITDA ratios have averaged 4.5, which is considered a normalized level. 16 (The levels reached in 2007 with ratios of over 6 are considered by most to be unsustainable.) Therefore, the most basic measure of Leverage Risk would be to compare the total debt-to-EBITDA ratio (at purchase) for a fund relative to the average ratio of 4.5. (Some further research is needed to establish a decay rate for this factor, as leverage ratios will fall as cash-flows increase and debt is paid down over the funds life. For the purpose of this discussion, I will assume that a relatively high ratio at purchase constitutes an elevated risk for the life of the fund. Also, more research around the range of ratios is needed to establish a more

objective comparison; for example, ranking the fund by quintile versus the historical range of dispersion around the mean.)

Sample Leverage Risk Spectrum Table Risk Level Risk Score Debt/EBITDA Lowest 1-2 <4 Moderate 3 4.5 Highest 4-5 >5

The risks of leverage are most evident in the current economic environment, as some speculate that private equity valuations (most of all, the highly-levered companies in 2007 vintage funds) have fallen faster and further than public equities. Jenkinson (2009) highlights the fact that the Private Equity ETF (Power Shares Listed Private Equity) and Blackstones share price are down 70 and 80 percent, respectively. 17

WACC vs. ROC Spread Risk The spread between the weighted average cost of capital and return on capital constitutes an important relationship for an LBO. It is the fundamental relationship between the cost of buying a company and the profits generated by the GP in excess of that cost. 18 Froland (2008) highlights the fact that the WACC/ROC spread plotted on a timeline between 1990 and 2007 reflects a 3-4 year lag to subsequent buyout returns, which is believed to be the amount of time for the companys realizations to be reflected in the market.19 The value of any company can be increased in four ways: increasing the return on existing assets, increasing the expected high-growth period growth rate, lengthening the high-growth period, or reducing the cost of capital. Each of these methods is related to either cutting costs or increasing the efficiency of operations. 20 Poorly managed companies are prime candidates for buyouts, because the value of control the ability of the GP to enact changes to make the company more profitable becomes very significant. Damodaran (2008) states that a potential target should have the following qualities: Underperforming stock Compressed margins relative to sector Return-on-equity (ROE) below cost of equity and return-on-capital (ROC) below the cost of capital Management-related flaws that are repairable21 The efforts of the GP should therefore be reflected in the WACC/ROC spread. A low sector-relative spread for a portfolio company as the fund matures would indicate that the company represents a fundamentally unprofitable buyout investment; this constitutes an increasing risk that lower multiples of capital will be realized upon exit. The spread risk

for a given company should be highest right after the company is acquired, and should decrease as the GP is able to add value to operations over time. To evaluate this risk, the LP should gather data on the sector spreads (using available public market data) and rank each of the portfolio companies in the fund relative to its sector by quintile. A weighted average of on the industry-relative rankings could then be used to establish a risk level for this risk factor. Sample WACC/ROC Risk Spectrum Table Risk Level Risk Score Weighted Avg. Quintile Rank Lowest 1 Top Quintile Moderate 3 Third Quintile Highest 5 Bottom Quintile

2 Second Quintile

4 Fourth Quintile

The WACC/ROC spread should, in theory, capture a range of various GP specific factors that have been shown in studies to have an impact on fund returns.22 For example, the number of portfolio investments, sector focus, number of GP employees and diversity of functional background should translate into a higher ROC for portfolio companies; experienced and focused GPs will be able to achieve superior operational results.

Industry Risk: Cyclical vs. Non-cyclical Industry exposure should be considered as a stand-alone risk, as buyout portfolio companies are not immune to the effects of the business cycle. More importantly, investors should analyze and monitor fund exposure to highly cyclical industries and sectors. Companies within certain industries and sectors can be classified as cyclical and non-cyclical, depending on how their profits are affected by the business cycle. Profits for cyclical companies tend to be closely tied to the growth of the economy; when the economy is growing, profits will tend to grow even faster. However, when the economy is contracting, profits for cyclical companies will tend to fall faster as well. Because people tend to have less discretionary income when wages are down and unemployment is up, purchases for items such as cars and travel tend to wane. Periods of slow economic growth also decrease demand for new construction and expansion, so construction, heavy equipment, and energy-related industries will suffer as a result.23 Companies within these sectors must have strong balance sheets in order to withstand a prolonged downturn, or otherwise risk going out of business. Traditionally non-cyclical, or defensive, sectors consist of utilities, health care and consumer staples. Companies within these sectors provide services that are considered necessities, and therefore profits remain relatively stable throughout the business cycle. These companies are considered defensive because they protect

investors during a downturn at the cost of giving up any profit upside when the economy is recovering. An LP should therefore evaluate industry exposure for each fund and estimate a relative risk score based on the types of companies that are in the fund. (An argument exists that GP specialization within one or two sectors is actually beneficial, due to the high level of industry-specific skill and experience that results from specialization. However, even the most successful companies are not immune from the business cycle if they operate within a highly cyclical industry.) Sample Industry Risk Spectrum Table Risk Level Risk Score Defensive Sector/Industry exposure Lowest 1-2 100-60% Moderate 3 60-40% Highest 4-5 40-0%

Conclusion The combination of all of the risk drivers into one risk score allows for the comparison of buyout fund investments within a portfolio on a relative risk scale. Funds that have a relatively higher score at a given point in time can be considered higher risk investments within the LPs buyout fund portfolio, and should be viewed as having a higher than average risk of underperforming the aggregate return for the buyout universe. It is not the intent of this exercise to attempt to quantify risk as an exact measurement; the purpose is to create a way to think about buyout fund risk in terms of fundamental factors. I believe that only once risk is understood in real terms, rather than abstract numbers, can it be avoided or managed. Sample Aggregate Risk Score Table Risk Level Aggregate Risk Score Lowest 1-2 Moderate 3 Highest 4-5

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Anson, Mark. The Handbook of Alternative Assets. Wiley, 2002. p. 404 Froland, Charles. 2008. The Fortunes of Private Equity. CFA Conference Proceedings Quarterly, September 2008: 54-62. 3 Phalippou, Ludovic. 2007. Investing in Private Equity: A Survey. The Research Foundation of CFA Institute: 1-22. 4 Phalippou 15. 5 Phalippou 15. 6 Harrell, Michael. Speigel, Jennifer. The Debevoise & Plimpton Private Equity Report. Spring 2004: 16-22. 7 Harrell, Michael. Speigel, Jennifer. 19. 8 Boersma, J., Brown, S., and Franklin, W. 2005. Appropriate Pricing and Valuation of Portfolio Companies. CFA Institute Conference Proceedings: 33-38. 9 Aigner, P., Albercht, S., et al. 2008. What Drives PE? Analyses of Success Factors for Private Equity Funds. The Journal of Private Equity, Fall 2008: 63-85. 10 Froland 54-62. 11 Aigner, P., Albercht, S., et al. 63-85. 12 Damodaran, Aswath. 2008. The Anatomy of an LBO: Leverage, Control, and Value.CFA Conference Proceedings Quarterly, September 2008: 16-28. 13 Damodaran 19. 14 Damodaran 20. 15 Froland 58. 16 Jenkinson Tim. 2009. CFA Conference Proceedings Quarterly, March 2009: 1-7. 17 Jenkinson 1-7. 18 Froland 59. 19 Froland 59. 20 Damodaran 25. 21 Damodaran 25. 22 Swamy, G., Zeltser I. 2005. Predicting Venture & Private Equity Returns Harvard Business School Case Study. 23 http://www.streetauthority.com/terms/c/cyclical-industry.asp