Third, the thesis will provide some lessons which could be applied for investing to Private Equity in Vietnam for investment managers, who are managing fund and considering to allocate a
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LITERATURE REVIEW cececceccesceeseeseeseeteeeeeeseeseeeeeeneenneens 5
The concept of private €QUIẨY . c6 cv siết 5
Private equity, a niche yet rapidly growing segment of the investment landscape, has rebounded significantly after a decline in capital commitments following the tech bubble burst Defined as a financing method that supports entrepreneurial ventures, business expansion, acquisitions, and restructuring, private equity operates primarily outside public securities markets This investment approach typically involves profit participation by the general partner and is often structured as a limited partnership.
Private equity is distinctly different from marketable securities, necessitating a careful evaluation of specific risks and considerations prior to making an investment, as well as ongoing assessments after the investment has been established.
- [liquidity — Commitments to private market investments are usually in the form of limited partnerships, with terms of 10 or more years There
! Source: VentureXpert definition are no markets for these partnership interests and they cannot be liquidated or easily transferred This is a true long-term commitment.
Volatility in private capital investments is often understated, as assets are typically valued at cost until a significant event occurs, leading to a misleading perception of price stability Furthermore, management fees and certain losses are recognized early, contributing to the phenomenon known as the "J curve effect."
The returns achieved by investors are significantly influenced by the expertise of the fund-of-funds manager and their ability to establish strong investment partnerships.
- Time Commitment — The amount of time Committees, Staff and
Consultants must spend in monitoring private capital investments is significantly greater than with other asset classes Cost and complexity multiply over time.
Reports and performance data are released quarterly, typically with a delay of at least 60 days Returns are assessed using an Internal Rate of Return (IRR) method, and there are no passive benchmarks available for performance comparison.
- Cash Flows — Are complex to manage and capital calls often have short notification periods and must be fulfilled on a timely basis.
There are two types of Private Equity: Venture Capital and Buyout.
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Venture represents investment in unquoted companies that are expected to go public This is what we mean by Private Equity in general We have 4 subcategories in the Venture market:
*The company was created and needs financing to start producing, develop a marketing strategy and launch its products
This is the growth phase where the firm needs extra liquidity to finance its development 5a es are increasing, the firm starts to be profitable and
Expansion needs funcs to support inventories and accounts receivables.
*The corporation reaches maturity It is generally associated with the
Replatemen| purchase of the firm by outside investors The owner of the company still t capital or have the majority of shares later-stage
Venture companies often struggle to secure debt financing due to their lack of tangible assets for collateral As a result, their access to loans is significantly restricted Additionally, investments in private equity are typically staged, allowing investors to reassess and potentially withdraw from the project at each milestone, thereby minimizing their risk exposure.
A buyout involves the investment in public companies or their divisions that are considering going private, typically executed by external investors seeking to acquire a controlling interest These investors often utilize a mix of their own capital and borrowed funds to finance the acquisition, allowing them to take over the targeted firm effectively.
In a Leveraged Buyout (LBO), the acquirer secures loans or bonds using the target company's name to obtain favorable financing terms, leveraging the acquired company's cash flow for repayment The acquirer aims to enhance performance by reducing costs and typically plans to sell the target company, often through an initial public offering, within about five years.
- Management Buyouts follow the same goal, where a part of the managers of company raise funds to take control of it.
Venture capital and buyout are two distinct sectors of Private Equity, with venture capital focusing on acquiring minor stakes in emerging companies, while buyouts involve purchasing or gaining control of established firms Buyouts are generally considered less risky due to the maturity of the company, its publicly traded stock, and proven historical performance, which also facilitates easier exit strategies An "exit" refers to how Private Equity investors realize their investments, typically through methods such as initial public offerings, trade sales, sales to other Private Equity firms, or company buy-backs As a unique asset class within Alternative Investments, Private Equity stands in contrast to Traditional Investments like stocks and bonds.
There are three ways of investing in Private Equity as shown in Figure 1.3. Principal means of investing in Private Equity An investor can:
1 Directly invest in private companies.
2 Invest in a Private Equity fund who will then choose in which companies to invest in and how much.
3 Invest in a fund of funds who will then invest in Private Equity funds.
Figure 1.3 Principal means of investing in Private Equity
[vectors] —> [Fund ofFunds ——]—> [FETands ——] —> [Company]
Private Equity funds typically operate as Limited Partnerships, where the investment manager is referred to as the General Partner or Venture Capitalist The members of the Limited Partnership, known as Limited Partners, contribute capital but have limited involvement in the management of the fund.
Limited Partners rely on the General Partner to perform essential functions such as conducting due diligence, structuring financial contracts, and monitoring investments Additionally, the General Partner is responsible for providing resources to portfolio firms and developing exit strategies for investors to maximize returns.
Private Equity funds can specialize themselves by industry, geography, stage of financing or size of companies invested.
In a governance structure characterized by moral hazard, the asymmetric information between Limited Partners and fund managers necessitates a well-structured compensation system to align incentives Typically, the General Partner receives a fixed salary of approximately 1% of committed capital, along with a performance share known as carried interest, which is generally 20% Additionally, Private Equity funds typically charge fees ranging from 0.75% to 1.25%.
When choosing an investment, managers encounter an adverse selection issue due to uncertainty about which firms are performing well This makes their ability to select the right investments vital for the fund's success Conducting thorough due diligence by firms seeking financing is one effective way to reduce information asymmetry in the Private Equity market.
Funds of funds invest in various Private Equity funds rather than directly in companies, providing investors with broad sector exposure and enhanced diversification at a lower cost They are particularly appealing to individuals, as some Private Equity funds may be inaccessible to them Additionally, due to their substantial investment size, funds of funds serve as a preferred financing source for Private Equity funds, allowing these funds to avoid managing numerous small investors.
A fund of funds typically imposes a management fee ranging from 0.75% to 1.25% per annum in addition to the standard fees of a Private Equity fund Investors face a crucial decision between opting for a fund of funds or managing their own Private Equity investments, with the size of their investment serving as the primary factor influencing this choice.
The direct investment strategy is not advisable for non-professional investors.
Investing in Private Equity requires careful analysis due to the significant information asymmetry present in the market Individual investors looking to diversify their portfolios should consider investing in a fund of funds, as this approach can provide a more balanced exposure to various private equity opportunities.
Size ranking na
In the venture universe the fund size ranges termed small, medium, large and mega correspond to capitalization amounts as follows’:
Small 0-25 $Mill Medium 25-50 $Mill Large 50-100 $Mill Mega 100 $Mill+
Small 0-250 $Mill Medium 250-500 $Mill Large 500-1,000 $Mill Mega 1,000 $Mill+
Investing in Private Equity differs from traditional stock investments, as it typically involves an initial negative cash flow during the early years Over time, however, investors begin to realize returns, a phenomenon often depicted by the J-curve.
Typical fund annual cash flows to investors
An independent research of Ennisknupp showed that the expected return of Private Equity is excess all other investment types but following by the highest beta and standard deviation.
Table 1-1 Beta, Standard deviation and Expected return
Asset class Beta with expected standard expected respect to arithmetic deviation compounded/ world market — return Geometric return
US bonds 0.39 5.2 6.6 5.0 Core real estate 0.68 73 11.7 6.6 Private equity 2.83 13.7 30.2 9.2 [Source: Ennisknupp, updated July 2008 - ENNISKNUPP capital markets modeling assumption, page 5]
For long-term investors, the expected compounded or geometric return is a crucial assumption, representing the asset's anticipated long-term performance This geometric average return is typically lower than the arithmetic average return, particularly in the presence of uncertainty in annual returns, as indicated by standard deviation.
To account for expected return compensation from private market investments, the arithmetic expected return for private equity is adjusted from 10.7% to 13.7% As a result, the compounded return for private equity rises from 6.2% to 9.2%, reflecting a common industry expectation of an additional 3% return over public equity investments.
1.5.3 Real IRR of Private Equity
The Internal Rate of Return (IRR) is widely used to evaluate cash inflows, outflows, and final net asset value, but its relevance can vary in certain situations Accurate timing of investments is crucial for the IRR to be effective, yet obtaining this precise data is challenging, as major sources like Venture Economics and EVCA typically offer information only at an aggregate level.
Investment Horizon Returns as of 31 December 2004 (%)
Stage 1 year |3 year |Š year | 1Ũ year Early Stage -06| -§./6| -Š.4 -0.5 Development 8) -5.5| -0.4 9.4 Balanced -2.9 -6} -1.1 10.4
Note: Returns are net to investors after fees and carried interest.
[Source: Ludovic Phalippou and Maurizio Zollo, 2005 - The Performance of Private
Recent data on Private Equity performance reveals that the global influence of the Internet bubble has led to a decline in returns, with the three-year Internal Rate of Return (IRR) dropping to -2.3% and the five-year IRR at just 1.9% These figures highlight particularly low returns in the Early Stage category, which is known for its higher risk.
Private Equity represents a long-term investment strategy, typically involving funds with an average lifespan of 10 years Investors often realize significant excess returns only after this period, which is why a 10-year return rate, such as the 9.8% observed in our case, is commonly referenced when evaluating Private Equity performance.
Choosing top quartile fund managers is crucial in Private Equity, as the performance gap between effective and ineffective managers is much larger compared to other asset classes In Private Equity, the difference in returns between the lower and upper quartile is approximately 15%, while this disparity is only about 1% for bond fund managers and 3% for public equities Thus, selecting the right fund manager can significantly impact investment outcomes in Private Equity.
14 quartile fund manager tends to keep having the best returns As we can see in Figure 1.6 Performance of upper and lower quartile, access to top partnerships is critical.
Figure 1.6 Performance of upper and lower quartile
@ Upper Quartile 15.0% + @ Median ld Lower Quartile 10.0% +
Venture capital buyouts all private equity
[Source: Ludovic Phalippou and Maurizio Zollo, 2005 - The Performance of Private
The performance analysis in Figure 1.6 reveals that the lower quartile of private equity returns fell below the returns of US T-Bills Therefore, when constructing a private equity portfolio, it is crucial to consider both the allocation weights and the selection of top-performing fund managers.
LESSONS FOR PRIVATE EQUITY INVESTMENT IN i30) 4
This article begins by defining the Private Equity asset class, exploring its various types and investment structures It further examines research findings related to the performance of Private Equity investments Lastly, the paper discusses the impact of Private Equity on emerging markets.
1.1 The concept of private equity
Private equity, a niche yet rapidly expanding segment of the investment landscape, has rebounded from a significant decline in capital commitments that followed the collapse of the telecommunications and technology bubble Defined as a form of financing that supports entrepreneurial endeavors, business expansion, acquisitions, balance sheet restructuring, or the privatization of public companies, private equity operates primarily outside public securities markets This investment approach typically involves profit participation by the general partner and is often structured as a limited partnership.
Private equity is distinct from marketable securities, necessitating careful evaluation of specific risks and considerations prior to investment and continuously thereafter.
- [liquidity — Commitments to private market investments are usually in the form of limited partnerships, with terms of 10 or more years There
! Source: VentureXpert definition are no markets for these partnership interests and they cannot be liquidated or easily transferred This is a true long-term commitment.
Volatility in private capital investments is often understated, as assets are typically valued at cost until a measurable event occurs, leading to an illusion of price stability Additionally, management fees and certain losses are recognized early, contributing to the phenomenon known as the "J curve effect."
The returns generated for investors are significantly influenced by the expertise of the fund-of-funds manager and their ability to establish strong investment partnerships.
- Time Commitment — The amount of time Committees, Staff and
Consultants must spend in monitoring private capital investments is significantly greater than with other asset classes Cost and complexity multiply over time.
Reports and performance data are provided quarterly, typically with a delay of at least 60 days Returns are assessed using an Internal Rate of Return (IRR) methodology, and there are no passive benchmarks available for comparison.
- Cash Flows — Are complex to manage and capital calls often have short notification periods and must be fulfilled on a timely basis.
There are two types of Private Equity: Venture Capital and Buyout.
Venture represents investment in unquoted companies that are expected to go public This is what we mean by Private Equity in general We have 4 subcategories in the Venture market:
*The company was created and needs financing to start producing, develop a marketing strategy and launch its products
This is the growth phase where the firm needs extra liquidity to finance its development 5a es are increasing, the firm starts to be profitable and
Expansion needs funcs to support inventories and accounts receivables.
*The corporation reaches maturity It is generally associated with the
Replatemen| purchase of the firm by outside investors The owner of the company still t capital or have the majority of shares later-stage
Venture companies often struggle to secure debt financing due to the absence of tangible assets for collateral Consequently, their access to loans is significantly restricted In contrast, investments in Private Equity are structured in stages, allowing investors the flexibility to withdraw from a project at each milestone, thereby minimizing their risks.
A buyout involves the investment in public companies or their divisions seeking to transition to private ownership This process typically includes an external investor purchasing shares of a public company to gain a controlling stake Buyout firms usually finance these acquisitions through a mix of their own capital and borrowed funds.
In a Leveraged Buyout (LBO), the acquirer secures loans or bonds under the target company's name to obtain favorable financing terms The cash flow generated by the acquired company is then utilized to repay these debts To enhance performance, the acquirer typically implements cost-cutting measures and aims to sell the target company, often through an initial public offering (IPO), within roughly five years.
- Management Buyouts follow the same goal, where a part of the managers of company raise funds to take control of it.
Venture capital and buyouts represent two distinct sectors of Private Equity, with venture capital focusing on acquiring a minor stake in emerging companies, while buyouts involve purchasing or taking control of established firms Buyouts are generally considered less risky due to the maturity of the company, its public stock status, and its historical performance, which also facilitates easier exit strategies An "exit" refers to the methods through which Private Equity investors can realize their investments, such as through initial public offerings, trade sales, sales to other Private Equity firms, or company buy-backs Private Equity is classified as an asset class within Alternative Investments, differentiating it from Traditional Investments like stocks and bonds.
There are three ways of investing in Private Equity as shown in Figure 1.3. Principal means of investing in Private Equity An investor can:
1 Directly invest in private companies.
2 Invest in a Private Equity fund who will then choose in which companies to invest in and how much.
3 Invest in a fund of funds who will then invest in Private Equity funds.
Figure 1.3 Principal means of investing in Private Equity
[vectors] —> [Fund ofFunds ——]—> [FETands ——] —> [Company]
Private Equity funds typically operate as Limited Partnerships, where the investment manager, known as the General Partner or Venture Capitalist, oversees the fund's activities In this structure, the other participants are referred to as Limited Partners, who contribute capital but have limited involvement in management decisions.
Limited Partners rely on the General Partner to perform essential functions such as conducting thorough due diligence, structuring financial agreements, and monitoring investments Additionally, the General Partner provides vital resources for portfolio companies and develops effective exit strategies for investors.
Private Equity funds can specialize themselves by industry, geography, stage of financing or size of companies invested.
In a governance structure characterized by moral hazard, the asymmetry of information between Limited Partners and fund managers necessitates a compensation model that aligns incentives effectively Typically, the General Partner receives a fixed salary of approximately 1% of the committed capital, alongside a performance-based share of the fund, known as carried interest, which is usually around 20% Additionally, Private Equity funds generally impose fees ranging from 0.75% to 1.25%.
When choosing an investment, managers encounter an adverse selection problem due to uncertainty about which firms are successful This makes their investment selection critical for the fund's overall performance Conducting thorough due diligence by firms seeking financing is essential to reduce information asymmetry in the Private Equity market.
Funds of funds invest in other Private Equity funds rather than directly in companies, providing investors with broad sector exposure and enhanced diversification at a lower cost This investment approach appeals to individuals, especially since some Private Equity funds may be inaccessible to them Additionally, funds of funds are a favored financing source for Private Equity funds due to their substantial investment sizes, allowing these funds to avoid managing numerous small investors.