For US private equity and venture capital managers, Q2 generated the best returns since the end of 2007, when listed markets began sliding, and for the first time since its introduction mark-to-market valuation methodology benefited managers, according to research from US Consultancy Cambridge Associates.
Managers waved goodbye to three quarters of straight losses as returns, aided by mark-to-market valuations, climbed into the black. But a weak economy and sluggish listing environment ensure that managers must put more work into portfolio companies to engineer successful exits, according to the Cambridge Associates research.
For the first time since it was introduced, the “mark-to-market” valuation methodology benefited managers, as rallying public markets and the tentative return of initial public offerings (IPOs) helped to maintain, and in some cases increase, valuations for private equity and venture capital assets.
These positive returns were reflected in specialised indexes run by Cambridge Associates that chart the performance of US private equity and venture capital managers,
The private equity index, which represents nearly two-thirds of capital raised by institutional private equity partnerships between 1986 and 2009, rose 4.3 per cent for the quarter against the 20.7 per cent return of the Russell 2000 Composite, the strongest of the small- and large-capitalisation indices for public markets.
The managers’ performance was driven primarily by increased valuations for companies in sectors that were hammered by the recession, such as retail, financial services and energy, and their subsequent rebound.
Venture capital delivered muted, but positive, returns. The managers in Cambridge’s venture index, which oversee more than three-quarters of capital raised by partnerships between 1981 and 2009, saw their returns push up to 0.2 per cent against the Russell 2000 Composite’s 20.7 per cent.
Looking back further in time, however, the indexes show luminous histories for both private market strategies.
In the five years to June 30, private equity brought in 9.9 per cent, and venture 5.7 per cent, while the Dow Jones Industrial Average (DJIA) and Russell 2000 notched -1.7 per cent and the S&P 500 -2.2 per cent.
Going back 10 years, private equity gained 7.7 per cent, and venture 14.3 per cent, against the -2.4 per cent of the Russell Composite, the best performer among the public market indices.
Over a longer timeframe, however, the listed markets closed this gap. The 20-year numbers show that private equity posted 11.4 per cent, and venture 22.7 per cent, against the 9 per cent of the DJIA, which provided the strongest returns among the listed market indices.
This history shows that, apart from the six months to June 30, 2009, the private market strategies have “handily outperformed” public markets, Cambridge states.
While the listed market rally benefited most private equity managers, their venture capital peers experienced mixed fortunes. The market rebound was offset by weak economic conditions and a subdued IPO environment, and the financial crisis has ensured that many venture managers would struggle to produce outstanding 10-year results.
“The combination of the technology bust at the beginning of the decade and the current recession has caused venture returns to suffer since 2000,” Cambridge states.
To illustrate, Cambridge compares to the 10-year return of the venture index, 14.3 per cent, with the nine-year return, which drops to -5.2 per cent.
The occurrence of a second market collapse within a decade puts venture managers with portfolios dated to 2000 in a difficult position, Cambridge states. Due to the “time value” of money, long holding periods reduce internal rates of return and increase the likelihood that interim valuations will be affected by mark-to-market pricing.
Private market strengths
For the private equity index, performance is driven by five vintage years comprising 76 per cent of the index: 2000 and 2004-07. From these vintages, the strongest returns came from 2007 portfolios, which reached 5.8 per cent for the quarter, benefiting from improvements in the real estate, retail and financial services sectors.
The 2005 funds’ gain of 4.3 per cent was attributable to improving valuations for energy, financial services, consumer, healthcare and software companies. Although technology companies boosted returns for the 2004 vintage, they weighed down the 2000 portfolios, which instead benefited from investments in healthcare, retail and media businesses.
Eight industry sectors account for 90 per cent of the investments in the index. Of these, only media produced negative returns, down only by 0.3 per cent. The biggest three industries – consumer, energy and healthcare – rose between 3.4 per cent and 4.4 per cent. But retail, financial services and healthcare contributed most to the index’s return. Some vintages with fewer investments, such as 1999 and 2001, delivered the most ouperformance but comprised less of the index.
But this relief from three consecutive quarters of negative returns does not mean that near-term outperformance is certain. Macroeconomic forces, such as higher unemployment, tight credit markets, decreased consumer spending and declining property values remain as headwinds for portfolio companies, particularly highly leveraged assets.
The scarcity of exit opportunities and, in the absence of easily available credit, the need to inject more equity into deals, meant that capital calls have outpaced distributions and managers will need to put more work into companies for the foreseeable future.
In the venture capital index, the best vintage year was 1999, due to higher valuations of IT and software companies. That year, in addition to 2000-01 and 2004-06, account for nearly 80 per cent of the index. Healthcare, one of the largest sectors alongside IT and software, was a strong sector, bolstering the 2000 and 2004-06 vintages, and was up by an overall 3 per cent for that quarter, followed by software and IT.
But both private equity and venture capital managers need a healthier economy and more stable financial markets to bring back the outperformance of the past.
