Show Me the Money!
Cash is King when Selecting Private Funds in Today’s Market
By Rick Nathan, Senior Managing Director
The private equity market is finally emerging from the great valuation reset and, once again, Cash is KING! Market values began to soar in the 2020 pandemic year, reaching record levels by yearend 2021. Led by the technology growth sector, a flood of IPOs and SPACs brought on a celebration of paper values through every segment of the market, from venture capital to mature buyouts. Public markets welcomed the flimsiest of new listings and investors could do no wrong.
This world changed completely in January 2022. As interest rates began their steep rise, public markets tanked and private financings dried up. Geopolitical events and interest rate increases triggered a heightened intolerance of risk. Companies seeking capital clung to the old valuation multiples that investors now refused to pay, in a classic market stand-off. Nobody could agree on what these companies were now worth. Some investment funds took write-downs across the board, reflecting these new macro conditions. The majority did not, reasoning that a 5-to-7-year investment horizon valued on long-term market multiples should not be so sensitive to the ups and downs of the stock market. Many other firms stood somewhere in the middle, based on the specific nature of their portfolio (early-stage, more mature), their industry sector or their detailed company-by-company circumstances.
With vastly fewer private market deals, fund managers faced a much weaker current dataset for their mark-to-market comps through this period. Our broad fund-of-funds portfolios across our Kensington funds (and including many others we review in detail but decline), sometimes include overlapping assets in different funds’ hands. This unique perspective showed us how different fund managers would place much different enterprise values on the same businesses — an anomaly we had rarely seen in two decades of experience. Some funds acquired assets in the secondary market at a ‘deep discount’ well below traditional liquidity discounts, and then wrote them all the way back up to their stated values, ignoring the market signal from their own transaction! As these old benchmarks eroded, it became more challenging for investors to evaluate fund managers, since everyone was showing strong performance on paper¹.
Investors in private market funds have traditionally relied on an alphabet soup of metrics, from IRRs to MOICs to TVPIs. These analyze a fund’s data from different perspectives and are intended to provide a comprehensive view of a fund manager’s performance — and generally provide good quality indications of performance in normal market conditions. However, with the heightened valuation uncertainty and reduced financing volumes of the past two years, the assumptions and judgement underlying many of these conclusions have not been fully market-tested. Many investors do not have the additional resources required to validate these fund manager reports, and they ask us how to get more confident selecting private funds at this point of the cycle, which everyone agrees is becoming increasingly attractive.
Across all of the financial datasets, there is one simple measure that avoids all of these concerns: cash. Every fund manager has the same goal, to deploy capital received from its investors and return it with a profit. Paper measures of interim performance can be interesting to see from time to time, but the only measure that anybody really cares about is cash returned: can the fund manager successfully sell its portfolio companies for more than it pays for them? It is the simplest and easiest measurement to evaluate and understand. No tricky formulas or subjective assumptions are required.
As we look at fund managers for prospective investment in 2024, many of the historical datapoints are less useful. Everyone shows strong interim performance as they benefit from the paper mark-ups of the recent boom cycle. But if everyone looks so good on paper, how do you tell the difference? We look for the funds that have generated actual cash profits:
- Did you sell any companies during the boom for a big gain?
- If you didn’t sell your winners, why not? Can you show us they are worth more today?
- What are you working on selling right now? When will we see the results?
We want to back fund managers who seize opportunities in the market to achieve actual cash gains for their investors, not just interim valuations along the way.
The past 12 months have shown a series of successful exits across our Kensington funds. 2023 was a record year for distributions, as our Kensington Private Equity Fund sold five strong companies for significant gains, realizing total proceeds for our investors of over $300 million including realized capital gains of $200 million. These included a buyout investment that generated the largest single gain in our 28-year history and another that was Canada’s largest venture exit to a strategic buyer in many years. Our Kensington Venture Fund also delivered cash distributions from the successful sale of portfolio companies. As we look to the year ahead, we see more opportunities for additional portfolio exits and cash distributions. We understand that this is the performance that matters to our investors. Cash is KING.
The volatility in valuations of the past few years may make the task of evaluating private fund managers seem more challenging than ever — whether in venture capital, growth equity or buyout. But it’s really not so difficult to look beyond the alphabet soup of unrealized returns and reported valuations and just focus on the purest, simplest data point: Follow the Money.
Visit us at www.kcpl.ca for more information. Follow us on Twitter @kensingtonfunds.
References
¹ During the past 3 years, our Kensington valuations program has grown significantly as we have enhanced our own efforts to value all assets based on standardized valuation models and objective performance criteria, including through the increased use of third-party independent valuation firms to supplement our team.
