Asset Management

Session 6: Incentives and Performance Evaluation

Svetlana Bryzgalova
sbryzgalova@[Link]
Measuring performance of private assets
What is private equity?

10th century: commenda

• Passive owners put some capital together
• An active manager goes on a voyage
• Passive owners could lose only so much as they invested (LP)
• Active manager’s liability is unlimited (GP)

Today PE is an investment in privately owned companies, which trade directly between investors (not via the
exchange).
Private and public equity

Public equity (S&P 500) Private Equity

Market Centralized and liquid Over-the-counter and illiquid

Transaction costs Tiny or small Enormous

Valuation Easy and objective in real Difficult and subjective and
time available infrequently

Horizon Immediate Long term (around 10 years)

Contracts Standard Complex

Largest categories: leveraged buyout and venture capital (investing in early stage companies)

Massive search frictions in setting up a match between investors and a project, or liquidating it:

• During the great Recession Harvard University tried to exit one of the PE fund, and faced a 50% discount.
Return measures

Internal Rate of Return:

%&'()&*+(&,- ./&0 ( − 2/.&(/3 2/33(()
!" = $ =0
1 + 899 :

Problems:
• Easy to manipulate
• IRR is not a return
• No risk adjustment

Sorensen, Wang and Yang (2012):

• An appropriate break-even IRR is 13-17% for asset owners comfortable with beta 0.5
• For beta 1, break-even IRR are 17-19%.
• An average buyout fund has IRR of 16%, and even that declined after 2004
IRR is very sensitive to sequencing

Exit a'er 1 year Stay and earn more

t=0 -100 -100

t=1 150 150

t=2 +25%

t=3 +25%

t=4 +25%

t=5 366

IRR 50% 30%

PV and IRR often disagree when projects have different length and cashflow timing
Ways to manipulate IRR

Change the timing of the cashflows:

• Move investment later
• Move payout earlier

Example: subscription line, credit provided by a bank, backed up by investor

commitments:
• Start investment early on, but use the credit money
• Pay out the loan later, use investor commitments
• Compute IRR from the later date

Compute IRR not for the individual fund, but for a vintage
• About half of the buyout firms use it
• One great performing fund masks the failure of others
• Weighted average across the funds would be worse
Multiple
∑*+,-.+/0-+12, 34+5 (-)
!"#$%&#' = ∑843+-49 8499, (-)

Less open to manipulation than IRR, but equally meaningless:

• No time value of money

• No duration
• Less than 2% of PE prospectuses report holding period returns weighted by cash
flow
•
• No risk adjustment
• Sorensen et al (2012) take into account risk and leverage, estimate the break-
even multiple at 3-6.
• After 200, neither VC nor buyout funds reach these values

No compulsory reporting of PE funds: when performance is poor (multiple <0.1), IRR is

often missing (80% of the cases)
Academics vs industry

Private Equity Growth Capital Council reports that at the end of 2011 PE outperformed net of fees S&P 500:
• For 1 year horizon: by 7.1%; for 3 year horizon: by 5.7%; for 10 year horizon: by 7.6%

Selection bias in most industry studies

• Underperforming funds don’t report many key numbers
• Survivorship bias

Focus on multiples, IRR and other non-return metrics

• IRR are not actual returns, no account for risk
• Most measures are easily (and often!) manipulated

Net asset value (NAV) is often biased upwards

• Zombie effect (old and inactive companies have high accounting values)
• Oppenheimer & Co paid $2.8 mln to settle charges that it inflated the value of investment in its PE fund (increasing
IRR from 3.8% to 38.3%)
Fees are massive

Venture capital Buyout

25% Mean 75% 25% Mean 75%
Carry per $100 $8.09 $8.36 $8.37 $4.93 $5.28 $5.66
Management fees per $100 $12.04 $14.80 $17.61 $8.77 $10.35 $11.65
Total revenue per $100 $20.24 $23.16 $26.11 $15.75 $17.80 $19.60
Proportion incentive fees 40% 36% 32% 31% 30% 29%

GPs collect on average 6% in flows in fees.

Kauffman foundation report (2012)

The Ewing Marion Kauffman Foundation promotes entrepreneurship and education.

• In 2011, 45% was invested in PE

``We Have Met the Enemy… And He is Us:

Lessons from Twenty Years of the Kauffman Foundations’s Investments in Venture Capital Funds and the Triumph of
Hope over Experience”

Average VC investment failed to return investor capital after fees

``Investors like us succumb time and time again to narrative fallacies, a well-studied finance bias… The historic narrative
of VC investing is a compelling story filled with entrepreneurial heroes, spectacular returns, and life-changing
companies.”

Report advocates to move away from IRR and multiple to relative performance measures, based on small cap stocks
The rise of the unicorn

u·ni·corn [ˈyo͞onəˌkôrn]
NOUN
1. a private VC-backed company
with a valuaEon over $1 billion

Also see decacorn ($10 bln) and hectocorn ($100bln)

January 2025: More than 1500 unicorns around the

world

Rising interest from sovereign wealth funds, mutual

funds, etc.
Unicorns: are they real?

I'm talking about companies that have never made any money, that have a bad
concept and that are valued at billions of dollars, so here we go again… You look at
some of these tech stocks that are so, so weak as a concept and a company, and
they're selling for so much money.

Donald Trump, the U.S. President

“In the unicorn context, there is a worry that the tail may wag the horn, so to speak, on
valuation disclosures. The concern is whether the prestige associated with reaching a
sky high valuation fast drives companies to try to appear more valuable than they
actually are.”

Mary Jo White, Former Chair of the SEC

How to value speculative companies with infrequently traded shares and complex
financial structures?
Post-money valuation

Post-money valuation = Share Price of Latest Financing Round X Total Number of Shares

Example:
Square raised a $150 million Series E round (funding sequence: e.g., Seed, A, B,….) at $15.46 per share

• WSJ, Economist, Fortune, and other media outlets say “Square is now worth $6 billion”

• All mutual funds and many VC funds write all of their Square shares up to $15.4

• Academics approximate Square's return between rounds using the change in valuation

• Employees believe common shares are worth $15.46 and options are worth $15.46 – strike price
Not all the shares are the same

The valua/on assumes that all classes of shares have the same value as the Series E Shares.

In Square's case, the Series E Shares were

a) Guaranteed their money back in any exit

b) Senior to all other shares
c) Guaranteed a 20% return in IPO

Typically later series have addi/onal protec/on/benefits, and hence, are intrinsically more valuable than series A
Not all the shares exist so far

The valuation includes shares that are not been issued, and may never be issued.

Unissued shares are OWNED by the current shareholders and are included in Series E price.

Adding them back in is double counting.

What if we do the cashflow analysis?

Square’s true value was about $2.2 billion, not the reported $6 billion

Most classes of shares are overvalued by almost 200%

Gornall and Strebulayev (2020)

U.S. unicorns ($1b + valuation, founded after 1995, VC-backed)

Gathered contract data on 135 of them from Certificates of Incorporation (closely worked with 10+ lawyers)

Supplemented with VCExperts, Venturesource, Pitchbook, Thomson, CB Insights, and Crunchbase

Major contractual protections given to latest investors in most companies, while common shares lack all of them
and are 56% overvalued.

The code for adjusting the valuation of the unicorns could be found on Will’s website: [Link]

Ø IPO ratchets (15%) Ø High liquidation preferences (16%)

Ø Ability to obstruct down-IPOs (24%) Ø Participation (19%)
Ø Cumulative dividends (11%)
Ø Senior to all (32%)

48% of unicorns have fair values below $1 billion. 15 unicorns are overvalued by more than
100%.
Most unicorns are overvalued by 29-59%

Some by a lot more

Mean P25 Median P75

Financing date 2015 2014 2016 2016

Number of Rounds 5.6 4.0 5.0 6.0

Investment ($m) $256 $100 $150 $300

Post-money Value $3,322 $1,100 $1,684 $2,700

Fair Value $2,588 $792 $1,105 $1,806
Overvaluation 50% 24% 34% 59%

Overvaluation of Common Shares 71% 23% 36% 71%

Does the market recognize it?

Partially: highly overvalued unicorns usually exit below their post-valuation price

300%
LinkedIn
250%

200%
Groupon
150%
Exit Return

100%

50% Demand Media

Nutanix
0%
0% 20% 40% 60% 80% 100% 120% 140% 160% Box 200%
180%
-50% Good
SolarCity Square
Onlive Technology
-100% [Link] Better Place
Overvaluation
PE in a nutshell

``In the absence of truly superior fund-selection skills (or extraordinary luck), investors should stay far, far away from
private equity investments.”
David Swensen, Chief Investment Officer of Yale University (2012)

1. Everyone is hoping for catch the next unicorn, - Microsoft, Apple, etc.

2. Information is poor
• Contracts are opaque
• Fees are hard to understand

3. Selective reporting

4. Massive industry claims and promises

Capacity constraints
Alternative investments
Investing in Lego!

• Supply diminishes over time

• Collectable value (like comics)

• Active secondary market trading since 2000

• Affordable

• Example: Café Corner was

released in 2007 for £89.99
£90 à £2,900 in 12 years!
The Telegraph, December 2015

Average set return of 12% since 2000

FTSE 100: 4.1%

Gold: 9.6%

A LEGO investing community:

[Link]

A lot of popular sets are Star Wars-themed

A formal study of 2,322 LEGO sets

• Annual returns from -50% to +600%

• Average: 18.5%, st. deviation: 35%, skewness: +9%
• Sharpe ratio: 0.4
• Ebay charges listing and final sale fees, which further decrease returns by about 4%
• Storage costs? Capacity?

Source: Dobrynskaya and Kishilova (2019)

Trading watches?

“I get better returns from trading old watches than dealing with
equity or real state.

The strategy of investing in watches can give you fantastic returns, as the supply of old watches is very limited, why
liquidity is decent. However, it requires a lot of effort in understanding the market for them, studying limited editions,
and knowing jewelers, whose clients may be interested in buying the stuff. The sheer capacity of this trade is extremely
limited. “
An anonymous trader from a major investment bank

Some strategies have natural capacity constraints. Some decisions are naturally bad ideas.

Others emerge because of the institutional frictions.

Agency problems

• In an ideal world, intermediaries act in the best interest of investors

• However, due to fees, compensation contracts, and career concerns, managers may have an objective that is not in
line with the objective of end-investors

à May lead to moral hazard problems in terms of risk taking, which may then affect performance
Explanations for the poor track record of the industry

Following factors can be obstacles to generating good performance:

I. Structure of management fees

II. Closet indexing
III. Benchmark considerations

Lot of academic and regulatory work studying the link between agency problems and mutual fund performance
I. Management fees and fund size

Industry mainly uses an ad valorem fee model, i.e., fees are a fixed percentage of assets under management

Even if fee rates decrease as assets under management increase (maybe due to fee discounts to large investors),
aggregate fees and revenues usually increase

Generates an agency conflict between the manager and the investor:

• Revenues are largely fixed per asset and costs decrease per asset

• Therefore, the money manager has an incentive to increase fund size to secure larger profit margins

• Larger fund size is not necessarily good news for the investor
Size and performance

Larger funds may use scale to provide exposure to asset classes and factors more effectively. There are economies of
scale in generating beta.

However, larger funds may be worse at producing alpha.

Reasons:

§ Larger funds are forced to hold more names

§ Market impact larger
§ Constraints on short selling more binding
§ Brain drain / limited span of control
Trade size and market impact

When you want to buy or sell something, you submit an order to an exchange.

Every exchange allows for different types of orders and their execution protocols.

Most widespread types: a limited order and a market order.

A limit order says you’d like to buy or sell Q units of an asset at a price P or better.
• Example: a limited order to buy 50 shares at the price of $30 or lower (each).
• A limited order exists for a specified period of time, or until it gets fulfilled.
• Limit orders provide liquidity to the market.

A collection of all the active limit orders is the limit order book. It reflects market depth and liquidity, demand and supply.

A market order says you’d like to buy or sell Q unites of an asset, at whatever is the best market price.
• Market orders take liquidity from the market.
A typical order book

Large orders generate price impact and lead to worse execution prices
Fund size and performance
Annual alpha net of fees in AUM quintiles

0.4% 3-factor alpha 4-factor alpha

0.0%

-0.4%
Annual alpha

-0.8%

-1.2%

-1.6%

1 (small) 2 3 4 5 (large)
-2.0%

Source: Chen, Hong, Huang, Kubik (2004)

Rate of return or value added?

• On average, mutual fund managers don’t produce additional risk-adjusted returns after fees.
• If managers were talented, you would see persistence in their performance (alphas) - there is very little evidence.

Berk and van Binsbergen (2015) notice the following:

1. talent is in short supply

2. fund managers compete for flows

3. there is often decrease returns to scale to a particular strategy, especially when it involves stock picking

4. when a manager is talented, and is able to identify market inefficiency (say, 10mln risk-free profits), return rates
are inversely related to the fund size.

5. Maybe we should measure fund manager performance by the value she creates, not the rate of return?
Mutual funds and their size

Peter Lynch (Fidelity Magellan):

• First 5 years: 2% gross monthly alpha (AUM ~ $40mln)
• Last 5 years: 20 bp gross monthly alpha (AUM ~ $10bln)
Trading in reality and on paper

Implementation shortfall is the difference between the pre-cost paper return on a simulated strategy and the actual
realized return

It consists of the following components:

1. Brokerage commissions and short-sales costs

2. Bid-ask spreads: Difference between the bid and ask prevailing at the time of the trading decision

3. Market impact: Difference between the actual transacted price and the bid (sale) or ask (purchase) price
prevailing at the time of the trading decision

4. Opportunity costs: Lost profits from failing to execute trades suggested by the trading strategy
Profits to a typical fund under different fee structures

Return
Profit, flat 1%
Profit, flat 1-return 20%
Return (dollars) Profit, flat 2%
Profit, flat 2-return 20%

AUM
Diseconomies of scale: Alpha and fund size

Manager
Alpha revenues

Growth of the fund

I. Incentives: size, performance, and fees

Fixed fees encourage the manager to increase the size beyond what might be in the best interest of the investor

Adding a performance fee makes the manager stop increasing the fund size earlier

However, fund size may sAll be too large compared to what is best for the investor
• Many funds riding momentum are currently oversized
• Retails investors oDen do not understand that CAPM alpha could simply be a momentum beta: Song (2020)
• hLps://sg.fi[Link]/news/[Link]

Key takeaway:
Designing incenAves helps to overcome agency problems in money management
II. Closet indexing

Returns on active funds can be driven, despite their name, mostly by the returns on the passive benchmark

Holdings data make it possible to calculate how much a particular fund deviates from its benchmark

Active Share equals the sum of the absolute differences in portfolio weights of the fund and the benchmark in all the
assets:

1 1234 67389:;<=
Active share = . 0/ − 0/
2
/

where > refers to a particular stock in the portfolio

Illustration

Measure the difference in portfolio holdings of the fund relative to the benchmark

Example:

• A fund is compared to the S&P500

• The S&P500 invests 50% in Apple and 50% in GM
• The fund invests 20% in Apple and 80% in GM
• The Active Share equals:

|0.20-0.50|/2+|0.8-0.5|/2 = 30%
Active Share of Fidelity’s Magellan fund
Active Share over time

Closet indexers

Index funds
Active Share over time
III. Benchmark considerations: Window dressing

Investors are likely to look at the fund to see if the manager has bought winners and sold losers

Natural time to do this is at the end of each year when the fund publishes an annual report

Before publishing the report, the fund may do some window dressing to look better: it sells losers and buys winners.

Why bad?

1. Generates additional trading costs

2. Distorts performance measurement
3. Shift manager’s attention away from the main job
III. Benchmark considerations: Risk shifting

Mutual fund inflows follow past performance:

• Funds with high relative returns have high inflows, generating revenue for the fund company

Flow-performance relationship is nonlinear:

• Outperform your peers by a lot in a given year…lots of money flows in; underperform by little, money doesn't
really flow out much.

Can lead to strategic risk shifting

Measuring risk shifting

Risk shifting measure = Difference between a fund’s current holdings volatility and its past realized volatility

!" = Past realized volatility is the standard deviation of the fund’s actual returns over the prior 36 months

!# = Current holdings volatility is the standard deviation of the returns on a portfolio that has the weights of the
current holdings

Risk shifting measure RS = !# − !"

If RS > 0, the fund has increased risk in the current time period compared to the past
If RS < 0, the fund has decreased risk
Risk shi&ing and fund performance
Annual 4-factor alphas in risk shi&ing deciles (more risk shi&ing hurts investors)

Risk shifting decile

0%
1 2-3 4-7 8-9 10

-1%
Annual alpha

-2%

-3%

-4%

Source: Huang, Sialm, Zhang (2011)

Takeaway

• Alpha declines with the fund size, it is not constant in real life!
• Beta is much more stable, and has some economy of scale

• Conflicts of interest between managers and investors deteriorate fund performance even further

Next week: Arbitrage!

• SCM case

• Limits to arbitrage: margin requirements, etc

• Dangers of shorting