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Understanding the Private Equity Investment Cycle for Institutional Investors

Like investing in any other asset class, there is a private equity investment cycle or process when it comes to PE investing, at least for institutional investors.

What is an "institutional investor"?

Institutional investors are typically the larger investors, such as insurances, pensions, endowments, sovereign wealth funds, multi-family and larger family offices, who not only write larger checks (i.e. make relatively bigger commitments of at least $5 million each) to private equity funds but also have a predefined mandate or investment strategy that is defined by specific investment targets and goals.

Furthermore, they follow an investment process that is more formal, rather than follow “gut feeling.” The due diligence and types of analysis that institutional investors conduct are also usually more sophisticated, and the post-commitment portfolio tracking and monitoring is in itself a process that follows their own predefined requirements.

While all investors have their own unique investment processes, most institutional investors generally follow a variation of the private equity investment cycle, which includes five key phases where the last stage provides a feedback loop to Stage 1 to complete the cycle.

Five Key Phases of Private Equity Investment Cycles

  1. Asset allocation planning

  2. Market mapping

  3. Due diligence

  4. Post-commitment portfolio tracking

  5. Portfolio statistics & management

Stage 1: Asset Allocation Planning

Asset allocation planning is a holistic approach toward setting portfolio-level strategic and tactical allocation guidelines that are based on top-down targets driven by the demands of the individual institution. This might be driven by wealth preservation, deployment of a certain amount of capital, maintaining a specific Net Asset Value (NAV), or a portfolio return target (e.g. MSCI + 6%).

A macroeconomic view of the world and expectations of trends in market cycles are used to determine which asset classes and strategies best fit the overall goal of the investor. Most investors undertake an annual review that results in allocation targets across various asset classes such as equities, fixed income, real estate, and private equity.

For private equity, an asset allocation model can be developed based on the unique behavior of different sub-classes (e.g. venture, buyout, debt, infrastructure, etc.) and regions (e.g. North America, Europe, Asia, etc.). For this type of portfolio modeling work, CEPRES provides portfolio forecasting, stress-testing with different macroeconomic conditions, projecting NAV, cash flows, and risk/return outcomes.

By understanding the behavior and risk/return characteristics of both private equity and its various sub-asset classes, and also the existing portfolio of investments, institutional investors can determine which private equity fund strategies would complement the portfolio and allow it to achieve its targets.

Related Article: How to measure private equity returns

Stage 2: Market Mapping

After developing an asset allocation plan for a private equity program, the next step is to understand the market and investigate patterns that help you choose the best funds for your portfolio. For example, should you invest in Asia via large US or European GPs who invest in the emerging markets and can help those portfolio companies expand globally, or instead choose a local GP that originates in Asia? Should you seek venture capital managers who take a hands-on approach with active board participation or not, and what are the consequences? Are 2nd or 3rd generation funds from GPs really better than their 1st fund?

Exploring and investigating such market nuances help you optimize your tactical plans and choose fitting GPs for due diligence. This can be captured as a market map that provides expectations of the relevant markets and GPs. With the increased number and diversity of fund managers and strategies now available to you, this approach is more critical than ever.

It is also a good idea to develop a forward calendar and track GP developments and fundraising plans. which allows you to discover and have a complete view of all GPs that might fit best for your investment pipeline.

Stage 3: Due Diligence

Although it’s simply another stage of the overall private equity investment cycle, private equity due diligence is an extensive process in itself that can be very time-consuming and cumbersome.

Six stages within a thorough due diligence process:

  1. GP track record initial screening

  2. GP track record data gathering and processing

  3. Quantitative due diligence and analytics

  4. Qualitative due diligence

  5. Preparation of investment recommendation for Investment Committee approval

  6. Legal due diligence

It is certainly possible (and necessary) to elaborate on the various aspects and nuances within each of these stages, but it suffices to just highlight them for this article.

Of these six stages, qualitative and legal due diligence are rather standalone items that require manual effort to process. However, the other stages can certainly be optimized by leveraging technology, market intelligence, and investment expertise.

Stage 4: Post-commitment Portfolio Tracking

After making a commitment to a private equity fund, you should monitor the portfolio developments. This includes tracking investments and analyzing fund and portfolio company results on an ongoing basis. At the fund level, you can understand whether it is on track to meet your target expectations.

At the portfolio company level, you can monitor the success of your GPs in deploying capital, creating value in the operating companies, and delivering solid returns. This will allow you to ascertain the fund’s current performance, trajectory and ultimately, the impact this fund has on your broader portfolio.

Within CEPRES, this portfolio tracking function also enables you to benchmark your portfolio, single funds, and portfolio companies to a vast, global universe of funds and deals. You can also see how new a GP’s track record stacks up against your existing portfolio as a further due diligence verification step.

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Stage 5: Portfolio Statistics & Management

Institutional investors actively track capital calls and distributions to and from the funds during the entire life of the fund, which is typically 8 to 10 years plus additional extensions of 2 to 3 years depending on the fund’s strategy. In addition, it is also very valuable to track investment data of the portfolio companies and aggregate it so that you can assess ongoing risk, return and value created by each GP and for your complete portfolio.

To complete the private equity investment cycle, you should regularly analyze your portfolio on CEPRES and benchmark it against the market universe at both the fund and deal level. Additionally, using CEPRES Predictive Intelligence, you can forecast the outcomes for returns, cash liquidity, NAV, and risk on a forward-looking basis and identify weaknesses as a feedback loop to asset allocation planning in stage 1. This will then provide evidence for your investment board to demonstrate how you pick the best strategies and GPs to achieve your portfolio targets and improve your investment risk/return profile.

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