In our last issue of Made in Africa (Issue 14), we discussed increasing interest in permanent capital vehicles (PCVs), covering an overview of the key drivers for PCVs, limitations in respect of investor appetite and a high level comparison of PCV structures and terms as compared to a ‘typical’ PE fund structured as a fixed life, self-liquidating limited partnership (a “Typical Fund”).
In this piece, we focus on a key feature of the PCV formulation: valuation. The method of valuation of the assets of the holding vehicle impacts, for example, upon the economics of investor admission, as well as fees, which are often calculated in full or in part on NAV, and incentivisation. Investors therefore seek a robust approach to valuation in part to ensure they are not overpaying in any of these areas. If a PCV lists on a stock exchange, the valuation of the PCV assets will also tie into the market price and the perception of whether, absent other market considerations such as the relative attraction of different sectors, the valuation presented by the manager is reasonable.
With Development Finance Institutions (DFIs) and other investors increasingly looking at investment in longer term capital vehicles and alternative structures, managers need to ensure they get their approach to valuation right. Below, we discuss high-level issues around the impact of valuation on investor admission, management fees and incentivisation.
One of the attractions of raising capital through a PCV instead of a fund with a fixed fundraising period (usually 12-18 months) for managers is that they can fundraise on an on-going basis or via multiple rounds of fundraising. This can fit an organic growth strategy, where fundraising can be matched with the more immediate asset pipeline. There is also the possibility, which can be particularly attractive for first time fund managers, to raise capital to fund a track record, with the performance of the existing asset base potentially making subsequent fundraising more attractive to prospective investors.
Managers using a PCV therefore must determine on what basis (if at all) to ‘equalise’ investors coming in at different times such that they share in the investments made prior to their admission to the vehicle. In a Typical Fund, subsequent investors are drawn down upon admission to fund their proportionate share of the existing assets and expenses, i.e. they are ‘equalised’ across the fund. This equalisation payment (plus interest) is then returned to the first or earlier close investors who have essentially funded the subsequent investors’ proportions, so that all investors have funded the same proportion of their subscribed commitments. The interest payment recognises the time value of money in respect of the amounts originally drawn down from the earlier investors on behalf of the subsequent investors. With fundraising for PCVs taking place over a longer period of time (or even an indefinite period in the case of evergreen vehicles), fund managers however need to assess whether an amount equal to interest is appropriate in a PCV.
The value of the fund’s assets may increase significantly more than an assumed rate of interest over the period of time in which capital is raised in a PCV. Existing investors will be averse to see their holdings diluted, with subsequent investors receiving the benefit of asset performance for an effective cost (i.e. a lower interest rate) below the market price. There could also be an incentive for prospective investors to wait to see if they can gain a price advantage upon admission.
The entry price for subsequent investors in a PCV therefore reflects better alignment for investors if admission corresponds to the net asset value (NAV) of the existing assets to ensure the earlier investors are properly compensated for the dilution of their holdings. Managers need to be careful from a governance perspective to manage a perceived conflict whereby higher prices can deter incoming investment but protect existing investors, whereas lower prices can incentivise incoming investment but may overly dilute existing investors. Setting the right valuation price is therefore key in ensuring investors are comfortable on admission and have confidence in the Manager. Managers may therefore need to obtain periodic third party valuations of the vehicle’s assets, with such valuations adjusted appropriately (e.g. a cash adjusted and/or projected growth basis) for when subsequent investors are admitted.
There is also the question as to whether to equalise all. If subsequent investors are equalised, then all investors are drawn down to the same extent, which has the advantage of all investors being in the same position. However, managers also need to consider whether this unduly exposes earlier investors to further cash drag and whether it would be more equitable to leave earlier investors fully drawn and issue units at a NAV-based price when drawing down from subsequent investors.
A longer term vehicle may lead managers to contemplate charging management/advisory fees on a different basis from a Typical Fund (where the fees are generally structured on commitments during the investment period and then on the acquisition cost of unrealised investments until the end of fund). One reason for this is that the time and attention required to manage an asset may not correspond to the original acquisition cost of such asset over the longer term. Equally, where an asset has decreased in value below its acquisition price for a long period of time, investors may be averse to paying management fee based on the original acquisition price, especially if there is no requirement to realise the asset.
Like listed funds, PCVs therefore commonly implement valuation based management fees (sometimes after a commitment based fee for an initial investment period). Contrary to the perceived conflict in valuing the entry price for subsequent investors mentioned above, investors would want to ensure that assets are not over-valued and they are not paying too high a management fee, whilst managers would want to avoid under-valuation, which would result in a lower fee. A straightforward answer to balancing the valuation concerns in respect of entry price and fees is to ensure a robust valuation process to give both existing and prospective investors comfort that the valuation is reasonable.
Accordingly, managers should carefully consider detailed valuation policies, tailored to the asset classes being invested in and the appropriate type and frequency of independent checks (which may range from audits, in respect of private equity, to independent valuations in respect of real estate and infrastructure), in order to give investors comfort on the consistency of the valuation methodology in the long term.
Whereas the investments of a Typical Fund are required to be realised during, e.g., a 10 year lifespan (usually with opportunity for a 1-2 year extension), the investments of a PCV may not be realised for extended periods of time, if at all. Managers therefore may need to look to structure incentivisation to take account of unrealised value.
There are many variations to consider when considering incentivisation, including factoring in investor requirements. Where, for example, a vehicle has a pure yield focus, this may point to a performance fee based on exceeding a certain yield threshold. Where assets are intended to be exited regularly across the life of the vehicle (though the acquisition cost base of such assets may be reinvested), a share of distributable cash (similar to a Typical Fund) may also be appropriate.
Where a PCV has a focus on capital accretion without realisations (including alongside a yield focus), managers may need to depart from the Typical Fund model in order to capture the unrealised growth in value of the vehicle’s assets. In this regard, a robust valuation methodology becomes more important than ever. Hand in hand with this goes the approach to handling dips in valuation subsequent to performance fees being paid out to the manager.
The exact performance incentivisation model can vary significantly from manager to manager, taking into account the asset base, the investor base (including the negotiated position) as well as the management fee (which, if NAV based, can itself be perceived as a kind of performance fee). While there are various detailed permutations that may be considered, one simple, high-level approach may be to structure performance incentivisation to take into account the value of the assets as at the end of certain pre-determined performance periods, with performance related amounts accruing to the manager if the total return exceeds a hurdle threshold. How this performance is then paid across to the manager may then depend on the cash liquidity of the PCV and, absent cash, whether the manager seeks to be able to drawdown from investors to fund performance fees or, if the intention is to list the PCV after a certain period of time, crystallise incentivisation by way of a share issuance upon IPO.
Permanent capital vehicles and longer term hybrid vehicles raise many interesting issues, of which valuation is just one. Valuation impacts on various aspects, including the investor admission, compensation and incentivisation mechanics. It is fundamental to get the valuation mechanics right at the outset in order to get investors comfortable that the economics of the vehicle will work effectively and that there is an alignment of interests of the investors (including amongst themselves), and the manager.