What’s the big deal?

The investment world is rife with challenges; investors are searching for yields in a market where high return opportunities often come in the form of complex investment structures that can be difficult for even the most educated investors to dissect. As a result, it can be a challenge for private equity and asset management firms to clearly articulate performance to both current and prospective investors and provide robust and transparent updates to further build trust and confidence.

In addition, private equity and asset management firms must have a clear understanding of the historical and forecast performance of the funds over time to understand the impact of their decisions on overall investor returns and management compensation. This can become particularly complicated when dealing with complex provisions in the Limited Partnership Agreement (“LPA”) around areas, such as capital recycling and carried interest calculations.

We have seen that many managers lack the appropriate tools to effectively monitor and track fund performance, which has led to suboptimal decisions and potentially embarrassing errors and/or omissions.

How effective is your returns model?

There are a number of factors to consider when evaluating your returns model and if it’s designed to meet the needs of the fund and your investors. A good returns model should not only be transparent and save you time, but also possess the following attributes and capabilities:

  1. Contain all the relevant returns metrics and key performance indicators for your various investor classes.
  2. Provide a clear view of forecast cash flows for the fund, including investing requirements, capital calls, “dry powder” available, carried interest and investor distributions.
  3. Differentiate realized vs unrealized historic returns.
  4. Align with historical data from your systems, to allow for a meaningful comparison of actual versus forecast results and to provide robust returns calculations over the life of the fund.
  5. Provide a carried interest view aligned with the terms stipulated in the LPA (e.g. “American” versus “European” structure, clawbacks, etc.).
  6. Capture the use (current and prospective) of various types of leverage and any related covenants.
  7. Use analytics to understand and clearly communicate what drives fund performance (e.g. drill downs to particular investments, regions or asset classes).
  8. Forecasts based on “value drivers” including sensitivity and scenario analysis to varying outputs in order to better understand key risks of fund performance.
  9. Be flexible. Returns models require flexibility to be replicated – if needed – across multiple funds. This helps ensure that appropriate variables can be modified for differing, more complex structures and geographic locations and regulations.
  10. Compliance with any performance standards for which you have stated compliance (e.g. Global Investment Performance Standards “GIPS”), or with regulations that the manager is subject to (e.g. NI 31-103).

A model that works for you

Your returns model is a critical strategic planning and reporting tool. It should capture the nuances of complex structures, and enable you to understand how your investment decisions and asset performance impact the overall returns provided to various classes of investors. Specifically, your model should allow you to:

  • build trust and confidence with current and prospective investors
  • better evaluate investment opportunities and the impact on overall fund performance
  • understand potential carried interest cash flows
  • clearly articulate performance to investors