This article was written by Cindy Valentine (partner) and Ravi Chopra (managing associate).
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.
Investor admission
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.
Management fee
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.
Performance
incentivisation
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.
Conclusion
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.
More articles from Made in Africa Issue 15:
UNPRI publishes a standardised DDQ on responsible investing
Made in China? Financing Nigeria's infrastructure
Asian Influence - Singapore’s increasing role in Africa
Financial regulation in South Africa - New developments
Africa mining M&A in 2016 and beyond