Drivers of Investment Returns: Value Creation Analysis Improved

March 21, 2017

Behavioral economist Daniel Kahneman taught us that making sense of what people say can be more valuable than tearing them down—asking whether something is true, it turns out, can reveal more about the person asking than the person being vetted. With nearly GP claiming to be an expert in what we call Operational Value Add (OVA), we similarly believe these claims are worth exploring.

As a research-focused firm, we strive to ask the right questions when evaluating investment opportunities. Unfortunately, the calculus for evaluating managers hasn’t changed as quickly as the market.

When private equity emerged in the 1970s and 1980s, financial engineering alone could produce high returns. With fewer managers using similar approaches, comparing them was simpler. But as the asset class has matured and become more crowded, fund managers have had to rely on other strategies and techniques to generate attractive returns for investors and carried interest for themselves—complicating the process by which LPs evaluate and compare them. To deliver high returns through the economic cycle, today’s GPs need to generate OVA within their portfolio companies.

Value creation analysis (VCA) was developed to help LPs select the managers with which to entrust their capital. But in an asset class that is more sophisticated and exacting, the standard VCA can leave many questions unanswered. Measuring a manager’s historical performance is still important, but understanding how that manager tends to create value is critical.

Collecting enough of the relevant data can be problematic to a rigorous value creation analysis; in addition, traditional approaches are difficult to compare across strategies and managers; our DIR and SPI™ address these issues.

The purpose of this paper is to familiarize you with an analytical tool that you will see in our investment memos and future research reports.

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