Unexpectedly last week, I stumbled upon an S-Curve hidden between the lines of a study released by an established private equity funds of funds firm with a cautious introductory question: “do private equity funds sometimes just run out of steam?”
The stated objective of the study is “to understand whether there are inflexion points in the life of a private equity fund where expected value creation and distributions may become negligible relative to total value already generated.”
Based on the analysis of the Total Value to Paid In (“TVPI”) produced by the median fund in the dataset, the study has found that value creation and cash generation were limited after year nine in the life of a private equity fund, relative to total returns.
The authors themselves seem to have inadvertently stumbled upon the S-Curve, a concept that I introduced in one of my previous posts to better describe the pattern followed by the total returns of private market investments.
Like many other phenomena in nature and in the economy, they behave like sigmoid functions showing that there is a point in the life of a fund when returns turn from marginally increasing to marginally decreasing.
While providing (further seemingly unintended) evidence for this phenomenon, the referenced study does not progress towards investigating its causes. The approach adopted in the study (that relies on TVPI quartiles and IRR and then limits itself to the median fund) would anyway not be of help because it does not allow a proper methodological consideration of time. But the point it raises is about a critical and necessary attitude that I believe needs to be fostered in the industry to get it past the dumbness of the “patient capital” message.
As secondary transactions become normal practice and liquidity requirements increasingly important, the crucial price-performance relation has to be re-wired so that investors are able to judge performance in terms of risk premium and decide the strategy for their primary and secondary private equity allocation based on the expected co-movement of the target portfolio with listed markets, given their risk appetite.
I take the opportunity to contribute to the momentum being created around such message and tie the study’s results to our S-Curve findings in the belief that raising investors’ valuation awareness takes the industry’s transparency and liquidity practices to the next level.
One of the key corporate finance lessons regarding valuation is about not factoring in abnormal growth for the long-term. And this point applies particularly well to leveraged buyouts that are structured to produce their peak levels of performance within the (medium) contractual terms of the funds (with leverage progressively reduced by cash and operational improvement reverting to a possibly higher mean). For a relative value decision such as the one related to excess returns, it is the “when” and the “how long” of the performance that matters.
Behind the S-Curve lies the missing explanatory element of the study, that is the concept of duration, that matters for both its dimensions of “length of” and “moment in” time. As discussed in our mentioned previous post, duration adjusted returns synthesize and qualify two factors that are critical for addressing the question raised in the study:
- Past distributions that, over time with divestitures leave less capital at work in the fund;
- Future distributions, possibly marked as “expected future exit value” in NAVs (i.e. their present value).
It is a stable duration reference frame that makes it possible to sync corporate finance dynamics with the financial markets, modeling cash flows into rates of return, properly gauging the quality of NAVs, evaluating them against other asset classes and eventually identifying the moment when future performance is already accounted in past performance or not worth the risk:
It is duration that marks the “break-point after which it is not necessarily rational to hold on to a portfolio of private equity funds, taking into account an investor’s cost of capital for the asset class as well as the investment opportunities that may be available elsewhere”.
In case of cash flows, never neglect duration….