PE Duration Disambiguated (Smooth Capital)

Getting responses to questionnaires is an art and I can’t say I master it. Nevertheless, I had a few especially kind readers of my previous post who contributed their opinion (thanks!) to the embedded polls. Their results make it more interesting and “independent” to define “surprising” certain different data available in the industry.

There is nothing more relative than time, unless you talk about real money!

AE

As I was waiting for the polls’ results during the latest winter holidays, I spent some time digging out for other data about duration to compare against them (and for the above picture for which I hope I do not breach any copyright).

Among the findings, the piece with the apparent most important industry and academic credentials of endorsement or association (ILPA, Cambridge Associates, HEC, LPEQ) is also the most surprising, as it floats data that foster the useless illusory mythology of the 3-year duration of private equity fund investments.

Dur Peracs

With all the statistical limitations applicable to the case, similar to a conference raised-hands count, the audience that I polled unequivocably agrees on the fact that 3 years in not the answer (click on “see results” below).

Anyway, of the 14 people who expressed their vote, 100% think that duration is longer than 3 years and 93% (13/14) expect duration to be higher than 5 years. 50% of the voters think that duration is longer than 7 years.

To sum up, we have “industry and academia” to produce 3 years duration data, readers to favour the 5-7 year bracket (mode) and the findings reported by the fund-of-fund manager plus the S-curve arguments shown in our two previous posts that suggest duration > 7 years.

The question on what’s the reality goes beyond its semantic relevance. It has valuation and portfolio management implications.

A 2.7-year duration transforms a 1.37x multiple into a time weighted compounded average growth of 12.4% per annum and resounding alpha numbers. If the same multiple is actually produced over 7 years or more, performance is south of 4.6% p.a..

So, where do the perception differences originate from?

The industry approach gets the duration (usually) shortened by (usually upward medium term) market trajectories and randomly biased by volatility as it unrealistically assumes that an investor would, in alternative to commit to a PE fund, buy and sell the market (the MSCI index) following the random pace of the capital calls and distributions of the PE fund.

This is a disguised PME approach again – whose issues I dealt with in an earlier post. And also this is about net duration (i.e. it does not care about the performance-wise idle time between the start of the fund and when the net duration happens) – so it is not calendar time but a math exercise.

And from a math perspective, find it interesting to note that this approach that is “marketed” as LP-championing has a strong embedded Gp-ish PME twist.

As for my readers’ modal preferences instead, they reflect well the practitioners’ perception of the calendar time representing net duration, i.e. the time it takes for transforming the bulk of the invested capital in cash again.

My voter’s perception ties well with the (S-Curve) findings that value creation and cash generation were limited after year nine in the life of a private equity fund, relative to total returns – i.e. total duration.

But now, hold on. Don’t think I am here to dump private equity. Do not use the argument of the longer than advertised duration.

I am here to say that a proper consideration of duration leads to more efficient valuation of performance and its drivers and more aware handling of portfolio risks.

What I am saying (here and in this blog overall) is that duration should not be an endogenous variable of the performance equation, dependent on the performance itself, as it incorrectly is the case for the IRR and the various PME (including this one) approaches.

And why am I saying that? Because, treating duration correctly (i.e. as an exogenous variable as is the case in every solid arbitrage pricing models for which time is an input and reinvestment an issue – on the topic I have an earlier post) evidences diversification benefits otherwise non visible and allows interpreting leverage risks in way otherwise non possible.

The true advantage of LP structures over their duration, to the benefit of both GPs and LPs if not abused, is that the cash dynamics (the commitment long-term availability as guarantee at sight plus the distributions) and leveraged beta plus premium exposure create “barbell” conditions for delivering efficient, smooth and convex performance profiles (without triggering volatility defaults and stop losses): that is better Sharpe ratios because cash has zero equity volatility.

Well managed LP structures are smooth capital; and smoothing does not refers to not marking to market but to the capital protection from duration decay.

 

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