Stranded Capital, Fire Sales Or….

I wrote in my previous post that actual durations of PE funds are longer than those that are the perceived industry standards. The 14-year number reported in the headline of an article of a recognised magazine is a different thing, but it ties well and allows some reasoning about LP extensions, fire sales and the possible rational alternatives for investors.

I’d like to take a slightly different perspective than the fee-centric one of the article. What I believe is interesting to discuss is the rationale of the decision between fire sale and fund extension.

“In reality, it rarely comes to a distribution or fire sale.”

This is interesting. Investors seem to think that extending the contractual life is better than imposing the liquidation of funds within the typically acceptable horizon of 10+2 years.

The article suggests that the optimal approach could be:

“(…) look for higher returns as compensation for the additional illiquidity and fees and negotiate and negotiate the termination of fees after year ten.”

On the other hand, while higher returns are deemed possible in this final recommendation, actual 14-year returns are defined unsatisfactory (i.e. not delivering the excess 300-500 basis points) and deprecated earlier in the article.

“(…) investors rarely get paid greater returns for taking any illiquidity and fees beyond year ten.”

This apparent contradiction could be easily explained if the article was only about venture capital investments.

Given the binomial nature of these investments, for an investor sticking to funds’ interests for longer (and free of charge) would be like receiving lottery tickets valid for any future draft!

If that’s the author’s objective, smart try. Still, it would be wise to take a probabilistic look at potential outcome versus cost of capital.

If instead the article’s reference to VC included buyout funds (as the “classic” definition implies), extending the maturity of the funds would not necessarily be better.

Whilst exception are always possible, on average buyouts’ abnormal growth – be it induced by operational improvement or financial leverage – has limited duration before it reverts to normal market levels. Decreasing marginal returns are ineluctable.

As discussed in an earlier post, by year 8-9 (i.e. when duration stops growing) the bulk of the value creation of a PE portfolio is realized.

Using figures provided in the article and assuming overall MOICs of 1.5x or more, this implies that, even if for 40% of the VC allocation 30% of the committed capital was in portfolios’ tails, 30% discounted secondary sales would reduce overall total returns (Darc/CAGRs) by less 0.2% per annum – i.e. the overall performance would not meaningfully change.

Unless it is a VC fund with waived fees (or even so), before allowing an extension, check the secondary market and run a duration adjusted return scenario analysis….


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