Pink Floyd’s Private Equity Songs

The temptation of another private equity musical license was too strong to resist – the titles of some of the most famous songs and albums of one of my favorite rock groups may seem to have been made on purpose to introduce and comment upon certain highly debated arguments in the PE industry.

TIME (The Dark Side of the Moon, 1973 – Roger Waters, David Gilmour, Richard Wright, Nick Mason)
The hottest topic of the period: how long it takes for a fund to give money (will comment later upon how much) back to investors.

Palico came up recently with the following analysis that shows that most GPs are not liquidating their funds within the terms of their 10-yr contractual maturity.

Interesting and timely coincidence, one of the most debated points at a recent conference was about GPs’ idea to promote funds with contractual life even longer than the usual 10+2+2 years (to include the extension clauses). The point GPs make is that longer funds would make it possible to have adequate “war-chest” available to capture the right opportunity almost at any time.

From the investors / LPs’ perspective, contractual maturity terms should not matter per se (leaving aside all fee-related arguments). What should instead matter are the implications on duration and return expectations deriving from the longer maturities for as much as they translate in longer liquidation terms.

MONEY (The Dark Side of the Moon, 1973 – Roger Waters)
Longer liquidation terms imply longer duration which, according to theory and consensus, should command expectations of higher risk premiums / total returns.

The expectations of higher returns in longer funds is in apparent contrast with GPs’ relevant vision – in which returns are reportedly anticipated to be lower.

The contradiction may be a matter of language. Longer durations imply lower IRRs, lower than the high teens levels traditionally expected from PE investments. But this is a mechanical effect of the following relation that ties total value on invested capital (TVPI) to IRR:

Duration = log n (TVPI) / log n (1 + IRR).

Irrespective from IRR levels and dynamics (whose relevance in concrete performance terms is anyway limited), returns in time weighted terms should embed higher premiums, the longer the duration.

The industry customary (and potentially misleading) reference to IRRs should be no excuse. Investors should allow themselves not even a momentary lapse of reason (1987).

Because the higher financing risk that is implicit in longer commitments and in the subsequent possibly longer transactions’ durations is left with investors, they should rationally demand higher risk premiums.

If this holds true, as it should, investors could take an agnostic stance towards the contractual maturity of the funds.

Ultimately, NAVs should be equivalent to future CFs, given ex-ante duration and return expectations (as formed during the phase of due diligence on the relevant GPs). As a consequence, at any stage of the life of the fund, using the secondary and derivative market investors would have the power to pull the trigger and give their allocation’s duration return expectations the final cut (1983). Selling earlier in the secondary market to shorten duration would imply accepting a lower risk premium – and perhaps (depending on how well fair valuation incorporates mark to market) a discount on the NAV of the transacted fund.

Independently form the time horizon, expectations of attractive returns should never let investors feel comfortably numb (The Wall, 1979 – Roger Waters and David Gilmour).

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