The Neglected Weight of Time (in Private Equity History and Valuation)

There are instances, you would agree, when putting time in perspective can make a real difference.

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Think about the history of private equity when looking at the table below (source: Peter Lazaroff at Plancorp, LLC, updated from a previous version in the CFA Institute’s Enterprising Investor blog):

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The industry developed during the longest (combined) equity bull market – August 1982 through to March 2000 (interrupted only briefly by the events of second half of 1987) of the last century. The S&P grew 15x in 17 years.

After the burst of the tech bubble in 2003, the industry rebuilt and continued its growth till the last financial crisis. Since 2009, the industry is consolidating its position of mainstream asset class.

The increasing demand for private equity during the bull market phases should have been justified by rational outperformance expectations of investors.

The chart below, based on XTAL’s analytics, shows by vintage year from 1995 to 2007 the 8-year risk premium average spreads for the US buyout funds in the Preqin database.

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Putting time in perspective, evidences don’t seem to support the rational outperformance expectations’ hyphothesis.

The analysis shows that if allocations to private equity had been driven by rational expectations, the most successful periods for private equity should have been the years of the market downturns.

Time seems not to have taught any lesson. Investors don’t seem to have looked beyond the single economic cycle. Or perhaps they had no time-weighted information to benefit from.

As a matter of fact, investors may have overallocated to private equity during boom phases because of the misleading information provided by the available  performance reporting standards.

Boom markets amplify the distortive effects that distributions cause to the IRR – making it look exceptionally attractive, without correcting for the fact that, with divestments, money leaves the table rather than being reinvested at the same rates as the IRR calculation assumes.

For (too) long the standard market practice has been to compare market returns to IRRs – you have certainly heard that’s not apple-to-apple.

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The consequence is that IRR has been the seeming outperformer, winning because it was running on a shorter virtual track.

At XTAL we found that giving time the right importance, by analyzing private equity data in proprietary duration adjusted time-weighted terms, balances benchmarking conditions, helps rational decision-making and yields informative and competitive advantages to our clients and partners.

We periodically share our views on the valuation of the private equity markets and in particular on the dynamics of the embedded risk premium.

This piece anticipates the reprise of our [α + β-Cen] Report that is named after the two brightest stars of the Constellation of the Centaurus, Alpha and Beta Centauri, known as the “Pointers” – the stars that navigators use to identify the Southern Cross and navigate south. And to know where alpha and beta are, when this can provide early signal about portfolio valuations “heading south” can be critical for investors navigating among investment alternatives.

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