Abstract
Private equity is an illiquid asset class; investors cannot sell their funds when they want to without potentially facing high losses. However, unlike other illiquid asset classes, private equity is a distributing asset - a cash-flow based asset class that generates liquidity when the underlying investments are sold. If an investor stops committing to new private equity funds then his residual net asset value (NAV) eventually decreases as the underlying investments are exited. For mature private equity portfolios, the investor’s net cash flow is likely to be positive, indicating that distributions are larger than capital calls. The NAV is transformed into cash without requiring any action from the investor; we refer to this process as the self-liquidation property of private equity portfolios.
The purpose of this paper is to have a closer look at this characteristic. We show that, on average, if an investor stops committing to new funds, a mature private equity portfolio is expected to distribute 25% per annum of its NAV after the last commitment year. This ratio decreases by 1.5% annually and strongly depends on the market environment; the expected net cash flow is 70% lower during a recession and 70% larger during a boom period. An investor can assume that its private equity portfolio will have returned 100% of its NAV after 4-5 years. Therefore, despite being considered an illiquid asset class, private equity is generating a sufficient amount of liquidity to receive its residual value in a reasonable timeframe.
Allowing the portfolio to liquidate itself might be considered a risky technique at first glance compared to a secondary sale. However, for mature portfolios, the transformation pace from NAV to cash is relatively high, which implies a corresponding market risk reduction. We show that compared to a public equity buy-and-hold strategy, the terminal value (after self-liquidation) has a much lower volatility whilst generating a significant outperformance despite the presence of cash drag. Therefore, unless a private equity portfolio is clearly expected to perform poorly, or an investor has immediate liquidity needs, there is no reason to sell it on the secondary market.
1. INTRODUCTION
Private equity funds generally have a contractual initial life of ten years – most often in the form of a limited partnership or equivalent vehicle. The terms of the partnership between the fund manager, also called General Partner (GP), and the investors, also called Limited Partners (LPs), are governed by a Limited Partnership Agreement (LPA), which generally specifies the term of the partnership, the management and performance fees, the governance principles as well as investment parameters and restrictions. The first 5-6 years correspond to the fund’s investment period, during which the GP can draw down from the capital committed by LPs. Generally, after the investment period, the GP can no longer draw down unused committed capital other than for fees, expenses and follow-on investments. As soon as investments are realized (underlying companies are sold or liquidated after going public), the capital and profits are returned or distributed to the LPs.
Figure 1 presents the typical cash flow and NAV evolution of a private equity fund during its life. Capital is called during the investment period; at the same time, the net asset value of the fund is growing. In later stages, cash is distributed to the investors. As one can see in this figure, after the investment period, the distributions become larger than the called capital and the NAV decreases. A private equity fund generates cash as the positions it holds are liquidated. The ratio of distributed and remaining value to the invested capital, called the total value to paid-in (TVPI), is one important measure of the performance of the fund. A value larger than 1.00 indicates that the investor has potentially made a gain. The gain is effective when the sum of all distributions is larger than the called capital. On average, liquidated private equity funds with vintages between 1986 and 2004 have a TVPI of 1.93x[1]. This measure does not tell the whole story as it does not take the timing of the cash flow into account. Therefore, it is often presented along with the internal rate of return (IRR) of the fund. On average, liquidated private equity funds with vintages between 1986 and 2004 have an internal rate of return (IRR) of 16.7%[2].
Fig. 1
Figure 1. Typical cash flow and NAV evolution of a private equity fund (mean NAV and cash flow of buyout funds with vintages between 1986 and 2004 from the Cambridge Associates database as of December 31, 2014).
As confirmed by previous performance measures, private equity can produce strong returns. However, investing in a single private equity fund can be risky as the amount of money lost in bad cases can be relatively high. The risk can be greatly reduced by diversification; for example, investing into five private equity funds per year during five years (total of 25 funds) leads to an iCaR of 0%. Some sub-asset classes of private equity are less risky than others. For example, just investing into three buyout funds during three years also leads to an iCaR of 0%, which would not be the case when widening the investment universe to all private equity funds. Throughout this paper, we consider a fictive investor that takes advantage of the diversification available in private equity by investing in different private equity sub-asset classes.
In section 2, we show that investing in a diversified private equity portfolio during a sufficiently long period leads to a self-liquidating portfolio i.e. cash is distributed to the investors as investments are exited and the portfolio’s net asset value is decreasing. After showing that the liquidation rate is larger than generally expected, section 3 links private and public equity to show that the observed high liquidation rate de-risks the portfolio and that the volatility of the terminal value is lower for private equity compared to public equity. Section 4 aims to give a better understanding of some of the external factors driving the liquidation rate. How important is the number of continuous years committing to private equity? What about the age of the portfolio? Is the market environment affecting the investor’s cash flow? The last section introduces some of the cash flow simulation methodologies that are available for investors to quantify the risks present in the portfolio. It also shows that these tools can be used for portfolio planning and design.
2. SELF-LIQUIDATION OF PRIVATE EQUITY
Illiquidity is one of the major perceived risks when it comes to considering private equity as an asset class in which to invest. By means of historical simulations, this section shows that despite being illiquid, private equity funds are self-liquidating i.e. after a certain number of years, the net cash flow is positive whilst the net asset value decreases.
Before examining how a portfolio of private equity funds is liquidated, we will first define how it is constructed. We simulate the portfolio of a fictitious investor who commits to private equity regularly and in a diversified manner. Therefore, it makes sense to use pooled cash flows per vintage year to approximate the private equity portfolio; the Cambridge Associates[1] database has been used for this purpose. The left hand side of Figure 2 shows the evolution of the net cash flow of portfolios committing USD 1 million per year during 10 years. Each black line represents the quarterly net cash flow evolution of a portfolio with different starting vintage years ranging from 1986 to 2005. The green line represents the average case. Typically, the investor needs about USD 3 million to finance this investment strategy and after 7-8 years, the portfolio starts to be self-financing i.e. the distributions are larger than the capital calls. Some scenarios are self-financing in later stages and also have higher financing costs. Figure 2 also presents the corresponding NAV evolution on the right hand side. The large swings correspond to the historical period where a large NAV growth took place followed by a significant decline in valuations: the dot com crisis and the aftermath of 9/11.
Fig. 2 and Fig. 3
[1] Quarterly private equity cash flow and NAV from the Cambridge Associates database as of Q4 2014. Cambridge Associates obtains data from LPs and from GPs who have raised or are trying to raise capital. Therefore, it might have a bias towards better performing managers. However, given the large coverage of the database, this bias is likely to be relatively low.
[1] Source: Cambridge Associates as of Q1 2015, Pooled TVPI of all liquidated private equity funds.
[2] Source: Cambridge Associates as of Q1 2015, Pooled IRR of all liquidated private equity funds.