By Steven Novakovic is the Managing Director, CAIA Curriculum for CAIA Association.
I’m not a contrarian by nature, but I do enjoy being a devil’s advocate and while reading a recent piece by JP Morgan on the importance of a reinvigorated private equity exit environment, I couldn’t help but come up with an opposing perspective. Certainly, JP Morgan is not alone in observing and ruing the dearth of exits, as exits have been on investor’s minds ever since the 2022 bear market turned off the exit spigot that had been wide open.
For context to my thought process, my career started at an endowment, in which we had the luxury of investing with an infinite time horizon and with considerable patience. While exits/liquidity events were always exciting and satisfying, for us, distributions simply meant there was new money to reinvest back into the private markets. Ultimately, the private's portfolio was not meant as a source of liquidity or future funding, rather the purpose was to generate a continued source of long-term growth. While we might get irritated by having funds that reached 10, 12, 15+ years in age, the reality was we didn't "need" that cash. The real agitation was questioning whether the money was optimally allocated or simply “stuck” in an underperforming investment being further dragged down by fees.
I appreciate that not every investor has the luxury of investing in perpetuity; however, I do believe that investors should allocate to and size their size their private portfolio with a very long-term mindset. Through this lens, a private markets portfolio, in many ways, can operate as an evergreen portfolio and (appropriately) not have a meaningful role in the overall liquidity plan for the investor.
Getting back to the topic at hand, when I read these articles about the urgency of private market exits, it makes me think of a handful of Warren Buffett quotes:
"Our favorite holding period is forever.”
And
"All there is to investing is picking good [companies] at good times and staying with them as long as they remain good companies."
As private market investors, our goals include maximizing return relative to risk. By definition, liquidity is not a feature of private markets, and frankly, any investor including private market investments in near to medium term liquidity planning may want to rethink that strategy. Given that, why should we be so anxious to sell investments that have simply hit some arbitrary holding period?
If the GP is invested in a good company that is continuing to grow and compound returns, why should investors create so much urgency around selling and getting liquidity? Are we sure we can reinvest the proceeds into something better? Yes, you may be selling at a higher multiple today, but that also means you are likely reinvesting at that higher multiple. I don’t seem to recall any instances where investors became frustrated with long-only managers holding onto a stock for years at a time. Why should private markets be different?
In many cases, the spirit of an expected holding period is based around the idea of buy an asset, create/enhance/add value, and reap the rewards once that value creation is (mostly) priced in. LPs pay fees for the value add, so why should LPs keep paying fees for a GP to hold an asset when there is no more incremental value to be created? Certainly, a fair question and one that is solvable by rethinking the schedule around asset-based fee structures. I don’t want to encourage asset gathering, but I also don’t want to encourage forced selling of good investments.
Another reason LPs may agitate for an exit is the concern as to whether the GP continues to have the requisite expertise to manage the investment. For example, is a seed-stage venture capitalist well suited to retain an investment you might find in a growth buyout fund? To that, I say, they may not be able to create as much value as the growth buyout fund, but they should be qualified to evaluate the investment merits and not destroy value!
Take Sequoia Capital, for example, in 2021 the firm launched The Sequoia Capital Fund, a new permanent fund offering. In the announcement, the firm gave the example of its investment in Square as a rationale for such a fund vehicle. Sequoia invested in Square in 2011, the company went public in 2015 at a nearly $3 billion valuation and by 2021, the company traded at a market cap of over $115 billion. Though not all investments turn out like Square, under the “traditional” model, Sequoia certainly would have felt pressure to exit the investment as soon as practicable following the IPO. For what purpose? To create liquidity, complete the circle of life, turn off asset fees and crystallize incentive fees, and maintain a profile of early stage investing? Sounds like weak arguments to force a bad investment decision (although I recognize that is easy to say in this very anecdotal rear-view analysis).[i]
Okay, maybe you’re willing to accept there is some merit in allowing a GP to make a judgement around holding onto high performing investments. But what about my portfolio exposures? I invested in the seed-stage fund explicitly for that exposure, now the fund is 15 years old and doesn’t look like a seed-stage fund anymore! I think we are at the point now where we have the tools to be more sophisticated in evaluating our total portfolio exposures and can adapt to having funds that have evolved in their profile. And why should wanting a neat and tidy portfolio get in the way of holding good investments?
Or perhaps you are concerned about the risk profile of this late life fund? It may have naturally exited many of the investments and now hold only a few positions. It is no longer diversified; it may have increased volatility and other changes in risk profile. Assuming this fund is part of a larger set of investments, all of that should be subsumed in the larger portfolio and not be problematic.
At this point, I will acknowledge that there is the issue of the numerator effect (i.e., the private markets allocation exceeding its appropriate size relative to total assets due to growth outpacing other liquid assets). This is a fair concern and one that could be managed by adjusting future commitment pacing and sizing, while also recognizing that I’m not advocating for no exits or never exiting, so it shouldn’t be unmanageable.
So where does all of this lead? Basically, I don’t think LPs should be in the business of pressuring GPs on exits just for the sake of having an exit (or because the fund is, sacrebleu, getting old).
Yes, there needs to be a conversation as to whether fees are encouraging asset gathering and discouraging realizations. Yes, there are times when an exit is absolutely the right decision even if it is a good company (e.g., the buyer is paying well in excess of intrinsic value). However, seeking exits simply because a fund is aging (why is this a problem?), or desiring liquidity from a private portfolio (again, liquidity shouldn’t be a primary aspect of a private market investment strategy; if it isn’t, you're likely reinvesting the proceeds right back into the private markets), are not compelling reasons to sell “good” investments. And by the way, if it isn’t a good investment, I can understand why it might be harder to produce an exit (although I’m not as confused by LP’s pressuring GP’s to more aggressively shed mediocre holdings).
What should LPs do when thinking about exits in their private markets portfolio?
- Start by asking what purpose the exit serves.
- Consider greater use of evergreen funds in private markets to create a greater alignment between the GP and LP in a long-term investing mindset.
- Recognize that continuation funds may hold high quality assets. Did the GP create this fund because of liquidity pressure from LPs or for asset gathering purposes. If it is the former, this may be an opportunity for long-term oriented investors to gain at the expense of short-term forces.
- Irrespective of the “bucket,” remember that investing is about owning good companies.
As with much of investing, it is essential to critically evaluate the circumstances and consider whether the actions we are taking are in the best interest of the long-term objectives of our portfolios.
Footnotes:
[i] I do appreciate this example introduces more complications around fees. Particularly the notion of paying a 30% incentive fee on the public market growth of Square from $3 billion to $115 billion. Also, the conflict Sequoia may face in wanting to realize some of the incentive fee. I believe these valid points are solvable, but a discussion for another time.
About the Author:
Steve Novakovic is the Managing Director, CAIA Curriculum for CAIA Association. In this role, he is responsible for managing the curriculum and ensuring the content remains relevant and reflects the current trends in the institutional asset allocator world. He joined CAIA Association in 2022 and has been a charterholder since 2011. Prior to CAIA Association Steve was a faculty member at Ithaca College where he taught a variety of finance courses including: Alternative Asset Management, Cryptocurrencies, and Wealth Management, among others.
Steve started his career at his alma mater, Cornell University, (B.S. 2004, MPS 2006) in the Office of University Investments. In his time at Cornell University, he invested across a variety of asset classes for the $6 billion endowment. His twelve years at Cornell generated substantial insight into endowment management, and fund investing across the alternatives and traditional landscape.
