By Jian Zhang, CFA, Partner, Adams Street Partners
Private equity represents an important component of the alternatives allocation for an institutional portfolio. This is primarily due to the fact that private equity is complementary to traditional asset classes and has proven to be accretive to overall returns while offering important diversification from public equity and fixed income markets. However, certain unique characteristics of private equity can present significant challenges to asset allocation decisions when included in a traditional portfolio.
The expected return and risk of an asset class are two essential inputs for asset allocations. Public markets use time-weighted returns over a given holding period and make the assumption that no transactions occur during the investment period. By contrast, the performance of private equity investments is traditionally measured by an internal rate of return, which accounts for all cash flows of the investments since inception. This may create a mismatch in the evaluation time horizon between an investor’s private equity investments and more traditional assets. It can also be problematic to use interim period volatility to evaluate the risk of private equity as used for other liquid or market-traded assets. Over a short period, the private equity market may appear less volatile than the public market because its performance relies partly on the valuations of underlying companies, which tend to respond slowly to market information and could be artificially smoothed.
There have been several methodologies developed to estimate private equity volatility by “unsmoothing” the appraisal-based returns using a broad pool of assets represented by different private equity strategies or subclasses. Although different approaches may give rise to somewhat different estimates, they nonetheless provide valuable information about how different parts of the private equity markets tend to move over time and their short-term risk characteristics. However, because there is no broad-based private equity benchmark, an individual investor’s private equity portfolio is likely to be different from the market by subclass, geography, fund size, sector exposure, vintage year, etc., and they each would face different investment opportunity sets when making a new capital commitment. Once a commitment is made in private equity, investors usually cannot trade in and out their positions frequently without significant transaction costs. Therefore, investment and allocation decisions more often need to rely on the economic value of the investor’s current private equity commitments, as well as the dispersion of their final outcomes once these commitments are held to maturity or fully liquidated.
Despite the cost associated with buying and selling pre-existing private equity assets, there has been significant growth in secondary market transactions driven by investors’ increasingly active approach to managing their private equity portfolios. LPs may go to the secondary market to 1) gain or reduce exposure to certain market segments because of a change in their investment strategy or economic situation, 2) manage unexpected risk as their holdings continue to evolve, or 3) simply obtain some liquidity from existing investments. Secondary sales, sometimes comprised of a large portfolio of assets, are also an option for private equity asset managers to generate liquidity and return capital earlier to their clients and to optimize a portfolio’s performance. Increasingly, we’ve seen GP-led transactions that are motivated to not only provide liquidity to existing LPs, but also realign the interest of various stakeholders, bring in new capital, and allow the sponsor to manage selected assets longer to create more value. Whatever the motivation for secondary market participants, the ability to select the transaction assets and the skill to evaluate their return potential on a risk-adjusted basis in the subsequent holding period are critically important to be successful.
Studies about private equity performance have often focused on cumulative or since inception returns of partnership funds, even though understanding the remaining funds’ return is equally important to private equity investors and managers alike. In a recent study published in the Journal of Alternative Investments, my coauthors and I provided the first large-sample analysis of buyout and venture capital fund values over their lifetime. We calculate the performance for a private equity fund’s remaining life based on the interim NAVs and the fund’s future cash flows, assuming an investment is made at the reported NAVs. We examine both absolute performance metrics (e.g., remaining fund IRRs and TVPIs) and market-adjusted returns (e.g. remaining fund Direct Alpha). Implicitly, this illustrates when the NAVs are “too high” or “too low”, on average, during the life of a fund. We find that the typical fund experiences a fall-off in returns after it is about seven to eight years old. More interestingly, the cross-sectional dispersion of fund performance tends to increase, not decrease, for funds more than five years old, despite having more mature assets. We estimate the determinants of future fund performance from the cross-section variation of funds. There is a variety of market-wide and fund-specific factors that predict future fund performance, including liquidity generated to date, previous fund performance, dry powder (at both fund and market level), public market returns, credit spreads, etc. But the relevant factors are different for both buyout funds and VC funds and can vary over a fund’s lifecycle.
Learn more from Greg Brown, PhD, Jian Zhang, PhD, and Wendy Hu, PhD, authors of "The Evolution of Private Equity Fund Value" in the Spring 2021 edition of The Journal of Alternative Investments.
These findings are relevant to private equity investors, especially participants in the secondary market. It would be interesting to learn how many of the effects we document in the study are reflected in actual secondary transactions. In addition, the market price could be affected by other asset or transaction-specific factors. Investment success may require targeting specific assets, taking advantage of special situations, and integrating good GP relationships with an experienced team that understands market dynamics.