By LARRY SWEDROE
Since its inception in the 1970s, the private equity (PE) industry has grown significantly. According to Preqin’s 2020 Private Equity & Venture Capital Report, there are now more than 18,000 private equity funds, with assets under management exceeding $4 trillion. An anomaly is that the growth has occurred despite a large body of evidence (the 2013 study Limited Partner Performance and the Maturing of the Private Equity Industry, the 2016 study Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting, the 2018 study The Grand Experiment: The State and Municipal Pension Fund Diversification into Alternative Assets and the 2020 study Private Equity Is Still Equity, Nothing Special Here) that has found:
- U.S. private equity returns can be replicated systematically through public equities, historically by selecting small, cheap and levered stocks — without sacrificing liquidity.
- The volatility of private equity returns is understated as a result of smoothing, and the risk-adjusted returns are comparable to those of public equities. An un-smoothing approach results in comparable standard deviations of returns for private equity and the S&P 500.
- Privately held companies carried three times the leverage of stocks included in the S&P 500 and almost 50 percent more leverage than the small, cheap and levered stocks that constitute the U.S. PE Replication Index — the greater leverage should be considered when measuring risk-adjusted returns. Given such high leverage, the default rates of private equity holding companies are higher than those of publicly listed companies.
More bad news comes from the authors of the 2017 paper How Persistent Is Private Equity Performance? Evidence from Deal-Level Data?, who concluded: “Overall, the evidence we present suggests that performance persistence has largely disappeared as the PE market has matured and become more competitive.”
Unfortunately, we are not done yet with addressing issues that negatively impact the performance of private equity. As the authors of the research paper from Cliffwater LLC explain: “Private funds take time to draw, deploy, and distribute capital, shifting the burden of cash management and commitment planning to the investor. While very large institutional investors have pacing plans, and serially commit across managers and vintages to obtain programmatic exposures, non-institutional investors may find this administratively burdensome.
In the case of cash management, a private fund presents not only a burden but also a dilemma. Because capital can be called in any amount, at any time, investors need to maintain ample liquidity to meet capital calls. This raises the question of where the ‘reserve’ for uncalled capital will reside — a money market fund, a low-risk ETF, or proxy asset class ETF subject to volatility? Each choice impacts liquidity, asset allocation, and ultimately returns.”
The authors went on to explain that the typical private equity fund that relies on capital calls reports returns since inception as internal rate of return (IRR). IRRs are dollar-weighted returns and are accepted as an appropriate way of calculating returns that are subject to variable cash flows. However, the simple IRR calculation assumes that distributed capital is reinvested at the IRR that equalises the capital outlays with the present value of future cash flows. A more appropriate measure for most individual investors is the modified IRR (MIRR), which does not assume distributed capital is reinvested at the constant IRR discount rate. Instead, it uses both a cost of capital and reinvestment rate to calculate a blended or modified IRR. MIRR not only accounts for the rate of return of the drawdown vehicle but also for the rate of return of the capital that sits uncalled and distributed. This is more methodologically correct and representative of a drawdown fund’s “true” IRR.
In their April 2021 study, Cliffwater limited the MIRR to include just the investment return of the “cash alternative” as it sits uncalled by the manager. They then measured the performance gap between general partner-reported IRRs and the MIRRs (those that include “placeholder” assets, such as fixed income, that many investors use to reserve for unexpected future capital calls). As a leading consulting firm, Cliffwater has access to private drawdown fund cash flow data, which enabled them to examine the differences between simple IRRs and MIRRs across a randomised sample of twelve 2016 vintage private equity buyout funds and a randomised sample of thirteen 2016 vintage direct lending funds. When capital was not invested with the manager, Cliffwater assumed it was invested in either three-month Treasury bills or the iShares Core U.S. Aggregate Bond ETF (AGG). Following is a summary of their findings:
- There are sizeable IRR gaps for both buyout and direct lending funds, demonstrating the importance of getting capital deployed faster and charging fees on invested capital rather than committed capital.
- Private equity firms reported an average IRR of 20.4 percent. Using three-month Treasury bills, the MIRR was just 8.7 percent. Using the AGG, the MIRR was 9.8 percent.
- Private debt firms reported an average IRR of 6.8 percent. Using three-month Treasury bills, the MIRR was 4.3 percent. Using the AGG, the MIRR was 5.3 percent.
- The average percentage of unfunded capital for private equity buyout funds was 61.6 percent over the life of the vehicle and 41.5 percent for direct lending funds—a factor that likely exacerbated the IRR/MIRR spread.
The authors added this observation: “Investors can likely decrease the IRR/MIRR spread by investing uncalled capital in an index or ETF that more closely matches the return profile of the drawdown fund. In doing so, however, one will have to contend with the increased volatility that comes with the increased return. Downside volatility would potentially leave the investor short of the necessary liquidity or cash to fund capital calls, potentially putting the investor at risk of defaulting on their capital commitment or crystallising unrealised losses as drawdown commitments are called. Anecdotally, we do not find such practices common, as defaulting on an LP commitment is a bright red line for investors in drawdown funds.”
Cliffwater concluded: “Investors should not ignore the shortcomings of the drawdown fund structure. Not only do they require more operational flexibility than their open-ended counterparts, but the calculation of returns can be highly misleading as we have shown. Factors such as the pacing of deployment and the willingness to bear additional risk with undrawn capital can bring about large differences in GP-reported IRRs. Given that over the life of a drawdown fund, uncalled capital can be as high as 60% of invested capital for buyout funds and 40% for direct lending funds, the choice of cash management alternatives will substantially alter the true return picture of a drawdown fund, as evidenced by the spread between IRRs and MIRRs. The spread is larger for buyout funds than it is for direct lending funds, as the IRR/MIRR spread is a function of the performance difference between the manager driven performance of invested capital and cash management performance of uncalled capital.”
Investors should note that, at least for direct private lending, with the introduction of interval funds such as Cliffwater’s Corporate Lending Fund (CCLFX) and Stone Ridge’s Alternative Lending Risk Premium Fund (LENDX), the open-ended structure eliminates the real-world burdens that can come with drawdown vehicles like vintage timing, high minimum investment thresholds, uninvested cash and cash drag on performance.
Important Disclosure: The information contained in this article is for educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. The analysis contained in this article is based upon third party information available at the time which may become outdated or otherwise superseded at any time without notice. Third-party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth®, Buckingham Strategic Partners® (collectively Buckingham Wealth Partners). LSR-21-95
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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