Time to pause or keep committing?

After the longest-running bull market in history, it might feel natural to pause investing and sit with cash waiting for the market to turn bearish. As this might be a plausible strategy for an investor managing investments in listed equities or fixed income, the case with illiquid investments such as private equity could be rather different, especially for an investor who is investing as a Limited Partner (LP) through private equity funds.

Market timing is perhaps the most challenging task investors face and often considered impossible even by the most sophisticated investors due to the efficiency of capital markets. Put differently, if the efficient-market hypothesis (EMH) holds, the investors should be better off trying not to time the markets and sit tight with portfolios constructed according to their preferred risk-return profiles. Instead, private markets are widely considered less efficient. For General Partners (GP) managing concentrated portfolios, timing the markets might be one of the ways to generate excess returns. For LPs, we do believe superior returns will be achieved by keeping risk exposure constant over time due to the long-term nature of fund investments. This is indeed easier said than done given the LPs have no control over the timing of the contributions that will ultimately build the net asset value. Hence, it is vital to set a systematic long-term commitment strategy.

Expected returns naturally play the most fundamental role in any allocation decision. Private equity has outperformed the public markets systematically in both the US and Europe over the long-term compensating investors for taking illiquidity risk in addition to other equity risk factors. However, when comparing historical returns of funds with different vintages, dispersion looks overwhelming. For instance, buyout funds in Western Europe that started investing in 1999 just prior to the dot-com crash generated a median net return of 4.15% whereas the funds that started investing in 2002 post-crisis have provided investors with a return of 20.20%. While these examples represent extremity cases, it is evident that vintage risk could have a material impact on a portfolio. An investor who kept on committing every year since 1994 in Western European Buyout funds earned a median net return of 11.60%. Therefore, we argue that investors should keep committing at every stage of the cycle and focus on selecting the top managers instead of right times to adjust the private equity allocation.

Selecting the future high performing managers may sound like an impossible task for several reasons. First, the managers debuting with first funds without historical track do typically receive limited amount of credence from professional investors. This is reasonable given the investment decision should be made mainly based on one’s gut feeling and confidence on recognizing the top-performing teams. Second, the established high performing top-quartile managers with long track can typically cherry pick their investors from queues behind their offices as well as dictate the fund terms. Simply put, it often takes decades-long relationships with these managers to build a portfolio of top-quartile funds. To provide some concrete evidence, Western European top-quartile funds, including all fund sizes and strategies, have delivered a median net return of 18.96% whereas the bottom-quartile funds provided their investors with a median net return of only 4.06%.

To conclude the above, we believe investors should simply put their resources on conducting profound due diligence on their managers with a view to build long-lasting relationships with them. Moreover, we argue that staying out of the markets makes investor’s portfolio returns highly unpredictable and increases the risk of poor vintage diversification. As this with no doubt requires patience and confidence on the strategy, we do believe the evidence clearly speaks for itself.

Written by

Teemu Blomqvist

Teemu Blomqvist

Focus:Secondary Investments

Sources: PEVARA Benchmarks. Performance data as of Q4 2018.