Cracking the Illiquidity Code

Cracking the Illiquidity Code

By Tom Keck, Partner & Head of Research; Lisa Larsson, Vice President, Research

Researchers at StepStone Group, a global private markets firm, recently released a white paper that puts the illiquidity of private equity into perspective. A fund’s life they reckon is too coarse a measure; the picture comes into focus when examining fund-level and deal-level cash flows, of which StepStone has plenty. The researchers conducted most of the fund-level analyses using a subset of 332 fully realized, US-dollar denominated funds. The deal-level analysis was performed using a sample of 5,532 buyout deals.

By looking at duration, StepStone demystifies the illiquidity of buyout investing. The paper finds that on average investors will get distributions on the capital they have invested in four-and-a-half to five years.

Flavors of Duration

The researchers looked at two definitions of duration: cash-flow and performance. They began with a set of 1,081 unique buyout funds raised between 1985 and 2007. After filtering out funds that are not denominated in US dollars, they were left with 332 funds.

To estimate the cash-flow duration, you need data on all the contributions and distributions. Estimating performance duration may be easier for some to achieve–you only need the IRR and the total value multiple.

According to the paper, the difference between the two measures is slight: cash-flow duration was on average only 0.22 years greater than performance duration. Either can be used to evaluate larger sample sizes, but when looking at one or two funds, cash-flow duration may be preferable.

Trends Over Time

StepStone’s researchers found that a fund’s vintage can affect its duration. Duration was quite high in the late 90s and again in 2006-7, which correspond to the tech bubble and the global financial crisis, respectively. The paper reasons that GPs bought companies during hot markets and had to hold them until the markets recovered. Its authors question whether 2017 and 2018 will be longer duration vintages.

Honing In

The cyclicality that manifested at the fund level was just as pronounced at the deal level. Turning to their proprietary SPI database, StepStone began with a set of 19,595 buyout deals. After filtering out unrealized deals and investments not denominated in US dollars, they wound up with 5,532 buyout deals. The periods of economic turbulence in the late 1980s, the tech bubble, and the financial crisis showed the highest median duration. The median duration for deals done in 1988, 1998, and 2006 were 5.3, 4.8, and 4.8 years, respectively.

Is Duration Different for Funds in Different Performance Quartiles?

As one might expect, funds with high IRRs tend to have lower durations. Interestingly, however, many of the worst-performing funds also had shorter durations. This suggests that funds that perform poorly will do so quickly. In other instances, poor performers could drag on for years as the manager hopes to recoup some of their own invested capital.  Organizing their subset of buyout funds by quartile according to Burgiss’s benchmarks, StepStone’s team once again found that the median cash flow duration was about five years.

Relationship Between Fund Performance & Duration

To see what, if any, relationship exists between raw fund performance and duration, StepStone computed the IRR and cash-flow duration for each fund in its sample. Funds with low cash-flow duration tended to have a wide spread in performance: IRRs ranged from -40% to more than 50%. As duration increases, the performance spread narrows. This can be a bit of a Catch-22: the average IRRs creep lower as well. Using a simple linear regression, StepStone found that for every year of duration, the IRR falls by 3.4%.

Portfolio-Level Duration

To help LPs that invest in more than one fund per year, StepStone computed the cash-flow duration for portfolios invested in two to 10 funds. The more funds an LP invests in, the less duration uncertainty they face. This risk was reduced the most by increasing from two to four funds. The difference between six and 10 funds was slight, suggesting that investing in six funds per year may be a good trade-off between managing duration risk and limiting the number of relationships.

Trends by GP

While not a harbinger of managerial skill, examining duration can shine light on a GP’s personality and proclivities. Drawing again from their subset of buyout funds, StepStone selected six GPs at random and compared the duration of their funds raised between 1985 and 2010. Some managers showed steady duration across all funds; others showed quite a bit of variability and signs of cyclical behavior. That the manager with the most consistent duration also invested in the greatest number of companies suggests that diversification may be the key to consistent duration.

StepStone is a global private markets firm overseeing more than US$250 billion of private capital allocations, including over US$46 billion of assets under management. The Firm creates customized portfolios for many of the world’s most sophisticated investors using a disciplined, research-focused approach that prudently integrates fund investments, secondaries and co-investments.

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