Morningstar has found a gap between the performance of the average mutual fund and the performance of the average investor in mutual funds. The reason? Investors buy and sell their funds at the worst possible times.
Private equity solves this problem for the LP. Investors commit to long lock-ups and can’t buy or sell out of a private equity fund in the interim. But long lock-ups don't affect when private equity firms decide to deploy the capital they have raised, and this is a bigger problem than most LPs realize.
Private equity funds flows are pro-cyclical. Private equity firms do more deals when debt is cheap and prices are high than when debt is expensive and prices are low. The result is that the dollar-weighted returns for private equity are much lower than the time-weighted returns.
We know that purchase price drives expected returns (if you need more evidence of this, please let me know). In the below graph, we can see that purchase price and private equity deal volume are tightly correlated: more capital is deployed when prices are expensive than when prices are cheap.
Figure 1: Deal Volume and Purchase Prices
Source: Pitchbook, Cambridge Associates
In last week’s update, I talked about how leveraged small value strategies are the best performing asset class when spreads are falling and the worst when spreads are rising. The key to success is to stay invested across the cycle – and, if possible, invest more money when spreads are high and less when spreads are low, thus timing the cycles.
But private equity does the opposite – deal volume increases when spreads are low and decreases when spreads are high. This is because sponsors typically are less able to get debt financing in times when credit markets are stressed. We can see this relationship below:
Figure 2: Deal Volume vs. High-Yield Spreads
Source: FRED, Pitchbook
The best times to invest in leveraged equities and private equity since 1999 were 2000-2003 and 2009-2012, but during these times, deal volumes dropped sharply! We can see this same effect in the most recent cycle, when deal volume dried up as spreads increased over the last 6 months.
Figure 3: The recent high-yield blow-out
Source: FRED, Pitchbook
Conditions for leveraged equity investing improved dramatically from Q4 of 2014 to Q1 of 2016: high-yield spreads increased from 4.7% to 7.6%. But deal volume dropped precipitously, even as valuations fell. This is pro-cyclical behavior: the exact opposite of what investors should be doing – they are slowing the rate of investing as valuations drop.
Private equity LPs who want to solve this problem, and behave in a less-cyclical fashion, need to find a substitute for private equity that can take capital at times when private equity sponsors can’t transact because they can’t get debt financing. These are the best times to invest in leveraged equities, but investors will miss them if they rely on private equity managers to time capital deployments. Needless to say, I think that buying leveraged small value stocks in the public markets is the best way to solve this problem, though I think private equity secondary funds are another great solution to the problem.
In short, investors in private equity need to be aware of the pro-cyclicality of the asset class, and think about how to mitigate the risk of sub-optimal market timing that is built into private equity.
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