Private equity performance tends to drop after periods of strong fundraising — but little may be gained from attempts to time this predictable cycle, according to a working paper from the National Bureau of Economic Research.
“We find modest gains, at best, to pursuing realistic, investable strategies that time capital commitments to private equity,” the researchers said in a recent version of the working paper. Such attempts will “likely lead to organizational difficulties for large asset managers investing in private equity.”
The authors of the paper — Gregory Brown of the University of North Carolina at Chapel Hill, Robert Harris of the University of Virginia, Wendy Hu of data provider Burgiss Group, University of Oxford’s Tim Jenkinson, University of Chicago’s Steven Kaplan, and David Robinson of Duke University — studied data on more than 3,500 private equity funds, including buyout and venture capital. Their research considered shifting allocations to a “pro-cyclical” stance that increases commitments when fundraising is high and takes a contrarian view to reduce them in “hot” markets.
Either way, the benefits seem slim, according to the paper.
“Since investors in private equity funds are typically large institutions, the potential timing benefits of adjusting annual allocations must be weighed against organizational frictions and costs due to swings from one year to the next,” the authors said. “Making low or no allocations for series of years likely makes it harder, if not impossible, to maintain relationships with and analyze seasoned” private equity managers who raise new funds every few years.
For buyouts funds, a “neutral strategy” that does not time commitments paid back $1.80 for every dollar invested, or a 1.8 multiple of absolute performance, according to the paper. That’s “quite comparable” to a counter-cyclical strategy that produced a multiple of 1.86 and a “pro-cyclical” adjustment leading to a 1.75 multiple, the paper showed.
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“Little is known about the practical aspects of investing in private equity across market cycles,” according to the authors. “Yet these practical issues have important implications for our understanding of the institutional structure of this market as well as the liquidity properties of the asset class.”
Unlike stocks that may be bought or sold “almost immediately,” investors in private equity funds face significant uncertainty surrounding the timing of the purchase and sale of companies. Fund managers control when their pledged money is invested and returned — a “commitment risk” for investors seeking to protect themselves in a private equity downturn.
Investors seeking to time commitments to make up for the fact that they can’t time capital calls face another potential problem, according to the paper.
A private equity team at a large asset allocator may be “hesitant” to ask for a small capital commitment when private equity markets are hot for fear of losing influence internally, the authors said, or the ability to command large capital allocations when markets “cooled down.”