Friday Letter: Bittersweet returns

Reinvesting record distributions is no small challenge. Are longer-dated funds the answer?

As an investor with a mature private equity portfolio, you’ll be having cash flows coming out of your ears at this point. In 2013, according to Cambridge Associates, distributions from buyout funds beat capital calls by more than 2:1. This year, according to LPs, the picture has been similar.

Which is of course brilliant, until you start thinking about what to do with all that money coming back. With asset prices trending ever higher, reinvesting is far from straightforward. The consensus is that the overhang of undrawn commitments is at a fresh peak, and not a month goes by without another survey coming out to suggest that investors are planning to put even more of their assets into private equity going forward. As one of the few strategies which in a near-zero interest rate environment continue to offer attractive return prospects, the asset class is bound to get busier still.

It may seem perverse, but this is where record distributions can begin to feel like a bit of a headache. The conventional private equity fund model has a hard realisation date built into it, and it’s a sign of the times that fund investors are now often describing the moment their GP sells another plum investment at a stellar valuation as a bittersweet experience. ‘What a great business that was,’ they say as they count their winnings. ‘Shame we weren’t able to hold on to it.’

It doesn’t surprise in the slightest that some of the industry’s great innovators have spotted a marketing opportunity in this. Carlyle and CVC have been linked to plans for raising a new type of fund with a longer life-cycle (up to 20 years), lower fees and lower returns, and although many LPs will deem it unsuitable, impractical and unattractive, you can bet your boom-time dollar that some will grab it with both hands.

Depending on how deep your pockets are and how strong your aversion to reinvestment risk, the opportunity to park some capital for the long haul, with a deeply institutionalised manager and the chance to earn a return that is still better than treasuries, will be appealing. So what if my IRR is going to be single-digit, a sovereign fund might ask; at least the money won’t be back in my bank account any time soon.

Lest anyone get carried away: this is unlikely to catch on as a mainstream approach to private equity investing. LPs may be lamenting the growing pressures of having to redeploy their proceeds into an ultra-liquid market, and undoubtedly some lower-cost capital will find its way into longer-dated, lower-yielding funds. But to the overwhelming majority, putting their cash into 20-year products will not be palatable. Instead, they’re going to have to meet the reinvestment challenge head-on.