Historically, the (pooled average) cash flow J-Curve of private equity funds had an average length of six to seven years until the capital was paid back, with shorter durations – and portfolio company holding periods – in the boom years and longer ones in economic recessions.
In comparison to the other groups, the ‘Roaring 90s’ were substantially above average: these funds had relatively consistent capital calls and early distributions with a break-even (DPI=1) after fewer than 6 years. So on average, funds returned the invested capital before this point. Some of the funds in our data set even returned capital after just three years. This period was characterised by a buoyant M&A market and continuously increasing stock market prices; volatility was relatively low, and there was an IPO boom at the end of the 1990s, which opened the exit channel for private equity- (and particularly venture-) financed companies. As a result, the holding periods of these companies shortened substantially, especially in the second half of the 1990s.
On the left side of the second chart, the pooled DPI of different vintage years is shown while on the right the averages for our groups can be found. While the funds in the ‘Roaring 90s’ would have returned more than their invested capital after six years, the “Tech Bubble” funds had returned just above a third of invested capital to investors. Due to the turmoil in financial markets, the ‘Debt Bubble’ funds were slower in returning capital, with only a quarter of invested capital being paid back.
The answers to these questions depend on both the quality and substance of the underlying investments, and the overall equity and debt market environment, including the level of M&A activity. The quality of the underlying portfolio companies can be reviewed by analysing their financials: mainly revenue streams, profitability and debts. Although a higher default rate at a portfolio company level cannot be observed currently, the level of debt still in some of the (mainly) larger companies raises question marks about future refinancing or sale processes.
Chart 3 (left) shows that ‘Debt Bubble’ funds are more like the other groups in terms of realised and unrealised value than one would have expected – the big difference, obviously, being the larger amount of capital in the unrealised part of the portfolio. Therefore, it is too early to state definitively that the overall returns of these investments will necessarily be low. Even if the IRR is likely to be lower, due to the longer holding periods, the multiples still seem to be comparable with other vintage years.
How investors can protect themselves
The obvious consequence for investors is that they currently have to plan for a decreased amount of incoming distributions relative to past years, at least as long as exit opportunities remain limited. However, given the higher expected volatility in cash flow behaviour, and the fast-changing market conditions we have seen recently, active investors can also benefit from the current situation by adjusting their strategies accordingly – since there are ways to improve the cash flow characteristics of private equity portfolios. Here are four of them:
Our analysis of the cash flow profiles of these five different groups shows that the patterns vary significantly. While the ‘Roaring 90s’ and the ‘Aftermath’ funds show relatively attractive cash flow profiles with quicker repayment periods, the ‘Tech Bubble’ funds show a very long J-Curve, resulting in DPIs well below one after a period of six years.