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Private Equity Returns, Cash Flow Timing, and Investor Choices

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Private Equity Returns, Cash Flow Timing, and Investor Choices Private equity returns, cash flow timing, and investor choices Stephannie Larocque,∗ Sophie Shivey and Jennifer Sustersic Stevenszx August 22, 2019 Abstract In a comprehensive sample, private equity fund lifetimes average 10 years but their cash flow durations average 4 years with substantial variation across funds. This creates cash management challenges for investors and makes the internal rate of return (IRR) an incomplete measure of performance. Do investors consider these facts when choosing between funds? We find that the portion of IRR that stems from cash flow timing - more than half the IRR on average - persists across a private equity firm’s funds and negatively predicts future performance, but facilitates fundraising, especially among insurance companies, endowment plans, and public pension funds, as well as relatively unsuccessful investors. ∗Mendoza College of Business, University of Notre Dame, [email protected]. yCorresponding author. Mendoza College of Business, University of Notre Dame, [email protected]. zOhio University College of Business, [email protected]. xWe thank Marc Crummenerl, John Donovan, Steve Foerster, William Goetzmann, Tim Jenkinson, Tim Loughran, Ernst Maug, Ludovic Phalippou, Stefan Ruenzi, Paul Schultz, Yannik Schneider, Sara Ain Tommar, Florin Vasvari, Michael Weisbach, conference participants at the Paris Dauphine 11th Annual Hedge Fund and Private Equity Conference and the Glion Annual Private Capital Conference and seminar participants at the University of Frankfurt, the University of Mannheim, the University of Notre Dame, Ohio University, and York University for helpful comments. We also thank George Jiang and Xue Li for excellent research assistance. We have seen a number of proposals from private equity funds where the returns are really not calculated in a manner that I would regard as honest ... It makes their return look better if you sit there a long time in Treasury bills. - Warren Buffett; May 4, 2019 1 Introduction Private equity is a fast-growing asset class, rivaling hedge funds with over $3.4 trillion under management in 2018, according to Preqin.1 One potential driver of the rapid rise of private equity is the attractive returns that private equity managers (general partners, or GPs) offer investors (limited partners, or LPs). The internal rate of return (IRR) is the headline measure of private equity returns and is used by data providers to rank funds relative to peer funds of the same vintage. Beginning with Kaplan and Schoar (2005), a large and growing literature examines the size and risk profile of private equity returns, typically focusing on IRRs or public market equivalents.2 Whereas prior literature takes the timing of private equity cash flows as given, we estimate the effects of cash-flow timing on reported IRRs and explore whether and to what extent private equity investors consider these effects in their investment decisions. Private equity investments present cash flow profiles that differ from those of other asset classes because fund manager, rather than investor, discretion largely dictates the timing of cash flows into and out of the fund. Since invested capital is often less than committed capital over the life of the fund, investors must be skilled at putting varying amounts of committed capital to good use before and after it is needed by the private equity fund. We assert that the IRR provides an incomplete picture of private equity returns because 1Private equity set to surpass hedge funds in assets, Financial Times, October 24, 2018. 2Public market equivalents, or PMEs, compare the return on an investment in a private equity fund to the return on a contemporaneous investment in a public equity index fund. 1 the return that the investor actually earns on committed capital throughout the life of the fund depends on both the cash flow choices of the general partner and on the investor's skill and opportunities for reinvesting capital outside the fund. In fact, the more skilled the private equity firm is at market timing, the less plausible the assumption that intermediate cash flows can be reinvested at the IRR.3 As many finance textbooks show, the calculation of IRR assumes that committed capital earns the IRR regardless of whether the capital is invested inside or outside the fund. To see why this results in an incomplete picture of private equity returns, and may mislead investors who focus exclusively on IRR, consider two funds - each of which has $100 of capital committed by its investors that can be \called" by the private equity fund manager, and must then be contributed by the investors, at any time. Fund A calls $100 from investors in year 4 and distributes $120 to those investors in year 5, reporting an IRR of 20%. Fund B calls $100 in year 1 and distributes $500 in year 10, reporting an IRR of 20%. An investment in Fund A earns 20% for one year; an investment in Fund B earns 20% each year for 10 years. Both funds report an IRR of 20%, but fund B is the preferable investment if the investor cannot earn 20% on her capital when it is invested outside of the fund. As this example shows, cash flow timing and the corresponding cash flow duration of the fund can greatly impact the cash actually earned by the investor for a given IRR. We use data on 6,945 private equity funds from Preqin, nearly half of which have cash flow data, in a sample spanning over 40 years. We find that duration averages 4.045 years while mean fund life is 9.9 years. Fund durations also vary widely, with a standard deviation 3Jenkinson and Sousa (2015) show that conditions in the debt and equity markets affect exit choice. Kacperczyk, Nieuwerburgh, and Veldkamp (2014) find that for mutual fund managers, market timing ability and security selection ability are related, but unlike private equity firms, mutual fund managers must manage the entirety of investors' capital throughout its time in the fund. 2 of almost 2 years.4 Considering that our sample's mean IRR is 12.5%, a 2-year increase in the amount of time the capital is in the fund would result in an additional 26.6% cash return on capital, with compounding and assuming the same rate of return. We next compare funds' reported IRRs to the returns implied by their cash-on-cash multiples, or \multiple-implied returns", which offer a benchmark measure of the return to private equity investors over the entire life of the fund and are largely unaffected by cash flow timing.5 This measure implicitly assumes that committed capital earns zero returns while it is outside the fund, which, while extreme, has the advantage that fund-level cash flow data are not required for its calculation. We study differences between the IRR and the multiple-implied return; we call the difference the \return gap". While multiple-implied returns are earned by all investors, return gaps are fully earned only by investors who are able to reinvest their capital at the IRR while it is outside the fund. We expect any investment with intermediate cash flows and a multiple greater than one to have a positive gap, as a byproduct of the opportunistic investment process in which private equity firms specialize. To the extent that some GPs aim to time investments to employ capital only when it earns maximum returns, or to the extent that GPs manage cash flows or IRRs, return gaps should be higher and persist across the GP's funds. A GP policy of trying to employ capital throughout the life of the fund would make the gap persistently lower. In our sample, we confirm that the fund types that tend to have more volatile cash flows and those where the 4Duration is calculated as the duration of distributions less the duration of contributions. The total is divided by four such that duration is in years. In the subset of these funds that are liquidated, duration averages 4.73 years with a standard deviation of 1.86 while fund life averages 12.11 years. For liquidated funds, we calculate fund life as the time it takes for the LP to receive 95% of total cash flows from the fund. 5The cash-on-cash multiple is the ratio of cash distributed to a fund's investors to cash contributed into the fund by the investors during the fund's life. See, for example, Lopez-de-Silanes, Phalippou, and Gottschalg (2015) and Phalippou, Rauch, and Umber (2018). Cash-on-cash multiples could be manipulated if the fund allows for recycling of capital returned during the investment period of the fund's life. Any upward manipulation of this multiple would weaken our results. 3 GP has more discretion in the timing of cash flows tend to have higher return gaps. For robustness, we explore alternate assumptions such as reinvestment of non-committed funds at the market rate of return as in the modified internal rate of return (MIRR), for the subset of funds with cash flow data. Focusing on the return gap, we first examine whether it persists for a given GP and thus reflects investment style. We find some evidence of persistence in the return gap across a GP's funds, in both quartile transition probabilities and regression analyses where we control for size, vintage, and fund type fixed effects. Next, we find that, while the multiple- implied return of a current fund is positively related to the multiple-implied return of the private equity firm’s subsequent funds, the current fund's return gap is negatively related to the future fund's multiple-implied return for many fund types. In the full sample, a one standard deviation increase in the gap is associated with a multiple-implied return of the subsequent fund that is 0.58% lower.
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