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When an investor decides whether to commit to a given PE vintage,1 they are, in essence, timing their allocation of capital. However, as with public equity, industry research suggests that PE investors cannot reasonably predict which PE vintages will outperform (Brown et al., 2020). And once an investor has committed to a vintage, decisions about when to invest the capital and exit investments are at the PE fund manager’s discretion.
The upshot: Rather than attempting to time PE markets, investors may benefit from a consistent commitment strategy that diversifies their exposure across various market environments and allows for the reinvestment of capital distributions from prior vintages.
In the research brief, Potential in Persistence: Staying the Course With Private Equity, we explore these and other insights, including:
- Why trying to time PE capital commitments tends to be futile.
- How PE has performed during times of market and economic uncertainty.
- How a consistent PE commitment strategy has fared compared to other approaches.
To learn how we can tailor a PE commitment pacing program to your organization’s unique goals and needs, contact your Vanguard representative.
- All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.
- Private investments involve a high degree of risk and, therefore, should be undertaken only by prospective investors capable of evaluating and bearing the risks such an investment represents. Investors in private equity generally must meet certain minimum financial qualifications that may make it unsuitable for specific market participants.
- With private equity (PE) investments, there are five primary risk considerations: market, asset liquidity, funding liquidity, valuation, and selection. Certain risks are believed to be compensated risks in the form of higher long-term expected returns, with the possible exceptions being valuation risk and selection risk. For selection risk, excess returns would be the potential compensation, however; limited partners (LPs) must perform robust diligence to identify and gain access to managers with the skill to outperform. PE investments are speculative in nature and may lose value.
- Market risk: Private equity, as a form of equity capital, shares similar economic exposures as public equities. As such, investments in each can be expected to earn the equity risk premium, or compensation for assuming the nondiversifiable portion of equity risk. However, unlike public equity, private equity’s sensitivity to public markets is likely greatest during the late stages of the fund’s life because the level of equity markets around the time of portfolio company exits can negatively affect PE realizations. Though PE managers have the flexibility to potentially time portfolio company exits to complete transactions in more favorable market environments, there’s still the risk of capital loss from adverse financial conditions.
- Asset liquidity risk: Various attributes can influence a security’s liquidity; specifically, the ability to buy and sell a security in a timely manner and at a fair price. Transaction costs, complexity, and the number of willing buyers and sellers are only a few examples of the factors that can affect liquidity. In the case of private equity, while secondary markets for PE fund interests exist and have matured, liquidity remains extremely limited and highly correlated with business conditions. LPs hoping to dispose of their fund interests early—especially during periods of market stress—are likely to do so at a discount.
- Funding liquidity risk: The uncertainty of PE fund cash flows and the contractual obligation LPs have to meet their respective capital commitments—regardless of the market environment—make funding risk (also known as commitment risk) a key risk LPs must manage appropriately. LPs must be diligent about maintaining ample liquidity in other areas of the portfolio, or external sources, to meet capital calls upon request from the General Partners (GPs).
- Valuation risk: Relative to public equity, where company share prices are published throughout the day and are determined by market transactions, private equity net asset values (NAVs) are reported quarterly, or less frequently, and reflect GP and/or third-party valuation provider estimates of portfolio fair value. Though the private equity industry has improved its practices for estimating the current value of portfolio holdings, reported NAVs likely differ from what would be the current “market price,” if holdings were transacted.
- Selection risk: Whether making direct investments in private companies, PE funds, or outsourcing PE fund selection and portfolio construction to a third party, investors assume selection risk. This is because private equity doesn’t have an investable index, or rather a passive implementation option for investors to select as a means to gain broad private equity exposure. While there are measures an investor can take to limit risk, such as broad diversification and robust manager diligence, this idiosyncratic risk can’t be removed entirely or separated from other systematic drivers of return. Thus, in the absence of a passive alternative and significant performance dispersion, consistent access to top managers is essential for PE program success.
- Private equity is generally only accessible to ultra-high-net-worth investors, either through direct investment or partnership with a private equity firm, which invests in a private equity fund. Only accredited investors who meet specific qualifications outlined in federal securities laws qualify to invest in private equity funds. Certain private equity funds require investors to meet the definition of “qualified purchaser” in addition to being an accredited investor.