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Private equity performance and asset allocation: impact of low rates and the J curve of cash flows

Private equity performance and asset allocation: impact of low rates and the J curve of cash flows. Financial Risks International Forum Paris – March 2019 Edouard Nouvellon (ULB). Outline. Introduction Private equity performances - literature review The impact of the J curve on the IRR

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Private equity performance and asset allocation: impact of low rates and the J curve of cash flows

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  1. Private equity performance and asset allocation: impact of low rates and the J curve of cash flows Financial Risks International Forum Paris – March 2019 Edouard Nouvellon (ULB)

  2. Outline • Introduction • Private equity performances - literature review • The impact of the J curve on the IRR • Modeling the combined impact of of the J curve’s shape and the deposit rates level • Conclusion

  3. Introduction • Family Offices and ultra high networthindividualsinvest more and more in PrivateEquityfunds • Commitedamount has been growingfrom 10 bnUsd in 1991 to 180 bnUsd in 2000 • In 2018, private asset market size close to 5,2 tr USD

  4. Privateequityinvesting Firm 1 Firm 2 Firm 3 USD Equityholder USD Equityholder USD Equityholder General partner USD USD USD USD Limtedpartners n-1 Limtedpartners n Limtedpartners 1 Limtedpartners 2

  5. Privateequityinvesting 10 / 12 years Investment period (4-5y) Exits period (4-6y) Fundraising (0,5 – 1 y) General partners closes investments and call(cash flows fromlimitedpartners to generalpartner) the commited capital fromlimitedpartners Limited partnerscommit (no cash outflow) a fixedamount to General Partners for them to takeshareholderequityduring the cominginvestmentperiod General partnersrealise exits and repaylimitedpartnerswith a realized positive return (cash flows fromgeneralpartner to limitedpartners)

  6. Privateequity performances • No transaction basedprices as liquid assets • Measuresfrom cash outflow and inflowfromlimitedpartners • Multiple on invested capital (MOIC) • Internal rate of return (IRR) IRR starting point = capital call IRR ending point = capital back to limitedpartners IRR measuredon’tinclude time betweencommitment and capital call

  7. Privateequity performances • Reported IRR by generalpartners close to 10% • Over performance on public equitiesis an open debate • 1,75% in 90’s and 1,5% in 2000’s - Kaplan [2015] • Liquidity and risk premium required for risk and illliquidity over listedequitiesiswidelyconsidered to 3 % • Existingliteraturemainly focus on this performance taken the IRR as given by General Partners

  8. Research question • Ultimate performance to the investorsshouldtakeintoaccount the commited but univestedperiod on which the return is not the same • Opportunity cost of the cash commited but not calledyet • This opportunitycostdepends • On the shape of the capital call • On the return during the periodbefore capital iscalled • This return isusually the risk free rate in order to avoidmarket and liquidityrisks

  9. J curve and IRR • J curverepresents the investor’s cash flow shape in % of commited capital • Entire J curveknown a posteriori after exits realized by the generalpartner Multiple on investment capital = 150% IRR = 10% In line with 3% risk premium on listedequities

  10. J curve and IRR • IRR measuretakesonlyaccounts the « cash at work » period • The investordoes not know when the commited cash willbe call, it as at pure generalpartner’ discretion • Quasi impossible to allocate the commited cash to risky assets • We assume that the cash commitedisinvested in cash depositwithzero duration

  11. Deposit rate impact on IRR for one J Curve • Corrected IRR with 3% deposit rate • Corrected IRR = 7,97%

  12. Deposit rate impact on IRR for one J Curve • Influence of deposit rate on IRR with the same J curve • Deposit rate has to be 9,1% to get 10% IRR as promised by privateequity

  13. Combined J curveshape and deposit rate • J curve simulation withsame 150% Multiple on Capital • Cash outflows • Considering 5 yearsinvestmentperiod • 100% commited cash invested by the generalpartner (assumption) • Cash inflows • Considering 10 yearsperiodwithoverlappwithinvestmentperiod • In order to correct the bias of concentration (high cash flow on the first twoyears), weapply 20 permutations

  14. Combined J curveshape and deposit rate

  15. Combined J curveshape and deposit rate • IRR distribution with 0% deposit rate Average IRR : 6,2% More than 93% IRR are below the 10% initial IRR Min IRR : 3,04% Max IRR : 26,96% The J curveshapeis crucial for the limitedpartners IRR

  16. Combined J curveshape and deposit rate • Resultswithdeposit rate revenues included in IRR The deposit rate during the commitment-not calledperiodcan bring close to 2% difference in IRR of privateequity

  17. Conclusion / Extension • The promised IRR by private equity is not totally delivered as we take into account the cash commitment’ impact on the whole asset allocation • The delivered IRR is on the cash at work • The shape of J curve has a crucial role on the private equity performance • The low rates also conditions the final private equity performances • The risk premium on listed equity can be deeply challenged

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