Before investing in the private markets, it is important to understand that a private markets commitment has a very different cash flow profile as compared to buying a publicly listed security or investing in a public market vehicle.
There are three phases to a private markets fund. The first involves deal sourcing and investing, the second involves value creation, and the third phase involves exiting the investment via a sale or IPO.
The chart above encapsulates the three phases, with capital invested incrementally in the first phase, companies held in the second phase, and finally, proceeds distributed as deals are exited. Due to this cash flow profile, investors use a different set of performance measurements to assess the performance of this asset class.
How do capital calls work
A private markets commitment typically does not require investors to fund the full commitment upfront. Instead, managers will periodically issue capital calls (also known as a drawdown) which are notifications to investors to fund an upcoming opportunity. Investors typically have one week to provide the funds upon notification.
In general, most private equity funds have a commitment period of three to four years where they can make capital calls. In other words, a private equity manager generally aims to source enough opportunities during this period to deploy the total capital committed.
Since markets are cyclical, the amount of capital deployed to each sector differs in each business cycle (peak, contraction, trough, recovery/expansion), allowing managers to invest in different deals across the commitment period. Besides maximizing returns, deploying capital across cycles also helps mitigate market volatility and changes in market trends.
Exposure over the lifecycle of a fund
However, an issue with calling and distributing capital at different times is that the average exposure of a private markets fund is typically lower than what an investor has planned.
For example, assuming an investor commits US$1 million. This amount is called in the first two years and exited at cost (for simplicity's sake) after a five-year holding period. The average exposure would only be US$ 714,286, as shown in the following table:
The solution to this issue would be to over-commit. For instance, if the investor were to commit US$1.4 million instead, an average US$1 million average exposure can be achieved, as shown in the following table:
Since the investor does not typically have to fund the total commitment amount upfront, over-commitment is feasible as the investor can re-invest exits from previous investments or arrange short-term liquidity facilities.
The J Curve effect
When plotting the cash flows of private equity funds, you may notice that they tend to follow a "J" shape, which is why private equity cash flow trends are described as following a J-curve, as shown in the following chart.
Source: Vanguard
Once capital calls are made, and investments closed, the manager will charge investment fees on committed capital, resulting in negative returns in the early years of the investment. As the investment matures, the investment strategy is implemented, and profitability improves, leading to positive returns for the investor.
There are no two similar J-curves as cashflows will be specific to each investment and depend on several factors such as the amount of fees and fee structure, the holding period, market condition, and the managers' skills. Additional factors could be the size of the initial cost, transaction costs, and investment timing.
Interpreting private markets performance measures
The main methods used to measure private markets performance are the internal rate of return (IRR) and multiple on invested capital (MOIC).
Starting with the MOIC, the measure shows the total value of realized and unrealized gains compared to the original investment. For instance, if an investor invests $100,000, and that investment is expected to increase to $150,000 in 5years, the MOIC would be 1.5x (150,000/100,000). However, MOIC does not consider the time value of money.
Investors also have to look at the internal rate of return, as it accounts for the time and speed of growth of an investment. As the following table shows, investments with the same MOIC can have very different IRRs depending on how quickly capital is distributed back to investors.
To conclude, while the MOIC gives a simple assessment of the estimated amount investors will receive from their investment, the IRR focuses on "how much" as well as "when."
Invest in the private markets like a pro
Since 2004, The Family Office has helped clients invest in the best opportunities across the private markets while successfully navigating the challenges associated with investing in this asset class. Reach out to us today, if you wish to invest alongside these same opportunities but are not sure where to start.
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