Perspectives on the Rising Popularity of Long Duration Private Equity
Category: Portfolio Management
With the transition to fall, the words “Go Long” will undoubtedly echo across football fields and backyards throughout the country. A broadly similar sentiment was on display last month at the Carlyle Group’s annual Washington DC Investor Conference. More specifically, there was a heavy emphasis on the private equity firm’s long duration portfolios, which included several Energy, Real Estate, and Infrastructure Funds. What stood out the most though, in our view, were the presentations highlighting Carlyle Global Partners Fund I (launched in 2015) and Fund II (expected to have its first close in October). The CGP effort is indicative of a broader trend within PE of taking an already long duration investment and making it significantly longer. Here then is a brief summary of why longer duration PE investing is blossoming, including what we see as the main benefits and drawbacks.
What is longer duration Private Equity?
A bit more background on what constitutes long duration PE before we delve into the potential pros and cons for investors: longer duration private equity extends the normal 10-12 year private equity term to 15 years-plus. Whereas conventional PE targets a 3-5 year company hold, long duration PE typically targets at least an 8-10 year hold. Conventional large buyout tends to be heavily control-oriented with an emphasis on IRR, aided by high leverage. The longer duration approach emphasizes bespoke governance, staged ownership transition, lower leverage, compounding returns (with some dividend yield), smoother returns and an emphasis on multiple on invested capital. Below is a chart from Bain which recently modeled costs and returns for a theoretical long-hold fund selling an investment after 24 years, vs. a typical buyout fund selling four successive companies over that period. If the fund’s portfolio company performs in an equivalent manner during this period, by eliminating transaction fees, deferring capital gains taxation, and keeping capital fully invested, then the long-hold fund outperforms the short-duration fund by almost two times on an after-tax basis.
Source: Bain Capital
Public listings have fallen by roughly 50% in the US and in many developed markets over the past 20 years as more companies have sought to avoid stricter regulatory disclosure requirements, as displayed on the US-focused chart below.
Nearly a 75% Decline in U.S. IPOs
Source: Carlyle Group; Jay Ritter, University of Florida. 2018. Based on CRSP data
Meanwhile, according to Preqin, global private equity AUM has grown at an annualized rate of 27% over the past 20 years. The desire to stay private for longer has been particularly strong among the rapidly growing technology and services driven businesses that often are particularly reluctant to divulge sensitive information that could aide their competition.
Source: Carlyle Group; Mauboussin, Michael J., Dan Callahan, CFA, and Darius Majd. The Incredible Shrinking Universe of Stocks: The Causes and Consequences of Fewer US Equities. Report. Global Financial Strategies, Credit Suisse. March 22, 2017; PitchBook 2016 Annual U.S. PE Breakdown.
Long duration can also be a particularly good fit with many founder-led businesses focused on growth, along with other businesses that stand to benefit from compounding growth while avoiding the cost and scrutiny of a public listing. Using an example provided by Carlyle at the conference, the Tori Burch management team had discussions about joining forces with Carlyle several years ago. At the time, the Tori Burch leadership team knew they did not want an exit in the standard 3-5 years, but rather something longer than a decade. As such, with no longer duration fund in place at that time, no deal was struck.
The Carlyle Global Partners I Fund was developed largely to appeal to such companies, while also providing a potentially compelling fit with endowments, sovereign wealth funds, family offices, and others with significant long-dated liabilities. Note that other prominent PE firms that have followed a similar path as Carlyle include Blackstone, Apollo, CVC, and several others.
Key Potential Positives
- Reduced fees. Long duration funds have typically charged fees meaningfully below the standard “2 and 20”. For example, Carlyle’s stated fee is 1.5% on amounts less than 100 million, with a 15% carried interest. The breakpoints extend to a 1% fee on investments over $500 million and a 10% carry for commitments over $750 million. Carlyle’s fees only apply to capital deployed, not committed. The result is a reduction of the often formidable PE j-curve and a significant reduction in the gross-net IRR spread.
- Reduced costs. We believe, the likely reduction in churn should lead to significantly lower transaction costs and greater tax efficiency, including the deferred taxation of capital gains.
- Lower risk through lower leverage. Carlyle assumes leverage of about 4x in its Global Partners Funds versus 6x in its more conventional funds. Naturally, lower leverage tends to reduce risk, but can also reduce returns.
- Less reinvestment risk. In our opinion, the ability to extend duration should reduce the likelihood of an exit at unattractive valuations during a market or economic downturn. In that sense there is less cyclical risk. Moreover, there are more opportunities to focus on operating improvements, along the lines of a Berkshire Hathaway holding company model. We believe this advantage may be particularly important at present with equity multiples trading near historical peaks on several measures, implying that favorable exits are likely to be driven more by underlying earnings growth than multiple expansion.
- Differentiated deal flow. Many founders and owners of private companies want a longer-term partnership. Traditional private equity funds can typically only offer a 5-6 year hold. The long duration strategy opens up the potential for a sourcing channel that was historically limited to family offices, sovereign wealth funds or other “Buffett”-like investors.
Key Potential Concerns
1) Reduced liquidity. We think this drawback is quite clear when extending the already long PE cycle by perhaps 5-10 years. There is also the potential opportunity cost in that tying up money for such a long period reduces the ability to capitalize on opportunities created by market dislocations.
2) Greater key man risk. Another rather obvious risk in a world where there simply aren’t that many Cal Ripkens.
3) Reduced value-add from the PE firm? To the extent that the private equity firms have a traditional playbook that allows them to improve efficiency and profitability within a few years, it remains to be seen how effective that playbook is over the course of over a decade.
The bottom Line
While we have summarized what we view as the most salient pros and cons, this overview would be incomplete without a perspective on net returns and our sense of where longer duration funds may fit within a diversified investment portfolio. In terms of returns, the typical PE model targets approximately 18-19% gross IRR and perhaps 14-15% net IRR, with a 2x gross multiple—albeit with a fair amount of lumpiness. Most long duration funds target closer to 15% gross (again, with lower leverage) and 12-13% net with less volatility; however, long duration funds are targeting a higher multiple of capital (typically 3x gross).
Athena’s view is that longer duration funds can be a complementary strategy to traditional PE. As stated earlier, there are various risks that accompany this type of structure, most notably the reduced liquidity and greater key man risk. Additionally, one might define longer duration funds as a more passive, beta exposure-type vehicle with a stable pool of longer-term capital for the GP.
However, for investors willing to lock-up capital for greater than 15 years, the potential tax benefits, along with access to differentiated deal flow and potential for outsized compounded multiple of capital may be particularly attractive.
Any description of tax consequences set forth herein is not intended as a substitute for careful tax planning. Recipients of this material are advised to consult tax counsel for advice specifically related to any and all tax consequences of an investment made with or through Athena. The information provided herein is not intended to, nor does it specifically advise on, tax matters pertaining to federal, state, estate, local, foreign or other tax consequences of an investment. The recipient is solely responsible for all tax consequences with respect to any investment made with or through Athena.