The idea that investors might prefer to wait longer to see returns may seem counterintuitive, but a recent report indicates that more than 50% of LPs see the potential value in having the option of a longer life fund. And it looks like private equity firms are picking up on the hint. The lifespan of the median fund rose from 11.5 years in 2008 to 13.2 years in 2014, according to Palico.
Some funds can now last anywhere from 10-20 years and investors can expect GPs to assume a more operational role, focusing on company growth over the very long term. They can also expect lower annual returns as profits are spread out over more years, extended periods of illiquidity, paying fees for longer, and the challenge of making sure the deal teams are goal-oriented. So where’s the upside?
The investment style of many of these funds can mimic how more permanent forms of capital, such as family offices, might invest. A longer life fund might be an option for investors wanting access to companies who don’t meet required return rates for the main fund but have the potential for impressive growth.
With many funds failing to produce the knock-out returns that once defined private equity, expectations from LPs are shifting and firms are adjusting. Even large private equity powerhouses such as Carlyle and Blackstone have introduced funds with longer lives, lower fees, and a mandate to consider such investments as minority stakes, family businesses and lower middle market and middle market companies.
Holding periods reach their peak
Since 2008, the average holding period for private equity portfolio companies has been on the rise. Pre-crisis, most private equity firms kept companies in their portfolios for about 3-4 years and this has been trending up in the years since.
Part of today’s dynamic M&A environment is a result of portfolio companies finally being exited from the last cycle. Many of these companies were held long past initial expectations as investors waited out an uncertain market. “Holding periods have gotten longer due to the financial crisis in 2008 and the continued softness in the US and global economy,” says Axial Member George Stelling of Quadrillion Partners.
The latest data, however, does show the lowest average holding period since 2012 (5.5 years) so we may see this trend reverse. “In the last 18 months, many exits have occurred as demand has revived, interest rates remain low, and valuations have gone up,” said Stelling.
Buy and build will shape the future
It’s not yet certain whether longer life funds will be a mainstay of the PE firm of the future. But Ernst & Young’s most recent market update indicates a longer term investment strategy is likely a necessary response to the changing industry.
We’ve written about specialization as one response private equity has had to a crowding of the market, and it appears that pursuing a buy and build strategy with their portfolio companies is another trend coming into favor. Financial sponsors are increasingly growing their companies through both organic and inorganic means. As such, we’ve seen financial buyers act a bit more like their strategic counterparts – pursuing partnerships and geographic expansion as well as seeking out add-on acquisitions over the life of the investment. As firms begin to focus on adding value through operational means, financial engineering strategies are becoming a tool of the past. While the end product is often a built-out enterprise that commands a high return, taking a more hands-on approach is time consuming.
Stelling discussed how the operational strategy used by private equity firms spells longer holding periods, particularly in the middle market. “Companies that require more operational improvements and implementation of various growth strategies will be held longer, since it takes time to implement and engrain changes in businesses. Middle market companies may take longer still, since they typically do not have the same level of resources that larger firms do.”
All of this said, it’s unlikely that the lengthening we’ve seen in the private equity cycle of late is a runaway train. The strong exit opportunities that exist for companies right now in a market flush with buyers, and the combination of low rates and easy debt are all factors that should prevent any continued movement. Call it another new normal — longer life funds are just something investors will need to get accustomed to and GPs will need to get competitive with.