Investors in private equity often wait for their capital to be repaid before investing in another fund. Whilst this may sound like prudent risk management, it can result in significant losses in returns over the long term. This is because, whilst capital from older funds is returned, it may remain uninvested for years if it is not reinvested in good time. Two analyses by Altaroc illustrate just how costly this wait can be.
In it, Louis Flamand, Chief Investment Officer of the European private equity specialist, examines the economic benefits of regular fund redemptions based on the so-called ‘re-up’ principle and quantifies the implications of different reinvestment strategies over a 20-year period.
The key findings:
• 46 per cent less capital growth simply by waiting: In the model calculation, the capital multiplier falls from 6.15x – assuming continuous annual fund subscriptions – to 3.80x if investors only reinvest once their capital has been fully repaid. The underlying fund quality is identical in both scenarios. The difference arises solely from the temporary failure to reinvest distributions.
• Up to 69 per cent lower value creation in the extended feeder scenario: If funds from the second performance quartile and a greater weighting of unfavourable investment years are also assumed, the modelled capital multiplier falls to 2.61x. Compared with the continuous re-up strategy, this corresponds to a reduction in capital growth of around 69 per cent. The result illustrates how reinvestment behaviour, entry timing and manager selection can reinforce one another.
• Distributions can finance new capital calls: Under the ‘re-up’ principle, returns from older fund generations are used to finance new subscriptions. In Altaroc’s target cash flow scenario, distributions cover ongoing capital calls from the seventh year onwards. This can significantly reduce the additional equity requirement. However, this is conditional upon the assumed returns actually materialising.
• Significantly broader diversification across funds and market phases: Whilst, in the scenarios examined, the wait-and-see investor makes only four fund subscriptions over a 20-year period – thereby gaining exposure to around 40 to 80 portfolio companies – a continuous re-up programme based on Altaroc’s model enables diversification across 50 to 70 funds and more than 1,500 companies. In addition to the larger number of investments, the exposure is spread across different investment years.
The analyses also highlight the significance of the fee structure for the actual utilisation of capital. In the case of traditional feeder vehicles in particular, fee provisions set aside in advance can result in a smaller proportion of investor commitments being invested initially.
The results are based on model calculations using defined assumptions regarding fund returns, capital calls, distributions and reinvestment. They do not constitute a forecast of returns that can actually be achieved. Both publications reflect the perspective of Altaroc as a provider of such private equity programmes.
You can download the two related analyses – the background paper on the ‘re-up’ principle and the in-depth study of the costs of inaction – here.
