Private equity is an inherently long-term play, though that longevity has been chipped away over recent years. The median hold in the US ticked down once again in 2019 and now clocks in at 4.9 years, continuing a trend that began in 2014. At that time the average holding was 6.2 years, according to data from Pitchbook’s US PE Breakdown report. The M&A boom of the past five years has provided funds with ample opportunities to exit their deals, compressing hold times.
This trend has been driven by top-quartile holding periods (that is, top quartile by duration, not performance), which were down to 7.1 years in 2019 from almost nine years as recently as 2016, but other quartiles have also shown falls.
This has interesting implications for the secondary market. One of the characteristics that make secondaries so attractive is their relatively short duration and unique returns profile, making them a complementary element of a diversified PE portfolio.
First, consider an LP investing on a primary basis. In the early years of their investment the fund will draw capital and charge management fees long before any realizations are made. This is the J-curve that temporarily eats into investor profits, the internal rate of return (IRR) turning negative before positive.
For the secondary investor acquiring a fund interest at a later stage of its life, this front-loading of fees and the wait while value is created at the portfolio level are mitigated. The J-curve is flattened or even avoided altogether. Squashing the time horizon in this way inflates the IRR of secondaries, although they typically deliver lower Total-Value-to-Paid-in (TVPI) ratios. In other words, investors usually see lower capital gains from secondaries than primary investments, but get their money back much sooner and therefore make better annualized, time-weighted returns.
The downtrend in medium-term holding period of the past five years suggests that this effect will, to some extent, have magnified. GPs returning cash more quickly indicates that the IRR returns of secondaries should be lifted, assuming of course that fund managers have not been selling companies early at the expense of TVPIs.
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However, we could well be at an inflection point, after which holds begin to stretch back out again. Panic selling in the stock market as coronavirus cases escalated has triggered central bank rate cuts, and economic forecasts for the year ahead are at their gloomiest since the global financial crisis. The Economist Intelligence Unit has shaved a full 20% off its outlook for 2020, from GDP growth of 2.2% down to 1.8%. We are not in the meltdown territory of 2008 just yet, but that could change given current historic levels of debt and rising systemic default risk.
As we saw in the last downturn, PE holding times began to rise in 2010, slightly lagging the start of the crisis. Assets acquired at the top of the cycle had to be held through a more challenging period as it took longer to build value in portfolio companies and exits were harder to pull off. Indeed, the very fact that holds fell once again in 2019 suggests that GPs have not been willing to cling to companies for any longer than is necessary, a good indicator that they have believed the market was due a reversal—or a correction at the very least. The question on investors’ minds now is whether we are witnessing a correction or the beginnings of something more enduring.
There are other, more structural reasons that PE holds are likely to rise—and possibly for good. While still a niche, long-dated funds are becoming more common as an alternative strategy for long-term value creation.
