Private Equity: Is Timing Everything?

mar. 02, 2020

Timing in life is everything. Yet counterintuitive to some popular beliefs, timing exposure to private equity only yields “modest gains at best,” according to new research forthcoming in the Journal of Financial Economics by David Robinson*, the James and Gail Vander Weide Professor of Finance Fuqua School of Business at Duke University’s Fuqua School of Business and co-authors.

Instead, investors should maintain a fixed allocation strategy, and resist the temptation to increase allocations to private equity when fundraising activity is high.

The findings seem to resonate well with the investor community and reintroduce the ever pertinent debate on portfolio construction and manager selection. Meaning that choosing the right manager, at the right time could, in fact, indicate that timing is everything.

 

Cyclicality in Private Equity Performance

In today’s world, timing commitment strategies are somewhat present on everyone’s radar. After the financial crisis, investors began to devote significant

resources into modelling expected cash flow when allocating capital to private equity. As a result, thinking about dynamic allocation strategies became a natural bi-product.

Historically, private equity performance, both for buyouts and venture capital, has been highly cyclical: periods of high fundraising have been followed by periods of low performance. So, if investors already know that, why don’t they do something about it?

At a first glance, it appears fairly straightforward to time exposure to private equity. However, David Robinson, also an Erling Persson, Visiting Professor at Stockholm School of Economics shows that it is extremely hard. His new research paper “Can Investors Time Their Exposure to Private Equity” shows that there are few realistic investable strategies to time allocation, both for buyouts and venture capital.

 

Why Are Timing Strategies Not A Winning Concept?

Timing exposure to private equity does not appear to be a ‘recipe for success’. But, why? The explanation to this question can partly be found by looking at commitment risk, and in part by considering market opportunities. Investors pledge capital but do not control when it is deployed or returned. Hence, investors can only time their commitments to funds; they cannot time when capital gets put to work. Making any limited partner’s (LP) timing strategy hard to realise in practice. When considering market opportunities, actual entry and exit decisions depend on the market conditions. Capital is allocated to a general partner (GP) who observes market opportunities, and acts on them. Hence, due to the influence of market opportunities, it can be observed that the GP’s decisions on capital calls and distributions ‘undo’ much of a limited partner (LP) attempts to time the market.

Therefore, according to the Professor's advice, LP’s should not time their exposure to private equity. Instead, they should maintain a constant presence, with a low relative exposure in strong markets. A strategy that unquestionably introduces challenges in itself: “A fixed allocation strategy requires investors to have counter-cyclical weights to private equity relative to the other elements in your portfolio and maintain roughly constant weights in different asset classes over time”.

 

What Do Investors Say?

From an academic standpoint, few gains can be made from timing the exposure to private equity. But, how do practitioners translate these insights? In a panel discussion at the Swedish House of Finance, Natalia Fontecha from StepStone Group, Roger Johanson from Carneo, Christina Brinck from AP6, and Bengt Hellström from AP3, shared their views. Centered upon manager selection and balanced portfolios. According to Christina Brinck: “Being

successful is a lot about fund selection and really trying to find the best manager in the segment.” And Natalia Fontecha elaborated that: “A lot of gains can be made in performance if you build your portfolio in a balanced and diversified way.”

These were perceived as key determinants of success in the contemporary arena, compared to impractical timing strategies. Or as Roger Johanson remarked: “I love academic papers because they show practitioners that you have to find your own way of working with the world.”

 

Manager Selection: The Real Timing Issue for Investors?

Why is manager selection of such importance? In private equity, the dispersion between top quartile and lower quartile performance is greater than in public equity. This makes it critical to choose a manager that will not rush into deploying capital even if the timing is not right. Natalia Fontecha underscored this point, adding that: “The data showing in a downturn market, the number of bad deals increase, there are also good deals that are to be found in a difficult market environment. (...) It all boils down to manager selection.” This reemphasizes the point with commitment risk, where Bengt Hellström seemed to capture the essence of manager selection in timing issues: “The most important thing is to choose the right GP that does the timing for you.”

Further, investing in manager selection is a matter of creating long term stability. Provided that, it is essential to make the right selection and stick with the managers for some vintages, as Roger Johanson mentioned.

Based on the insights, could it be that manager selection introduces far more complex timing issues? Presenting challenges that are perhaps less tangible than the cyclicality of private equity performance? Indeed, Christina Brinck’s concluding remarks raised a new timing issue: “The real timing question for us is actually: when to start investing in a manager and when to stop investing in a manager?” It certainly provides food for thought. And could, in fact, mean that timing is everything.