Evergreen funds do away with term limits altogether – they aim to carry on indefinitely by recycling investment proceeds and raising additional capital on an as needed basis, either continuously or in cycles. At the other end of the scale, short-dated vehicles (with a term of between three and five years) have proven a good way for emerging managers to cater to LPs wary of locking up their capital for as long as 10 years with a relatively untested team or strategy.
The latest departure from the 10-year model is the long-life fund, which has a term of around 15 to 20 years. Several major PE firms, including Blackstone, CVC and The Carlyle Group, have closed long-life funds recently. So how do they compare to the traditional 10-year fund?
Lower charges (definitely maybe)
The GP compensates LPs for the long-life fund’s extended lock-in by charging lower management fees (1% to 1.5%) and reduced carried interest (10% to 15%).
But those are just the headline figures, and further scrutiny is merited:
- long-life funds almost by definition will charge fees over a longer period. So, in the aggregate, its advantage over a traditional fund’s overall fee burden may turn out to be slight, if not negative.
- The attraction of cheaper fees is by no means peculiar to the long-life model. In the years since the financial crisis, institutional LPs have focused strongly on trying to control the overall fee burden within the funds they invest in. It is increasingly common for GPs of traditional funds to offer fee discounts (as well as valuable co-investment privileges) to LPs who make big commitments.
There is time to say goodbye
With an investment period that is double that of a classic fund, the long-life funds are under much less pressure to deploy capital quickly while retaining the wherewithal to make big-ticket purchases. It also has the flexibility to hold portfolio companies for a lot longer than the three-to-six year holding period that is common with a 10-year fund, so it can spread its operating costs over a longer period and, if economic conditions deteriorate, wait out the cycle rather than divest into an unreceptive market. In principle, returns should become less volatile with longer holding periods.
Some industry analysts have found that longer holding periods yield improved returns. In its Global Private Equity Report 2015, Bain & Co compared the performance of PE funds and their local stock markets and found that Europe-focused PE funds only outperformed European stock market indices on average investment holding periods of five years or more; similarly, US-focused PE funds only outperformed the S&P 500 for investment holding periods of 10 years or more.
The long-life funds that have recently come to market are advertising IRRs of 15% or less, compared to the 20% that PE funds have historically aimed to deliver.
In part, this implicitly recognizes that corporate valuations are high at the moment, thanks to multinational companies piling up cash and public equity markets booming on the back of a decade of expansionary monetary policy. Booming corporate-acquisition markets help GPs to divest at high prices, but at the same time make it difficult for them to find competitively priced companies to buy, which is putting the IRR under pressure.
The other reason for the lower target IRR has to do with investment strategy. With a lot of financial firepower in its tank and time on its side, a long-life fund should be able to enter sectors that require significant up-front capital investment and generate longer-dated cash flows, and which have for those reasons therefore lain outside the focus of the traditional LBO fund – for instance, aerospace, shipping, infrastructure and pharmaceuticals. But this strategy lowers the IRR by stretching the return timeframe – in effect, the fund is willing to forgo quick pay-offs in anticipation of more substantial or stable returns further down the road.
The lower-return profile of the long-life fund model may also explain the GP’s willingness to reduce fees on the product compared to a traditional 10-year fund.
With its elongated timeframes, the long-life fund is likely to interest investors with ‘patient capital’, such as sovereign wealth funds and big pension funds with very long-term liabilities. From an LP’s perspective, committing capital to a GP’s long-life fund (perhaps alongside a commitment to the same GP’s mainstream 10-year fund and making additional co-investments alongside it) enables the LP to deepen relationships with a small panel of ‘core’ managers, which saves it the time and expense of running regular due diligence investigations on lots of managers and funds every three, five or ten years.
The long-life fund is still a relatively new concept. Given their different investment profiles, the long-life fund is unlikely to replace the traditional 10-year model as the private equity industry’s workhorse. For the moment they have tended to be marketed by big multi-asset managers, joining a suite of product lines tailored to investor preferences, which enable their sponsors to diversify and compete in new markets. It will be some years before long-life funds have established track records that can be measured against 10-year funds and public market benchmarks. LPs will need to evaluate whether the promised savings in fees do indeed materialize, and indeed whether the buy-and-hold-long-term strategy, which is not unlike the style of investing practised by the likes of Berkshire Hathaway, can be more cost-effectively pursued outside of the PE fund model.