Cracking the Illiquidity Code

Once private equity investors sign a fund commitment, they begin a 10- to 15-year relationship with the GP. With time horizons this long, it’s no wonder the asset class attracts life insurers and pension funds; it’s also clear why many perceive private equity to be a waiting game. That shorter-term investors also invest in private equity, however, indicates the asset class is not as illiquid as the long fund life would suggest. To quantify the liquidity of these investments, we look at the duration of private equity cash flows and crunch the numbers from different angles using our proprietary data from SPI and SPAR.

The Toolbox

The tool we use to get a handle on the liquidity of private equity investments is duration. Why do we need something in addition to the hold period? The timing of the last distribution can be very different from when, on average, distributions were paid. Some funds have small residual net asset value distributed in year 15, but 99% of the distributions were paid out by year 9. Similarly, there can be a large difference between when contributions were paid, on average, and the close of the fund. A buyout fund typically has an investment period of five or six years. In vintages where deals are hard to come by in early years, most of the contributions may occur late in the investment period.

Duration allows us to idealize the cash flows of a fund as an investment with two cash flows: one contribution, and one distribution. Duration comes in two flavors, based on available data:

• Cash flow duration, requiring all contributions and distributions; and
• Performance duration, requiring the internal rate of return (IRR) and the total value multiple (TVM).We take a closer look at these measures next to see what they mean and when to use them.

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