Modeling Private Investment Cash Flows with Market-Sensitive Periodic Growth
In this paper, IAS explores a modification to the TA model in which a series of periodic growth rates are used to model distributions and valuations.
Institutional investors have increasingly allocated to illiquid private assets for the potential diversification and private asset premium benefits. Institutional private asset opportunities are today broadly available, and CIOs must decide how to allocate their marginal portfolio dollar not only between equity and credit, but also between public and private vehicles.
How can a CIO compare an investment with a higher expected return, but higher return uncertainty, with another investment with a lower expected return but lower risk? A natural way is to rank them based on their return-per-unit-of-risk. But such a comparison is difficult if the expected returns and risk for some investments are not measured reliably. This is an issue for private investments due to their illiquid nature, the absence of market prices and the confidentiality of the related performance data. We offer a framework to fairly compare private and public investment performance.
To highlight the issue, Figure 1 shows the growth of a dollar in various U.S. investments between 2005 and 2018. Figure 1 reflects linked periodic returns (e.g., quarterly IRRs for private assets and total returns for public assets). It appears buyout private equity funds were the best investment by a wide margin, followed by mezzanine credit funds. However, their strong performance is misleading on several fronts:
Our goal is to assist CIOs in their asset allocation decisions by comparing private and public investment performance on an equal-risk basis. The first step is to reliably estimate the expected returns and risk of private investments by addressing the three issues above. To do so we create a self-contained, fully replicable, private asset portfolio – a composite portfolio – wherein any uncalled and uncommitted capital is invested in a public index (a “default investment”) such as the S&P 500 index. All capital calls and distributions are financed from, and absorbed into, this default index investment. We then introduce a methodology to estimate private investment returns and risk based on the long-term performance and performance variability of the composite portfolio rather than the reported interim performance measures that underlie Figure 1. Our estimates are intuitive as they are based on terminal wealth outcomes (i.e., how much wealth you accumulated over a long period of time).
To estimate private investment risk, we use simulation to gauge the variability of terminal wealth for the composite private investment portfolio that follows a given LP fund commitment strategy (commit half of the uncommitted capital equally to five randomly-selected funds). Starting with a dollar invested in vintage 2005 funds we follow the strategy, investing subsequently in five funds from new vintages, for 14 years until 2018 when we measure the total terminal wealth of the portfolio. From this terminal wealth distribution, we compute the mean and volatility of periodic returns which we can more reliably compare with those for public investments.
Next, to perform a fair comparison, we lever returns so that all investments have similar risk to that of buyout funds. Figure 2 shows that the return-per-unit-of-risk (i.e., mean/vol ratio) are quite different from those based on traditional private asset return metrics. We find that levered investment in mezzanine is very competitive with buyout. The S&P 500 and 10y+ Baa x-Financial Corporate Index total returns, when levered, are also comparable to private markets.