Give £100m (€146.4m) to a private equity manager and ask him to invest it for you. It takes maybe a year for him to invest your cash in a business that suits his firm's criteria.
After, say, five years, the manager ‘exits' the investment by selling your interest in the business for £300m. The internal rate of return over the six years will have been around 20% before charges and the manager's take, or ‘carry'.
Now imagine that the manager invested your cash on day one. The investment is still ‘exited' five years later but the period your capital has been at work has been five years rather than six. The internal rate of return comes out nearer a gross 25% per annum - an improvement of some 5% per annum. That 5% differential is a measure of ‘cash drag', the uninvested portion of the portfolio which hampers performance in rising markets.
Over the years, the private equity industry has evolved ways of dealing with cash drag. In a limited partnership, investors are responsible for supplying the cash and reinvesting distributions at a time of the managers' choosing.
Private equity investment trusts (PEITs) remove much of the need for the end-investor to administer cash calls and distributions - shareholders in PEITs rarely receive distributions as few PEITS make dividend payments and few PEITs announce calls or rights issues to fund new investment. Most operate as closed funds with an indefinitely recycled pool of dedicated capital.
If PEIT investors wish to liquidate their interest they sell their shares; the capital within a PEIT is unaffected by turnover in its shares. PEIT boards decide on the appropriate management of capital on behalf of shareholders.
There are several ways in which PEITs can manage their capital, combining the managers' and directors' views of market opportunities.
If a board takes an optimistic view of the opportunities in the private equity market it might commit capital to the extent that the PEIT may use its borrowing capacity. Alternatively, the board might decide to expand the PEIT's share capital through a rights issue. Another board might be
sceptical about current opportunities and the PEIT might, consequently, accumulate substantial cash.
A third board might determine that shareholders' capital should be deployed via equity index futures rather than left in cash. A fourth might reinvest the cash in gilts. A fifth might decide to use its power to diversify the PEIT by appointing another private equity manager specialising in a different segment of private equity.
Decisions about the management of shareholders' capital will affect returns to PEIT shareholders. A cautious view, leading to large amounts of capital on deposit earning risk-free rates of return, could add significant value if market conditions turn out to be poor. Some 18 month on, the board may be able
to authorise a number of investments.
Uninvested cash, usually termed cash drag, is an inherent issue for PEITs because they are ‘evergreen' (permanent capital). Managers and boards will be keenly aware of the level of cash and actively weighing its potential uses. Burgeoning levels of cash may be even more a problem for the few ‘self-managed PEITs (the PEIT owns the private equity manager), as they are accumulating fee income in addition to realisations from investments.
Holding high levels of cash in the portfolio has been a long-standing feature of most PEITs and the impressive long-term returns do include cash drag, which has sometimes been significant. Cash held by proven managers at the right time of the cycle can purchase holdings in assets with long-term potential at good prices. While some shareholders may wish to encourage PEIT boards to return cash to shareholders, others will worry that this may contribute to illiquidity in that it shrinks the size of the PEIT.
A PEIT board is responsible to shareholders for the total return on their funds and does not have the luxury of citing internal rates of return on individual investments.
Cash does not always have to be a ‘drag' on the returns of a pool of capital dedicated to private equity investing; in some circumstances, it can actually enhance returns. One great advantage of the PEIT structure is that investors are able to delegate the potentially troublesome decisions required in the management of cash flows.
Andrea Lowe is the principal at iPEIT