Are Longer Holding Periods The Wave Of The Future In Private Equity? by Hugh MacArthur, Graham Elton, Daniel Haas, Suvir Varma and Mike McKay

Apr 02, 2018

 Private equity firms that specialize in buyouts have long been characterized by their three- to five-year holding periods. The expectation on the part of both PE funds and their investors is that the sponsor will aim to acquire companies and sell them profitably within five years, a schedule that then defines the plan to create new value.

But that relatively short duration has some drawbacks. It generates recurring costs for the funds and the limited partners (LPs) that invest in them, as well as recurring hunts for new assets by general partners (GPs). That may explain why a growing number of investors are putting some of their money in longer-term investment vehicles. Such patience, it turns out, presents an opportunity to generate higher returns on committed capital over the long haul, a Bain & Company analysis shows.

As discussed in Bain’s recently released Global Private Equity Report 2018, several large PE firms, including CVC Capital Partners, The Carlyle Group and Blackstone, have been launching buyout funds with longer lives. Blackstone raised $5 billion for a fund with expected holding periods roughly double those of the traditional buyout fund. Two first-time funds, Core Equity and Cove Hill, also raised more than $1 billion each in short order, with anticipated holding periods of up to 15 years.

Two main types of long-hold funds have come to market. “Core” buyout funds target portfolio companies with lower risk and lower return. CVC’s Strategic Opportunities fund, for instance, has a 15-year life span and targets an internal rate of return of 12% to 14% while charging lower fees. The second type is a long-hold buyout fund. It targets risk/return profiles, as well as fees, in line with traditional buyout funds. For this type of fund, investors don’t need to sacrifice a measure of returns in exchange for longer duration.

Both fund types offer several advantages:

Lower transaction costs, such as taxes and consultant fees, associated with buying and selling businesses
Fewer distractions for portfolio company management
Fully invested capital over longer periods and with less time waiting to be reinvested
Deferred taxation of capital gains, allowing capital to compound over time
More flexibility on the investment horizon, allowing funds to sell an asset at the optimal time
Access to companies looking for patient capital, such as founder-led businesses focused on growth
To compare long-hold performance against that of a traditional buyout fund, Bain recently modeled costs and returns for both. A theoretical long-hold fund sold its investment after 24 years, while the buyout fund sold four successive companies over that period. The model assumed that the portfolio companies performed similarly, but the long-hold fund eliminated transaction fees, deferred capital gains taxation and kept capital fully invested. Under that scenario, the long-hold fund outperformed the short-duration fund by almost two times on an after-tax basis.

Bain & Company
What should investors look out for? Holding assets over a long period requires a clear view of the duration risk that exists in most industries. Technology, regulations and competitive threats can change quickly. Re-diligence of portfolio companies on a regular basis, perhaps every three to four years, provides an updated understanding of industry dynamics and the competitive positioning of the asset. If the duration risk gets too high, pull the rip cord and sell. If the answer is to hold, then adjust the plan in order to keep creating value.

Another long-hold model outside the traditional PE sphere is also gaining traction—professionally managed private capital holding companies. The Cranemere Group, a London-based private holding company founded by a former CEO of AEA Investors, is a good example. Cranemere’s primary investors include family offices and sovereign wealth funds, which seek strong returns on their capital, not short-term distributions. They become shareholders, not LPs, in the holding company alongside most of Cranemere’s management team and board of directors. Investors are offered annual opportunities to sell, but having a permanent capital base means assets can be held indefinitely, with no need or incentive to exit an investment before it makes sense. It also leads to tax efficiency, as Cranemere is not required to distribute capital back to investors. Cash generated by a portfolio company goes first to the Cranemere holding company, not to shareholders, so there is no capital gains tax and the capital can be reinvested.

Given that long-hold funds have just started to emerge in the marketplace, it’s too soon to say how much capital they will ultimately attract. But for institutional investors (especially taxable investors) with long investment horizons, steering some capital to long-hold funds makes sense. Building longer-term strategies that incorporate M&A can help GPs compete more effectively for assets against corporate buyers. Indeed, GPs spend most of their waking hours either raising funds or buying and selling assets. Having the flexibility of more years to hold and nurture great assets could be a welcome change.