As I write about interpreting and predicting private markets’ returns, for the readers who missed one of my previous posts, I confirm there is no misspelling in the headline, it’s an S.
I am suggesting that the J-Curve now deserves a quiet obsolescence, after having accompanied the private markets industry through the long initial part of its life-cycle. The increased complexity and interconnection of the financial markets pose new challenges to investors and stakeholders (among those, in particular, regulators). New and more adequate tools are required to meet those challenges. The S-Curve evolves the J-Curve concept by introducing decreasing marginal returns to better reflect the self-liquidating nature of private markets transactions (and many other phenomena).
What in fact J-Curves, in their various versions (cash, IRR, etc.), do not properly reflect is the relevance of time vis-à-vis cash flows. The financial cost of waiting is what makes the distributions furthest in time progressively less relevant, causing returns to marginally decrease. Without a sigmoid correction, the J-Curve instills the perception (that actually could not be truly challenged during the 20-year long benign private markets environment before the recent crisis) that “patient investing” will lead to more money / higher returns. It also implicitly suggests that IRR reinvestment rates truly exist, which is instead not the case.
Deriving the S-Curve requires the adoption of a duration-based (thus time-weighted) performance calculation approach. Duration marks where J turns into S – and allows the interpretative and predictive shift that improves the pricing and risk management perspective in the private markets.
A couple of recent articles testify how increasingly academia is devoting resources to studying and understanding the dynamics and the drivers of the returns in the private markets.
- The more recent article, based on an academic paper titled “Estimating Private Equity Returns from Limited Partner Cash Flows“, sheds new light on the volatility of the private markets.The implications of the article that suggests that perceived volatility reduces pension funds appetite for the private markets seems in contrasts with the conclusions of a different study that finds that pension funds are increasing their exposure at a faster rate than other investors, even if they come from a lower allocation level.
- The earlier article describes the findings of another academic paper, titled “Private Equity’s Diversification Illusion: Economic Co-movement and Fair Value Reporting“, that show that private equity funds that adopted re-defined fair value accounting reported returns with increased market beta and correlations.
In spite of an academic post-crisis tendency to be more emphatic on the negatives of their findings, the papers deliver very positive elements to put the private markets in the correct perspective for simpler understanding (and accidentally provide additional independent validation to our S-Curve and time weighted approach).
- Both articles implicitly affirm the importance for risk and return to be valued in the context of all other asset classes, making relative value (and therefore time-weighting) the basis of the analyses.
Investors want to better understand how their private markets allocations fare versus all other asset classes and what they can expect forward-looking with regards to both risk and return.
- Both articles qualify and quantify the relationship of private markets’ fund cash flows to the listed markets, identifying significant correlation and related volatility (economically justified and expected but hidden behind the current obsolete and inadequate performance measurement standards).
As strong correlations exist, so does Private Capital Beta. The S-Curve approach, differently from the benchmarking academic methodologies referenced in the papers, is built on a layer of realistic constraints to produce practical and actionable results:
- Not being tied to the “chained” index series logic that instead both papers utilize, an S-Curve does not require any unrealistic assumption on the re-investment of cash-flows between different funds, by definition known only ex-post.
The returns of S-Curves can be replicated in concretely investable financial instruments and recorded daily.
- The duration-based framework of the model allows gauging the reliability of NAV fair valuation practices “in real-time”. Therefore, there is not need to do without NAVs to eliminate fair valuation noise – as one of the papers theorizes, at the cost of not knowing the returns of a fund for years.
S-Curves allow estimating statistically expected NAVs on a daily basis and probabilistic adjustedments on actual NAVs as reported. I argue that transparency has a lot more to do with the ability of anticipating possible return patterns (and thereby risk) than with the ability of seeing through the portfolios. There is just a bunch of S-Curves to ride….