CFA Lecture

Non-Timed Investing – Lessons from Private Equity for investing in Stocks

One of the key challenges for the asset class private equity (PE) is that it does not have the luxury of being able to time the market. Private equity firms operate with so called draw-down structures. Liquidity resides with LPs and is only called into the fund once a new investment opportunity has been identified. They typically have an investment period of 3-5 years. After the investment period, the management fee usually drops from being calculated on “committed capital” to “drawn” (or “called”) capital. Thus, PE firms are incentivized to allocate as much capital as possible within the investment period. If one segments market phases into “high-expected return environments” (inflated multiples / lower growth perspectives) and “low-expected return environments” (compressed multiples / higher growth perspectives), those investment periods will necessarily fall into phases of “low-expected return environments”. Hurdle rates (6-8%) and target returns (12-18%) for private equity funds do not adapt to this. Hence, PE must seek to generate returns independent of the expected return environment. As a solution, PE has over time developed mechanisms and investment patterns to achieve this goal. These methods can be employed irrespective of the expected return environment and notably also independent of asset class: private or public equity. This lecture gives an introduction into this investment approach by outlining the theoretical concepts and illustrating them with real world examples.