Possibilities of vintage funds.
Diversification is often held as a basic tenet of investing. Investors can seek to diversify across asset classes, allocating different amounts to bonds and equities depending on their appetite for risk. Investors can also seek to diversify across fund managers, ensuring they do not place their bets on the talents of a single individual. What is often overlooked, however, is the potential ability to diversify across time – something that can be made possible through vintage funds.
One year, many investments.
According to Mercer, a private equity vintage fund is one which makes allocations to a range of private equity investments within a single calendar year. The returns generated in each vintage year are similar to how one would label a bottle of wine, and generally reflect the underlying macroeconomic backdrop of that year. Remember that the quality of a bottle of wine is highly determined by the growing conditions in the year of harvest; similarly, the stage of the market cycle into which capital is committed from a vintage fund highly determines the performance outcome that is ultimately realized.
A private equity vintage fund can invest either directly into companies, or it may be a ‘fund-of-fund’ – that is, it pools capital to invest in other funds which themselves hold direct investments into companies.
The stage of the market cycle into which capital is committed from a vintage fund highly determines the performance outcome that is ultimately realized.
Past performance and today’s decision-making.
According to Mercer, investors may commit capital into a vintage fund once a year, or they may make fewer and larger commitments every other year. With markets plunging in excess of 30% in the wake of the coronavirus pandemic, the natural instincts of many would point to ‘buying the dip’ through a 2020 Vintage. Past performance suggests that doing so can maximize gains: The median return of 2006 Vintages – which invested in the bubble that lead to the 2008 Global Financial Crisis (GFC) – was 8.1%. Compare this to the median return of 2009 Vintages – which invested in deeply-discounted assets in the aftermath of the GFC – at 13.9%1.
On the other hand, there is a case for spreading out investments across a number of different vintages. Firstly, it is difficult to call out the bottom of the market with any certainty. Psychologically, it is also challenging to go in when others are going out. This would explain why between 2007 and 2009 new private equity acquisitions fell almost 80%, from a peak of nearly US $800 Billion to just US $170 Billion2. Secondly, what is sometimes perceived to be the dip can turn out to be false alarms, or so-called ‘flash crashes.’ For instance, global growth contracted in 2012 and 2015, only for it to rebound the year after to extend the expansion3.
Regardless of whether investors choose to allocate to a single vintage year – or create a vintage fund program that allocates over time – they should be reassured in knowing that vintage fund-of-funds are multi-dimensional and have built-in diversifications at the manager and strategy level4.
A vintage fund-of-fund invests in vehicles managed by many different underlying fund managers. While there is a strong correlation between the current and historical performance of managers (superscript 5), manager diversification helps to dampen the impact of any one manager’s performance. Importantly, said fund managers would each deploy a different strategy – opportunistic, buyout, growth equity, middle market buyout, and secondaries, to name a few. As the investment period for private equity is longer, different strategies may be in favor. Strategy diversification seeks to ensure an optimized exposure that will capitalize on the shifting opportunities over time.
These multi-dimensional layers of diversification – at the year, manager, and strategy level – aim to serve as a safety net when the unexpected happens. We saw this in pre-2008 Vintages, which were largely assumed to be the poorest performers across the board given the fact that they were deploying capital at the height of the market. However, there were wide dispersions in returns, with some quality fund managers having market cycle-appropriate strategies still able to generate attractive investment returns6.