Vintages and vintage diversification

29 March 2023

What are vintages?

In Private Markets investing, the vintage year refers to the year in which the first investment is made into a fund. A successful private markets strategy will often have multiple vintages, which are commonly named according to a chronological order or by their vintage year. For example, ‘XYZ Strategy 2’ or ‘XYZ Strategy 2022’, indicate that the fund is the second vintage of the strategy or the vintage beginning in 2022, respectively.

Private Market closed end funds tend to follow a multistage lifecycle comprising a few key phases. These include capital raising, the investment or deployment stage, managing the portfolio and then lastly exiting the investments and distributing capital. Figure 1 below displays example timelines of different close ended vintages.

Figure 1: Illustration of different vintage year funds

Chart is for illustrative purposes only. Assumes 1.5 year ‘Raising’ period, 3 year ‘Deploying’ period, 6 year ‘Managing’ period, 2 year ‘Exiting period.

Why is it important to diversify across vintages?

When producing a well-diversified portfolio, investors often consider a range of factors such as asset class, geography, sector, and strategy. A well-rounded approach to private markets investing also requires investors to consider how they approach allocating to different vintages. These allocations can have consequences for the cashflows of the portfolio, the returns experienced and exposure to risk. One concept which investors should be aware of is the J-Curve.

The J-Curve

The J-Curve is a phenomenon unique to private markets investments, which characterises the pattern that cashflows and the Internal Rate of Return (IRR) for a private market close ended fund tend to follow over the life of a fund. See Figure 2 as an illustrative example only.

Generally, in a private markets close-end fund, there are initially high outflows of capital as investments are made and funds are deployed. The IRR can be low and potentially negative during these early stages of a fund while capital is being deployed.

This may then be followed by a period of increasing inflows of cash as distributions are received from the underlying investments, while the investment manager is managing the investments and implementing their investment strategy.

Finally, as investments are realised (or exited), capital will be distributed back to investors. It is expected that in the later stages of the fund’s life, IRR will be higher as the investment strategy, if it is successful, has been able to fully play out.

By diversifying across vintages, investors may be able to space out their capital call requirements more effectively, as well as potentially achieve a steadier return and distribution profile.

Timing the market

Similar to investors in public markets, private market investors should be conscious of the implications of when they choose to invest into the market. Investing into certain vintages and not others, is comparable to public market investors deciding to invest in the market at certain periods of time and not at others. This active decision, which seeks to capitalise on market cycles, can be referred to as ‘timing the market’.

By investing into a specific vintage, investors will be subject to the relative ‘expensiveness’ or ‘cheapness’ of private market assets during both the investing and divesting stages. This can work in the investor’s favour if they are deploying capital when the market is relatively ‘cheap’ and exiting when the market is relatively ‘expensive’. However, the opposite can equally occur. With established timelines for private markets funds to deploy capital and realise investments, this may expose investors to an additional risk that is outside their control.

Figure 3 displays the Median Net IRR by vintage year for all available private capital funds reported in the Preqin Database. This includes strategies across private equity, venture capital, real estate, infrastructure and more. The year to year, and cyclical variations display the variation in returns experienced depending on when investors decide to commit capital.

Figure 3: Private Capital Median Net IRR by vintage year (1980 - 2018)

Source: Preqin Database. Median IRR is based on all available ‘Private Capital’ funds, as defined by Preqin for each vintage year. 1980 - 2018 represents all available data. Net IRR based on most up to date values. Benchmark 12% IRR is included for illustrative purposes only, the individual Private Capital strategies within the Preqin Database possess varying return targets. Returns quoted in USD.

Methods for vintage diversification

An investor’s ability to manage their private markets allocations is dependent on their scale and internal constraints. Two main avenues for managing vintage diversification exist, outlined below.

1. In-house vintage diversification
For large institutional investors, a disciplined long term investment program involving deploying capital across numerous different closed ended funds diversified by vintage can be adopted. This approach requires sufficient expertise and resources to support the ongoing management of the investor’s overall private markets investments portfolio.

2. Outsourced vintage diversification
Alternatively, investors may outsource the management of their private markets investments, including the diversification of those investments. This can be achieved by investing in a fund of funds or by setting up separately managed accounts with an investment manager, where the fund of funds or separately managed account invests into a number of different funds across prior, current and coming years.