Private Funds usually have a defined lifespan, often around 10 years, although this can vary. Some funds may seek extensions if more time is needed to maximize returns. Many people ask why it is such a long time. Let us explain how private funds operate and create value first.

Here’s how private funds works. They normally go through 3 phases (Investment, Harvest, Wind-Down). During each phase, the focus varies, as well as strategy and execution.  However, they all serve the overall fund strategy, and aim to build a fit-for-purpose portfolio and maximize the return.

1. Investment Period: typically lasts 3 to 5 years. During this time, the General Partner (GP) identifies, evaluates, and actively looks for investment opportunities to deploy capital into portfolio companies. The portfolio built during this stage will decide the fund’s overall success.  During this period, the distribution normally starts low.  As each investment moves through the life cycle,  it will then gradually grow to reach or even pass the preferred return. Similar to what is called J curve – we will have article to introduce this concept in the future.

The General Partner (GP) sources potential investments that align with the fund’s strategy. This can include the type of business, risk levels, leverage to be used, concentration, etc. Use an real estate company as the example, GP needs to consider if it’s a multi-family home, or retail, manufactured home, or others; GP also needs to evaluate how much risk are involved (risk for a pure development is higher than value-add, which is higher than a stable rental); higher leverage also mean higher risks (of course for the purpose of higher return).  In a nutshell, GP needs to balance the overall risks and potential returns, in order to get the best risk-adjusted return for the fund as a whole.

1. Harvest Period: This phase often lasts around 4 to 6 years. During the harvest period, the GP creates value and achieves high returns on investment for the Limited Partners (LPs). This involves leveraging the GP’s expertise, network, and resources to optimize the performance of the portfolio companies. Upon maximizing the value of investments, GP plans and executes exit strategies for the portfolio companies. This could involve preparing the companies for sale, taking them public through an Initial Public Offering (IPO), or finding strategic buyers.

To be noted , the portfolio companies in the fund were acquired during a 3–5-year time span, so the exit will happen gradually as well. This means upon each exit, investors will receive the regular distribution, plus the return of capital (ROC) and the profit from the exits. So, this is the stage where investors can expect much higher distributions. And often investors will be able to get all their invested capital returned by year 6 or so.

1. Wind-Down Phase: This final phase typically spans 1 to 2 years. After the majority of exits have been made, the focus is on finalizing the remaining investments, distributing returns to the investors (Limited Partners), and ultimately closing the funds.  By this time, investors will be able to get all their capital plus profit back. The fund calculates the final gross and net IRR to investors.

So back to your question at the beginning, and I hope you have reached the answer too – The reason for long term investment is because the fund manager needs a reasonable time to gradually invest into different deals and operate them to reach their highest return. However, the pure purpose is to largely reduce the risks, smooth market volatility,  and maximize the portfolio return.

Imagine a real estate fund targeting for 5 years was formed in 2020, its investment period would fall around 2021-2023. wind-down and exit around 2024/2025.  This fund would happen to invest during the market high (both price and interest rate), then sell and exit into an adverse market condition. Do you think the IRR will be good?  

If I use the analogy of stock investment, the fund’s long-term strategy is similar to the cost average investing and portfolio investment in stocks.