Finance, Industry Insights

The Power of Long-term Holds

Photo of a smaller tree beside a larger tree, symbolically representing long term vs short term investment timelines.

We have mentioned that long-term investments generate superior returns, but just how much higher are these returns? This is what we wanted to find out, so we created a simple model which shows that long-term investment returns are significantly higher when compared to a standard private equity hold. 

Read on to understand our methodology.

The Assumptions

First we had to set timelines for both the long-term hold and the standard hold periods. We set the true long-term hold timeline at 25 years and the standard hold at 5 years. Investors would pay a federal capital gains tax of 20% at the exit. We also set the state capital gains tax at 6%, although current state capital gains tax rates vary from 0 to 14.4%. 

For the traditional exit strategy, we set a timeline of 5 years per investment. While hold periods can vary, this is a pretty typical private equity investment horizon. For the shorter hold period, the investor has the same capital gains tax rates as for the longer period. To make the hold periods most comparable, we made the original investment and annual rate of return the same for each: $1 million and 12%. 

While the long hold had one investment for the 25 year period, the shorter strategy made five different investments in the same time period. This way, both strategies remained fully invested for the same amount of time.

The table below summarizes the assumptions.

Summary of assumptions for both long-term hold and short-term hold strategies.

The Results

The only difference between the two scenarios were the hold times. But, due to this difference, the traditional exit strategy paid capital gains taxes five separate times vs. only paying one time for the longer hold period. Each time taxes were paid, the net after-tax proceeds were reinvested. Losing the benefit of compounding returns from the amount paid in taxes, over time, significantly reduced the total gain for the shorter term strategy. The traditional strategy’s net after tax gain was $9.5 million vs. $12.9 million for the long-term strategy.  Despite paying $1.1 million more in total taxes, the long-term strategy generated about $3.5 million additional long-term after-tax proceeds. This is truly a dramatic outcome which highlights and reiterates the financial benefit of long-term holds.

Caveats and Other Considerations

Obviously we don’t live in a perfect world and annual rates of return, tax rates, etc. will all vary over time. Changing the rate of return has a significant impact on the outcomes.  Higher rates of return amplify the results and lower rates of return reduce the difference between the two models. For illustrative purposes, Increasing the annual rate of return to 15% from 12% generates an additional $5 million of after-tax proceeds for the long-term hold strategy!

This scenario simply looks at the numbers. It assumes the longer investment time period changes nothing but the hold duration. However, in practice, there are other ideas to consider: For example you may want to sell earlier if your investment is not generating the desired rates of return and you think you can redeploy the investment into a higher return asset. Or perhaps capital gains taxes are eliminated or greatly reduced in the future which makes selling and reinvesting less expensive. 

See the tables below for a closer look.

Table detailing results of the short-term investment hold period vs the long-term, for 12% annual rate of return

Table displays results of how a short-term investment hold period compares to a long one, for a 15% annual return rate.

If you have any questions about this model or are curious about other benefits of a long-term hold, please contact us.

/by