Liquidity Considerations in Private Market Investing
Ask a CIO #23
Earlier this week, I was sitting in a conference room catching up with the team at a private equity firm I’ve known for years. And like so many other conversations I’ve had this year, they were sharing the news that they were building out a team to focus on retail/wealth investors and were developing a product to deliver their existing strategy into that channel.
I’ve noted before that if I were still in my prior endowment and foundation seat, I wouldn’t be aware of the speed or the scale at which private managers are devoting resources and attention to servicing wealth channels. It doesn’t feel like a passing fad, and it’s happening fast. From what I’m seeing, every private market firm of a certain size and above is either in market with a wealth product, actively developing a product, or figuring out how to approach wealth.
Key to this whole trend is a recognition that bringing private market investments to a broader audience – one that hasn’t had years of training in how to manage the logistics of traditional drawdown private funds – requires new structures, or wrappers, that are easier for individual investors to use.
This week’s question, which I’m answering with my E&F LP hat on, highlights just how big a deal it is to simplify the mechanics of investing in private markets.
How do you think about managing liquidity risk? How do you anticipate cash flows from private portfolios?
I debated whether you were asking this question in terms of how I think about liquidity and cash flows specifically at Ivy Invest or whether you were asking more generally, how do institutional investors think about these things? I went with the latter because it’s just more universally applicable advice.
I’ll tackle your questions separately, though they are obviously interrelated. The first – how do institutions think about managing liquidity risk – is relatively straightforward.
Managing liquidity is effectively an exercise in managing cash inflows and outflows. To keep things simple, I’ll describe the process for a hypothetical foundation that has a mature portfolio, invested in funds across public markets and private markets (e.g. private equity, venture capital, real estate, infrastructure, natural resources, etc).
I’ll start with cash outflows, which I’ll bucket into two categories – known outflows and unknown outflows. For a foundation, known outflows include the foundation’s grants and operational needs, otherwise known as spend.1 This is the amount the investment portfolio is transferring to the operating account throughout the year, ideally at some regular cadence (often quarterly). Known cash outflows also include new portfolio investments. Unknown outflows typically come from the private market portfolio in the form of capital calls and unfunded commitments (more on this when we get to your second question).
For this hypothetical foundation, inflows come exclusively from cash generated by the portfolio.2 It could be investment income, redemptions from public market funds (including from hedge funds), or distributions from private managers (again, more on distributions when we get to your second question). Cash flows from investment income and redemptions are generally predictable, whereas cash flows from private manager distributions are not.3
Broad strokes, institutional investor portfolios have a subset of investments that offer daily liquidity and a generally much larger subset of investments that do not. Getting this investment mix “right” and ensuring cash inflows can meet required cash outflows is a meaningful part of any institution’s asset allocation and portfolio construction process. This, more or less, is how institutions think about managing liquidity risk.
Now for the fun part. You asked about anticipating cash flows from private portfolios – these are called distributions. It’s just as important to anticipate cash flows to private portfolios – these are capital calls.
For readers who are less familiar, the way a traditional private market fund works is that investors invest in managers through drawdown commitments. The investor makes a commitment to invest, let’s say $10 million, into the private fund. This $10 million is not invested day 1, but rather is called down over time at the fund manager’s discretion. Whatever amount the investor has not yet invested into the fund out of the original $10 million is called the unfunded commitment.4 The fund manager has a set period of time to call the capital – the investment period. The fund itself also has a set period of time before it is expected to end and return all proceeds to investors – the fund life.5
So the variables that we have here with a private investment fund include: 1) original commitment amount; 2) expected rate of capital calls; 3) expected life of the fund; 4) expected growth of fund investments (think of this as the expected return from the private fund investment); and 5) expected rate at which capital is distributed from fund investments.
Institutional investors, using a combination of historical data and future expectations, incorporate these variables into a private fund projection model. These variables are the inputs, and the outputs are the anticipated cash inflows, anticipated cash outflows, and value of the private fund. Once the model for each current and expected future fund investment is layered in, the institution will have a projection for cash flows and values of the total private portfolio.6
Tying it all back together, if a portfolio has private fund investments, part of managing liquidity risk has to include modeling the cash flows, both into and out of, the private portfolio. Institutional investors are generally highly aware of their liquidity position, and closely track both the known cash inflows/outflows and expected unknown cash inflows/outflows.7
And so I go back to where we started the newsletter this week. Setting aside the general opacity of private markets, the pure mechanics of investing in private funds can be complicated.8 That said, in my experience the potential returns and portfolio benefits of private markets are worth the effort. As more private market managers find ways to wrap their strategies in user-friendly structures, more investors will have the potential opportunity to participate. It may not be a universally smooth transition, but I do firmly believe that more options are generally a good thing.
Thanks for joining, and as always, reach out at askacio@ivyinvest.co!
Until next week,
Wendy
For a foundation, this spend rate is legally required to be at least 5% per year but can be higher.
I’m using a foundation example because foundations are typically closed pools of capital and don’t receive new donations or gifts. A foundation generally is fully self-sustained from investment returns. Endowments on the other hand are open pools of capital that grow with inbound gifts as well as investment returns.
To give a little more context, withdrawals aren’t always straightforward. For alternative investments in the public markets (notably hedge funds), redemption terms typically require advance notice and often come with delays in receiving the cash. There may be hard or soft lock up periods. All of these details need to be tracked to build a full picture of true liquidity and expected date of cash availability at any given point in time.
Day 1 in this example, the investor’s total unfunded commitment is $10 million. This is the amount that the investor is obligated to invest at whatever time the manager requests the money (sometimes with as little as 7 days’ notice). After the first capital call, let’s say it’s $2 million, the remaining unfunded commitment is reduced and is now $8 million in this example.
The running joke is that these are generally set up as 10 year funds, but they never actually live for only 10 years. After all the fund extensions, investors are often looking at 13+ years of investment.
The basis for this projection model was developed by Dean Takahashi and Seth Alexander of the Yale University Investment Office. I was able to track down an online version of the original paper here: Wayback Machine (archive.org). Back in the day, I used this paper to build excel based projections, but now there are lots of fancy software providers that incorporate this model into their offerings. There have been tweaks and updates to the model over the years, but this is where it all started.
When reality doesn’t match the modeling, as in the current environment in which distributions have not matched expected distributions, institutions have to adjust the levers they can control, namely new fund investments/commitments.
And as a cautionary side note, if an investor fails to fund capital calls, the investor becomes a defaulting LP. A defaulting LP may have their existing investment in the fund sold off to other LPs at big discounts or may have to forfeit any existing investments made into the fund with no payment or consideration. The fund manager of course can choose to offer LPs leeway within reason, but the financial consequences for defaulting LPs can be severe.