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Managing Private Fund Allocations

Capital
Administration
May 27, 2022
"Your capital called - said it was sorry for being such a drag."

The challenges of managing private market fund allocations

Things are pretty straightforward with traditional investment funds that invest in publicly-traded securities (equities, bonds, cash, and cash equivalents). You send the fund manager the money you wish to invest with them, the manager invests it in their strategy, and you choose when you want your capital back.1 So you buy, hold, and sell.

The allure of private markets

Private market strategies invest in privately-held assets (private businesses, private loans, real estate, etc.). Unlike traditional securities that trade daily on organized exchanges, private investments are usually "illiquid" – meaning opportunities to buy and sell these assets are limited and meaningfully less efficient. In exchange for accepting illiquidity, private market investors expect higher returns. Private market investors should expect to earn an "illiquidity premium" in finance-speak.

For context, the magnitude of the premium that private equity strategies have delivered relative to public equities has averaged around three percent per year since the early 1990s.2 And while the magnitude of private market premiums varies significantly by year, by asset class, by manager, and by strategy3, a premium of this magnitude is significant – and worth pursuing for some investors.

Funds that "call capital"

OK, so you are interested in earning this premium, and you feel comfortable with the illiquidity – so let's go, right? Well, there's a little more to the story.

In addition to the illiquidity, private market funds (Private Equity, Private Credit, Real Assets, and some Diversifying Strategies) are more complicated to allocate to. Investors make commitments to a fund manager4 , which then sources private investment opportunities and draws on investors' commitments as and when needed to fund those opportunities during the fund's "Investment Period." Capital is "called" during the Investment Period vs. fully invested upfront.5 And then, as the manager "harvests" the private investments in the fund, the capital is returned to the investor.6 Investment and Harvest Periods ranging from three to six years each are typical.

"Buy, hold and sell" doesn't work with private market investing

Given the uncertainty in timing and quantum of both capital calls and distributions, building and maintaining exposure to private investments requires a more thoughtful and active approach.

The primary challenge is how best to manage the capital intended for private investments though not currently invested - either because the capital has not yet been committed to a private fund investment,  or it has been committed though not yet called. And again, this challenge is not limited to building the private market allocation. Instead, the work is continuous because of the distributions generated by the private investments – which need to be re-invested to maintain the desired exposure.

How this un-invested capital is managed can have a material impact on the ultimate performance of a portfolio's overall private market allocation. The effective management of this capital is a balancing act between maximizing the return on capital that is not yet invested and minimizing the risk of not being able to fund commitments.

 

Threading the needle between risk and return while maintaining adequate liquidity is a fundamental challenge of allocating to private market funds.7


And related, though perhaps less intuitive, the pacing of commitments to private investments has a material impact on how exposure to private investments is built and maintained. If commitments are made too quickly, they will be unevenly distributed over time. Conversely, if commitments to private investments are made too slowly, building and maintaining a target allocation to private investments will be difficult.8

There are several approaches to managing private market allocations

Two primary decisions must be made when establishing and maintaining an allocation to private markets:

  1. The pace at which allocations will be made; and
  1. How to manage the uninvested capital (again, not yet committed, not yet called, and re-investing private market distributions).

Let's look at the most common approaches to both of these key elements:

The pacing decision:

The "idle capital" decision:

     

So there is no perfect solution here. Landing on the best approach is a balancing act with risk tolerance a key determinant – while also striking the right balance between simplicity and complexity.

Even the most sophisticated investors struggle with this

The California Public Employees' Retirement System (CalPERS) oversees approximately $450 billion9, making it the largest public pension fund in the United States.10 And despite CalPERS' considerable resources, it has struggled to manage its private equity allocation.  

When the pension fund hired a consultant to review its private equity program, it found that the recent pace of private equity commitments had been significantly inadequate to maintain the fund's 8% target allocation to the asset class. CalPERS' commitments to private equity had ranged from $3.3 billion to $6.7 billion in recent years. The consultant estimated it would need to commit more than $10 billion each year to reach and maintain the target weight.11 So yes, all investors struggle with how best to manage their private market allocations!

More on threading the needle

Our goal with this piece was to define the challenges inherent in managing private market allocations – and to lay out some of the primary approaches to tackling them. You will notice that the separate and super important topic of identifying and accessing the very best private market strategies was barely mentioned.

We believe that the "illiquidity premium" is worth pursuing for many family investors, though we also acknowledge how hard it can be to manage private market allocations effectively. This is an area that we continue to refine in our work with families here at Prime Quadrant. While private market investing has always been a core element of this work, making it easier for families to build and maintain exposure to managers and strategies that we believe to be best in class has been an intense focus for us over the last few years. Launching "access vehicles" for private market asset classes has helped take the edge off some of the issues we've discussed here (as the diversification within these funds partially mitigates the challenges with both the pacing of allocations and cash management). We will continue this work – and you should expect to hear more from us on how we plan to further support families as they thread the private markets needle.

Written by Terry Vaughan, Principal & Senior Consultant.

References

[1] Subject to any restrictions on redemptions – which are usually modest if they exist at all.

[2] J.P. Morgan Asset Management, 2022 Long Term Capital Market Assumptions, (p. 99, Exhibit 3), https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/insights/portfolio-insights/ltcma/ltcma-full-report.pdf

[3] To illustrate just how significant the differences in returns can be, consider the following: The standard deviation  of returns (a measure of variation) for mid-cap mutual funds was 1.7% from 2008 to 2018. For Private Equity funds with vintages (funds) in that same period, the standard deviation of returns ranges from around 10% to 31% per vintage. So the rewards for selecting the best managers (and the ramifications of selecting the laggards)are amplified in private markets. (from Pitchbook (2020), Basics of Cash Flow Management – Private Fund Cash Flow Series)

[4] Often structured as a General Partner

[5] And because your capital is called as the manager finds opportunities, it is generally difficult to forecast when the capital calls will occur

[6] If a manager sells an investment during the fund’s harvest period, then the sale proceeds will be returned to investors. During a fund’s investment period, capital can often be re-invested by the manager in new opportunities – so capital that is distributed to investors during the investment period can be “re-callable” and “re-cycled” by the manager.

[7] Pitchbook (2020),Basics of Cash Flow Management – Private Fund Cash Flow Series

[8] Building And Maintaining A Desired Exposure To Private Markets: Commitment Pacing, Cash Flow Modeling, and Beyond, Vishv Jeet, PGIM, November 2020

[9] As of 11-May-2022(Calpers.ca.gov)

[10] Wikipedia

[11] Pitchbook (2020),Basics of Cash Flow Management – Private Fund Cash Flow Series

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