1.7 Cash for Calls

Question 1

Between private debt, private equity, and private real estate, which is generally the slowest to be deployed and by how long?

Answer 1

Private equity capital is generally the slowest to be deployed by an average of about two years

Question 2

Benefits/drawbacks of investing uncalled capital in low risk/low return vs high-risk, high-return?

Answer 2

low risk/low return - beneficial from a liquidity perspective, but not from a return performance perspective (so opportunity cost)

high-risk, high-return - earn illiquidity risk premiums; however, these investments will likely lack sufficient liquidity to fund unexpected capital needs (so may incur losses)

Question 3

Call rates - how much committed capital is invested within 2 year and 5 year periods?

Answer 3

Only about 33%–50% of committed funds are usually invested within the initial two-year period, and about 80%–90% of committed funds are invested within five years

Question 4

What is the easiest and lowest-risk investment for uncalled committed capital? What is the benefit/drawback?

Answer 4

Most liquid asset. Very low returns - so significant cash drag.

Question 5

Why might an investor overcommit to private equity? What is the risk here?

Answer 5

Given that only a portion of capital is actually drawn and invested at a given time, overcommitting capital may be necessary to reach the desired investment allocation (e.g., a desired 5% allocation may actually require a higher commitment of about 10%). This could mitigate losses from cash drag.

This is risky from a cash flow perspective if a higher-than-expected amount of capital is called early in the investment that requires the investor to come up with additional funds (capital call risk)

Question 6

An investor might invest across multiple managers to reduce capital call risk. What are issues with this?
1. size…
2. horizon
3. managers

Answer 6

1. minimum investment amounts vs the size of illiquid allocations
2. number of investment horizons required (for adequate diversification)
3. number of managers required per investment horizon

Question 7

What is a way of reducing capital call risk that doesn’t involve overcommitting or diversifying across managers? (pro and con (and but))

Answer 7

Investing in evergreen funds - they generally have higher call rates (so quicker investment of capital) but tend to have lower returns on invested capital. But these lower returns may still be better to the returns on invested capital after considering call risk (and superior to holding uninvested funds in cash)

Question 8

Call risk depends on ICD and T of the EC.

Answer 8

Call risk depends on the initial commitment date and the timing of the economic cycle.

Question 9

On average, about X% of capital is called after X years, but the range has been between X% and X%

Answer 9

On average, about 66% of capital is called after three years, but the range has been between 57% and 73%

Question 10

What is the PME approach to reducing capital call risk? What are the pros (2) and con of this?

Answer 10

Instead of lower returns from evergreen funds, can attempt to mimic relatively illiquid exposure by using public market equivalent (PME) assets that possess risks and returns close to those illiquid investments. E.g. leveraged public equities for uncalled private equity commitments or high-yield bonds for uncalled private credit commitments.

This is generally successful in stable/strong markets as there is still underlying liquidity in the PME assets, and may be less cash drag vs keeping the funds in cash. BUT, strategy risks incurring losses in a market downturn.

Question 11

What does a liquidity tiering framework attempt to fix? How?
What are the 3 tiers?

Answer 11

The issues associated with PME assets being risky and cash having low returns. Tiering system where risk and investment horizon matches commitment rate, so as to maintain similar level of returns to PME assets while reducing shortfall risk.

Tier 1: calls expected in the next year, invest cash in IG bonds with durations up to 1 year
Tier 2: calls expected in Y2 and Y3, short term bonds with higher risk but higher expected returns - durations 1-3.5 years
Tier 3: calls expected after Y3, invested in PME assets

Liquidity tiering essentially matches asset and liability durations

Question 12

How is liquidity tiering approach to capital calls similar to a pension fund.

Answer 12

It is matching asset and liability durations to minimise shortfall risk.

Question 13

What are the four liquidity management strategies for managing uncalled capital?

Answer 13

1. full invested in cash or cash eq (most conservative)
2. fully invested in PME assets (most aggressive)
3. liquidity tiering based on average call rates
4. liquidity tiering based on the highest 10th percentile of annual call rates (more conservative than using average call rates)

Question 14

Conclusions around the four liquidity management strategies.
1. cash: lowest/highest
2. PME: highest, but high _ and _. Lowest __
3. ALT: lower___ but large ____, slightly more ____
4. CLT: lower ___, but large ___ and more ____

Answer 14

1. fully invested in cash - lowest risk and returns, highest cash drag
2. fully invested in PME assets - highest returns, but with significant volatility and high shortfalls. It had the lowest cash drag
3. average liq tiering - lower return than PME assets, but large reduction in shortfalls, slightly more cash drag than PME
4. conservative LT - lower return than ALT, but large reduction in shortfalls compared to AKT and more cash drag than ALT