Ramping Up a PE Allocation Over Time

Ramping Up a PE Allocation Over Time

Many investors with long horizons are increasing their allocation to private equity funds: to extract the gains from managerial skill in that field, to reap the illiquidity premium, and simply to diversify.

TIAA Endowment & Philanthropic Services has put out a paper on the creation and maintenance of a private equity portfolio, for the benefit of those institutions who feel the tug in this direction. The paper by Peng Wang, TEPS’ head of portfolio research, concludes that there is a “prudent upper bound for a private equity allocation,” a point beyond which there might be significant risks to the portfolio of further accumulation. But Wang’s suggested upper bound is a high one: a 50% allocation with an estimated unfunded ratio of about 23%. Even the upper bound of the optimal target range will see surprisingly high to some observers: 40%.

Three Generic Asset Classes

The paper uses a Monte Carlo model with scenario-based outcomes to help fix that ceiling and to address other questions faced by portfolio managers.

TIAA’s model presumes that there are only three generic asset classes: public equity, private equity, and fixed income. It presumes, further, that public equity investments will return 7%, with 15% vol, and fixed income will provide 3%, with just 5% volatility. Its Monte Carlo simulations look at what will happen with a PE allocation that begins at 0% and is built up gradually.

Wang’s discussion recognizes that “endowment investment officers have no control over the rate or the timing of private equity managers’ capital calls and distributions, [so] we focus on two key variables that they can control: the annual commitment rate and the risk profile of the assets waiting to be invested in private equity assets.”

Since the model presumes that the allocator is gradually ramping up, there will be some capital during the process that is “awaiting allocation” to PE—the chunk that will be in PE by, say, five years hence but that is otherwise committed now. What that capital is doing—whether it is in fixed income or in public equity—is an important issue for the model.

As to those capital calls and distributions, the simulations presumed a 10% standard deviation. That is a relatively large figure for this purpose, so the model can accommodate a wide range of experience.

Commitment Rate and Equilibrium

The annual commitment rate is defined here as the new commitment to PE each year as a percentage of the previous years’ portfolio assets.

At low rates of annual commitment, the equilibrium rate of private equity allocation is about twice the unfunded ratio, so that for example a 6% annual commitment rate will result in a base case unfunded ratio of around 15%, and a private equity allocation of around 30% at equilibrium.

An annual commitment rate of 10% corresponds to an unfunded liability level of 23% and an allocation of about 50%.

At year 30, the final year of the simulation, there is a 24% chance that the PE allocation will be higher than 40%. That scenario “corresponds to distressed public markets and/or slow distributions from the [PE] managers.” The most prudent target allocation, TIAA thinks, is between 30% and 40%.

Putting Capital to Good Use

One portion of the paper focuses on the case of a 6% commitment rate. As noted above, this corresponds to a 30% allocation at equilibrium, the lower bound of the proposed target. It focuses on this case in order to study the impact of the second control variable, the risk profile of the capital awaiting investment.

Private equity is of its nature illiquid, and this in turn makes rebalancing a challenge. That is why a PE allocation that is too large endangers the entire portfolio, especially in times of crisis when secondary markets may seize up.

The higher the risk profile of the capital awaiting investment, the higher the total portfolio returns, especially during the earlier period of the exercise, while to total private equity part of the portfolio remains low.

The paper concludes that allocators should keep the capital awaiting investment in the public equities. Public equities can be quickly liquidated, so that the rebalancing can be done when the time comes. And in the interim, the capital will have been put to good use.

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