Private equity investors have a distinctive cash management question: what do they do with the money that has yet to be drawn or called? Keeping cash in pillow cases is, here as always, less than the optimal solution.
One of the defining features of a PE firm is that an LP agrees that its money will be made available in periodic installments over a number of years (up to five). The General Partner decides when it wants to call the money, and it can make these calls with only a few days’ notice. That means the investors have to be sure they will be liquid when the notices arrive, but they will generally want to have the money working for them in the meantime.
A year ago, three of the managers of a leading PE investor, Pantheon Ventures (UK) LLP, discussed cash management matters in some detail in a paper for the Alternative Investment Analyst Review.
The authors were: head of investment Chris Meads; partner Nik Morandi; vice president Andrea Carnelli.
Default and Its Costs
Meads at al. began with a simple observation: the deterrent value of the consequences to an L.P. of missing a general partners’ drawdown request is considerable. “In some cases, the LP will be subject to a penal rate of interest until such time as it is able to meet its cash obligation [or it may be] forced to sell its position in the fund to other investors, potentially at a steep discount to fair value, or [be forced] to give up its entire stake in the fund….”
If the default occurs late in the fund’s investment period, after the LP has already made a number of payments in response to earlier calls, the loss implied if the GP carves up the defaulting party’s stake among the other LPs obviously can be a hefty one.
More subtly, an ineffective cash management strategy on the part of an LP can hurt it even if nothing quite as drastic as a default occurs. A call that catches the LP flat-footed will generate an emergency, and the LP may have to generate the necessary amount of cash through a fire sale of assets in its portfolio, with the usual loss of value that comes with such sales.
Public Equity Markets
In order to secure the liquidity necessary to prevent such a scenario, an LP might invest in U.S. securities, or other no-to-low risk securities. This has the same drawback as the pillow case scenario: high opportunity costs, especially given a low interest rate environment as at present.
The public equity markets, on the other hand, offer return and are quite liquid, but of course one runs the risk of a badly timed bear market.
How much risk to run? That is the question. Meads et al answer, “It depends.”
On what? On the specific drawdown profile of the private equity program involved. The authors break the possibilities down into three: single-fund, single-vintage portfolios; multi-fund, single-vintage portfolios; multi-fund, multi-vintage. Respectively SFSV, MFSV, and MFMV.
Assuming the simplest case, a SFSV portfolio, and assuming that the investor keeps the money subject to call in a market portfolio of equities, Meads et al crunch some numbers and find a risk of loss of approximately 18% corresponding to this cash management approach. Putting that another way, “on average one in seven LPs pursuing this strategy would have defaulted on their private equity investment at some point, unless they had had access to alternative cash resources.”
Is this scarily high or reassuringly low? “The results by themselves do not suggest any particular cash management strategy,” the paper tells us, but that one-in-seven inference “provides a very useful framework to help LPs come to a more well-informed decision.”
The risk of loss for an MFSV portfolio for the call reserve is almost the same on the same stipulations, 17% rather than 18%.
The risk of loss for a MFMV portfolio is dramatically lower, as one might expect from the temporal diversification that is a defining feature thereof. The key after all is to refrain from exposing one’s self to a badly timed bear run in equities, while awaiting those PE calls. With nine funds per year, the risk of loss falls to just 10%, even with 100% commitment to the market portfolio.
Thus, the authors reach this conclusion: “Vintage diversification appears to be the key consideration to take into account in determining how unfunded commitments should be managed.”