Managing Liquidity in the Private Equity Market

In recent years, the only thing seemingly predictable about private equity investments is their lack of predictability. Private equity investors accept that the timing of both the funding of their investments, as well as the distributions of any returns, is difficult to forecast and largely out of their control. Yet even the most knowledgeable investors still seek better ways to understand the likely behavior of their holdings of these long-term obligations.

Private equity partnerships differ from other funds or pooled investments in that investors commit an amount of money to the private equity fund, but they don’t pay that money into the fund until the manager/general partner has found a company in which to invest.

“These capital calls from the manager to the investor occur periodically during the first several years of a fund’s life,” says Bob Morgan, director of private equity at Northern Trust, “but not on a fixed schedule and typically with little advance warning.” For any given partnership, the distributions of investment returns are not expected for a few more years. “Payouts generally don’t occur until the companies within the fund are exited through a sale to another investor or by going public,” Morgan adds.

“The timing of these ‘exit strategies’ depends on a range of factors, such as the vagaries of the markets for public offerings and acquisitions,” says Raj Vora, vice president of private equity with Northern Trust. Moreover, each subsector within the private equity world, such as venture capital and buyouts, has its own patterns for capital calls and distributions.

“We know that if the general partner builds a good business, it will find a buyer at some point. But, it could be in one year or seven years,” Vora adds. “With private equity investments, there’s a high level of illiquidity, and limited partners can’t count on selling just because they need the cash.” Not surprisingly, many private equity investors have been interested in finding a model that could provide a reasonably accurate forecast of capital calls and distributions.

Attempts to Model Private Equity Liquidity

A private equity liquidity model that could provide a reasonably accurate forecast of capital calls and distributions is attractive for several reasons. Such a model would allow investors in private equity funds to better manage their own cash flows. It also would help reduce the risk of not being prepared to pay a capital call that might hit when their own liquidity was constrained. “The limited partners want a sense of when cash is going to be called and when it will come back,” says Steven N. Kaplan, professor of entrepreneurship and finance at the University of Chicago.

Moreover, investor desire for a liquidity model has assumed added urgency during the past few years, notes Paul Finlayson, global product manager in the alternative investments servicing group at Northern Trust. “As a starting point, the languishing IPO and M&A markets have slowed the pace of distributions and prompted greater concern on the part of investors about liquidity,” he says. “Many investors have prudently diversified across vintage years so new partnerships’ capital calls would be funded by the distributions of older partnerships.”

But some investors have had to sell other assets in order to meet capital calls as the distributions slowed to a trickle. “The liquidity shocks have made it very clear to people, in a way that hadn’t been clear before, that they have to pay attention to liquidity,” Kaplan says.

On top of the expected uncertainty of private equity cash flow, portfolio managers are now facing greater scrutiny from management, auditors and others. All want some assurance that their firms’ investments are prudent, and that the timing of future capital requirements and distributions can be reasonably estimated. “Every pension fund has a risk manager who wants information like the standard deviation of returns and the correlation with the public markets,” says Susan Woodward, Ph.D., founder of Sand Hill Econometrics in Palo Alto, California. Just as investors have placed a premium on understanding performance behavior, liquidity modeling is now being viewed as a vital part of risk management. To date, however, the options have been fairly limited. “There are no industry standards for modeling calls and distributions,” Finlayson says.

Of course, investors always have been able to review historical patterns of capital calls and distributions in private equity investing, Finlayson notes. The challenge investors face is determining whether these patterns can be applied to investments in different funds and made at different points in time.

Or, investors can simply assume that capital calls and distributions will ramp up at a certain rate before leveling off, Finlayson says. For added safety, investors using these assumptions often reserve more money than they actually think they’ll need. “However, such protection comes at a price,” Vora notes, “because the investors usually hold the extra money in highly liquid, but low-yielding investments.”

In addition, some purely quantitative models have been available, says Vora. “However, these offer no way to account for extraneous events that can have a significant impact on private equity investments and liquidity, such as a venture capital bubble,” he adds. When it comes to combining all these factors into a viable model, “there is nothing in widespread use that I’m aware of,” says Kaplan. “To the extent that such a model would allow investors to more accurately forecast their liquidity needs, they would be able to invest more in private equity, if they wanted to,” he adds.

Advances in Liquidity Modeling Techniques

“One reason for the lack of solid models until now has been the extensive work required to assemble and clean the data that’s available on private equity companies so that it can be used to develop a strong, solid algorithm,” Woodward says. Acquiring all the data needed and then getting it into usable shape is expensive and time-consuming.

For the last four years, Northern Trust and Sand Hill Econometrics have worked on developing a model that they believe more accurately forecasts private equity liquidity needs. The Northern Trust/Sand Hill team used least squares regression analysis, a proprietary database of 1,500 partnerships, as well as public market indexes and economic indicators to construct an analytical framework that can help investors understand the range of liquidity behaviors of their private equity portfolio. In back testing, the capital call schedule predicted by the model against actual capital call schedules, the model’s accuracy rate topped 90%, Finlayson says. “The information in this database is periodically updated and the model is calibrated annually to keep relevant to current conditions,” he notes.

Empirical evidence has shown that although capital calls and distributions are at the discretion of the fund manager, they tend to follow a pattern. Some of the drivers behind private equity cash flows include the state of public equity, debt and IPO markets, as well as interest rates, Kaplan says. Both capital calls and distributions tend to be positively correlated with the equity markets and negatively correlated with interest rates, he adds.

“In our near term factor model, for instance, we incorporate the behavior of the Wilshire 5000, which we see as the foot on the accelerator of the speed of capital calls,” Finlayson says. That is, rising public markets tend to lead to faster capital calls, with declining markets slowing the pace of capital calls.

The Northern Trust model can be customized to forecast a client’s probable range of near- and long-term capital calls for their private equity investments. The model takes into account factors specific to each private equity partnership, such as its type, its start date, commitment amount and the capital calls and distributions to date. The model then can develop median, best and worst case scenarios. For the near-term forecast, the model evaluates the influence of changes in public market performance.

“If the investor is fairly certain of upcoming events, such as the date of a future capital call, that information can be incorporated into the near term forecast,” Finlayson notes. The longer term model projects the range of potential calls and distributions, as well as their likely impact on the portfolio’s unrealized market value, which helps project impacts on asset allocation.

The liquidity shocks have made it very clear to people, in a way that hadn’t been clear before, that they have to pay attention to liquidity.
—Steve N. Kaplan

“Models that provide a range of possibilities usually are more useful and accurate than those that offer a single number,” Vora notes. “That’s because by providing a range of scenarios investors can, for instance, build in both optimistic and pessimistic levels of capital calls and distributions.” They also can create custom scenarios, such as faster or slower distributions by the subsectors within the portfolio. Similarly, the investor can review the valuations of the companies within the portfolio to forecast potential changes in the allocation within the portfolio.

Managing Liquidity

Modeling private equity cash flows can help investors better manage their liquidity and maintain their desired allocation of assets, but the process is akin to a beaver building a dam. Although the structure will result in a pond where the beaver can build a lodge in which to live, water is constantly flowing and the dam requires vigilant maintenance. Likewise, information is constantly flowing in and out of a private equity cash flow model.

“There will always be variability in factors being fed into the model, such as the general business market, or the particular management style and the underlying investments of each private equity fund in an investor’s portfolio,” Morgan notes. Ultimately, the goal of the model is to provide a structured framework that demonstrates process and diligence for analyzing these inputs and perhaps — much like the beaver’s lodge — a sense of certainty, even in the midst of an uncertain economy and investing environment.

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