December 15, 2022 | 20 Minute Read
Head of Portfolio Solutions for Alternatives Capital Markets and Strategy
Portfolio Solutions for Alternatives Capital Markets and Strategy
Portfolio Solutions for Alternatives Capital Markets and Strategy
For limited partners (LPs) in private market funds, the intermittent and unpredictable cadence of capital calls and distributions presents an ongoing challenge. Investors must balance the need to maintain sufficient liquid assets to meet capital calls with the desire to minimize the cash drag in the portfolio. A variety of processes are used to model fund cashflows—from simple heuristics to well-established and back-tested models. But regardless of the method employed, LPs today may need to reconsider their cashflow management strategy in the years ahead. Private fund cash flow profiles may look different going forward for reasons both structural and cyclical, borne of the current market environment.
One of the biggest structural changes to private fund cash flows is the broad adoption of subscription credit lines. These are loans taken out by the General Partner (GP) during the fund’s investment period, with the proceeds used to make portfolio investments. Costs of subscription lines typically include upfront fees for arranging the loan, interest on the drawn portion of the facility, and fees on the undrawn portion of the facility. The loan is secured by, and repaid with, capital called from the fund’s investors (i.e., LPs), so lenders typically require a look-through to the underlying LP base when underwriting and pricing the subscription line. As such, the terms may be more favorable for funds with large, established institutional LP bases.
The benefits of a subscription line are two-fold. First, it simplifies the administrative process for private markets funds by decreasing the number of separate capital calls that must be processed by both LPs and GPs. By bridging the time between when checks are written for new investments and when funds are received from LPs, the GP can wait until a certain amount has been deployed rather than calling capital separately for each deal. It can also eliminate the hassle of calling capital in anticipation of an upcoming new deal, only to have to return the capital if the deal falls through later. The second benefit is a potential enhancement to the internal rate of return (IRR): a shorter time frame between cash contributions and distributions from and to LPs mechanically increases the investment’s IRR. Partially offsetting this dynamic, however, is a decline in the overall multiple on investors’ capital (total value to paid-in, or TVPI) from the costs of the facility.
Typically, the benefits to IRR outweigh the downside to TVPI. The origination and undrawn capital fees are generally small for subscription lines, and interest expense on the borrowings is modest relative to the fund size given the short time frame and moderate size of the loan. Assuming a rather extreme case of once-annual capital calls, our buyout fund model indicates that the use of a subscription line could decrease the TVPI by less than 0.05x, while increasing the ultimate IRR by up to 1.2%; however, the impact could be significantly greater on an interim performance basis. Even in a period of rising rates (and, therefore, rising borrowing costs), the dynamic doesn’t change much. Based on our models, increasing the base SOFR rate by 1% may result in 10 bps or less of IRR degradation. This IRR accretion, magnified in the early years of a fund’s life, can be attractive to both GPs looking to show strong performance (particularly when marketing their subsequent fund) as well as LPs focused on IRR and concerned about the performance J-curve.1
Based on our model, assuming buyout with 20% gross return for investments. Calls spaced out equally over the course of the year. Sub line assumptions based on indicative industry terms in mid-2022: 3-year tenor for 30% of the fund’s commitments, interest rate on drawn commitments is 2% an assumed 2.25% base rate, 0.25% fees on undrawn commitments, up-front and arranger fees of 0.75% of the vehicle’s size.
One consequence of subscription lines for LPs is that capital calls are lumpier and larger than would be the case without a facility: the same amount of capital is called over the life of the fund but spread across fewer transactions. The effect on the predictability of the calls is uncertain. On one hand, the timing and amount of the calls could become less predictable—the uncertainty inherent in the timelines for sourcing and executing investments compounded by the uncertainty inherent in sub line repayment timelines. On the other hand, some GPs may use subscription lines to mitigate the uncertainty of investment timing. For instance, a GP may choose to set a regular capital call schedule, such as semi-annually or quarterly. Even without a set schedule, a GP may choose to guide its LPs to the magnitude of upcoming contributions, informed by investments made since the previous call.
Capital calls tend to decline in downturns, as buyers and lenders become more cautious, and sellers become more reluctant to transact at potential market bottoms. These dynamics are playing out today, as we saw both capital calls and distributions down sharply in 1H 2022. Both buyers and sellers are taking more time in price-discovery mode. Financing providers, too, have grown more leery: portions of the high-yield market have all but closed, and traditional bank lenders have retreated significantly as syndication has become more challenging.
The length and depth of the slowdown in deal activity may be mitigated, however, by several factors. The current environment presents opportunities to deploy private capital into publicly traded companies at valuations that have declined meaningfully from last year’s peaks. Investment can take the form of take-private deals or of acquisitions of smaller divisions of public companies. The latter is a key component of a platform-building private equity strategy, capitalizing on the trend of large corporations divesting non-core assets that may be attractive bolt-ons to a flagship investment. Another potential mitigant to slowing capital deployment, new to this cycle, is GPs potentially calling capital to repay a portion of their outstanding subscription line balances, in order to have more flexibility to meet future cash needs. GPs may also choose to invest additional capital into existing portfolio companies to provide support through the downturn.
In addition, GPs today may be under more pressure than in recent history to deploy capital over the next 12-18 months following a period of record fundraising. The main culprit is aging--rather than absolute levels—of dry powder. Absolute levels of dry powder are at record levels, but the fraction raised by funds currently in their deployment period is in line with the last two decades. Furthermore, the use of subscription lines may be overstating the amount of dry powder available, to the extent that these lines are financing some of the difference between capital raised and capital called from the LPs.
On the other hand, around 40% of dry powder today is in funds that are 2-5 years old—the highest figure in almost a decade.3 In a typical market, this pressure may have negative implications for portfolios—one study has found that “pressured buyers pay higher multiples, use less leverage, and syndicate less—suggesting that their motive is to spend equity.”4 However, funds that find themselves with meaningful amounts of dry powder to deploy through a downturn may end up benefiting from the ability to invest a greater portion of their portfolio at more attractive valuations. Another recent study confirmed what investors may intuit: “funds with a relatively high propensity to [call capital in bad times] perform better in both absolute and relative terms.”5
Distributions, the other side of the equation, are paralleling the experience of prior market downturns as well. After setting records in 2021, distributions have slowed down dramatically year-to-date: private equity exits have declined sharply, particularly for the largest transactions that often rely on public listings.
In part, this is due to fewer viable exit paths. For instance, IPO activity is down 62% year-to-date,6 as investor sentiment has turned more cautious. Transactions may also take longer to execute, as buyers and sellers take their time evaluating and pricing deals in an uncertain environment. However, this may also be partially driven by GPs’ choice to avoid selling into a challenging market, at potentially lower valuations. The ability to time exits in order to maximize value is one attractive feature of private market investments—one recent academic study has found that over half of funds’ IRR is attributable to cash-flow timing efforts.7 And indeed, private markets have historically outperformed their comparable public market benchmarks across a variety of time frames.
Evidence suggests that GPs tend to manage their investment towards a total value realization—for instance, targeting a 2x TVPI multiple—and, therefore, extend the duration of their investments to avoid selling against macroeconomic headwinds. This would decrease the fund’s IRR—but the impact would likely be muted. The impact on IRR of cash flow timing is more pronounced for cash flows occurring toward the beginning of the fund life compared to those occurring later on. Today, GPs have a growing array of options to manage the timing not only of capital calls but also of exits and cash flows. Continuation vehicles are increasingly being used as a way for GPs to continue holding on to promising assets that need more time than the original fund life allows. Even with these tools, as long as markets remain volatile, distributions may remain depressed.
Source: Cambridge Associates. Data for buyout funds. Capital called represents the average called across funds that were 1, 2, 3, and 4 years old in a given vintage year. Distributions represents the average called across funds that were 7-13 years old in a given vintage year. Shaded boxes represent the dot-com bust and the global financial crisis. As of 2021.
Taken together, the patterns of capital calls and distributions may translate into different outcomes for different LP programs. For instance, programs in ramp-up mode, consisting mostly of younger funds, may see smaller cash outlays relative to baseline assumptions: capital calls would likely decline in the near term while distributions would have been small regardless. This could be a benefit to LPs that may have made commitments to a target allocation prior to the recent market pullback and may now find themselves ahead of anticipated pace given the reduced corpus of the overall portfolio. Conversely, capital calls may outpace baseline projections two to three years down the road, when recent commitments approach the end of their investment periods and “catch up” to the anticipated pace.
Mature programs, on the other hand, may see negative overall near-term cash flow impact relative to baseline: decreases in distributions would more than offset the slowdown in new capital calls. Indeed, market data show that a mature buyout portfolio went from experiencing record levels of net distributions at the end of 2021 to being nearly cashflow neutral in 2Q 2022.8 Continued muted exit activity in 3Q 2022, as well as the potential for more frequent public-to-private transactions to act as a net-outflow—suggest that significantly reduced, or even negative, net cashflows are a real possibility. However, the dynamic may reverse once the market recovers, with distributions re-accelerating as portfolio companies are sold into a more constructive market.
Exit path trends may amplify these cash flow dynamics and may mean that a reduced net cash flow profile for mature programs may extend beyond the current market environment. Private equity funds are becoming an increasingly prominent buyer base for private equity exits, speaking for a greater portion of the volume of exits over time. So far this year, secondary buyouts (SBOs, transactions in which one private equity fund buys an asset from another) have represented their largest share of exits on record (56%). This dynamic is part of a long-term trend that may be cyclical but is likely to prove at least partially structural. One reason is that private equity GPs are becoming more competitive bidders. Their focus increasingly emphasizes portfolio company value creation, and many GPs have developed organizational resources and skill to enhance company operations and introduce synergies. With an approach and value creation capabilities akin to those of strategic acquirers’, financial sponsors can pay prices in line with—or even at a premium to—those paid by strategic acquirers. Furthermore, as private equity funds get larger, they are able to acquire larger companies while maintaining prudent diversification parameters. As such, the “natural exit point” at which a company outgrows private markets and must access public capital for further expansion, gets larger as well.
When a private equity-backed company goes public or is acquired by a strategic buyer, investors get a cash distribution. Conversely, public-to-private transactions mean net cash outlays. In an SBO transaction, cash stays within the private equity system. While the two funds involved in a given transaction have different LP bases, over the course of hundreds of transactions investors with a mature, steady-state portfolio can expect to experience somewhat offsetting cash flows from these deals.
At the overall industry level, more money staying in the system from sponsor-to-sponsor deals is one reason why net cash distributions have trended down in recent years. However, broad industry growth, which has increased the ratio of younger funds calling capital to older funds distributing capital, is also playing a major role in this trend.
Another factor to consider is the difference between the currency in which an LP’s portfolio operates and pays its beneficiaries, and the currency mix of its private markets investments. Over half of assets under management in private markets is managed by funds in North America,9 and the vast majority of that capital is denominated in US dollars (USD). For LPs in other regions, the USD’s recent strength may present both benefits and challenges. On one hand, the value of distributions would increase in local currency terms, potentially offsetting some of the decline in the overall level of distributions. On the other hand, LPs’ uncalled commitments would also rise in local currency terms, requiring more money than expected to meet capital calls. To the extent that an LP’s private markets portfolio is more tilted towards USD-denominated investments than is the LP’s liquid portfolio, recent FX moves would exacerbate the denominator effect as well.
Faced with a confluence of increasingly unpredictable, uncontrollable economic and market developments, LPs must concentrate their efforts on aspects they can directly affect. Within private markets portfolios, we believe LPs are likely to have the greatest impact by focusing on four actionable areas.
In private markets, diversification not only brings potential performance benefits but also has implications for capital call volatility. While each fund will deviate from “average” pacing, a set of random deviations can potentially offset each other—to a degree. Data from PitchBook suggests that an LP investing in a single buyout fund for a given period may face an 8% standard deviation of quarterly contributions. In other words, two-thirds of the time the actual amount called in any given quarter could be within a 16-percentage range—from 8% above to 8% below the average amount. The 95-percent certainty range is 32%; by allocating capital across 10 funds instead of one, however, investors can cut that range in half. Beyond this amount, the marginal benefit of diversification declines meaningfully. There are also limits to how many funds an individual LP could include in its portfolio. Consideration must be given to the organization’s available resources, such as the staff and funds available to shoulder the administrative burden of the asset class, as well as finite number of high-quality GPs and funds.
Source: PitchBook, Geography: Global. As of March 31, 2019.
Given the recent structural and ongoing cyclical market changes, even a well-diversified portfolio will likely experience episodic deployment and less predictable capital call patterns. The question arises, then, how much to manage to the base case versus the most extreme scenarios, balancing the risks of unanticipated liquidity needs with the costs of the performance drag from holding cash.
LPs may need to reevaluate their approach to managing their undrawn commitments. Some LPs keep an amount equal to a particular number of months’ worth of anticipated net capital calls in highly liquid instruments or cash, while allocating the remainder to assets that more closely resemble the risk/return profile of their private markets portfolio. Such an approach is unlikely to need a drastic revamp; however, investors could consider an adjustment to the magnitude of the cash flows associated with an anticipated capital call, or to the number of months of capital held in reserve. For LPs holding reserves equal to 6-12 months’ worth of anticipated capital calls, little if any adjustment may be necessary. On the other hand, LPs who take a cash management approach to their unfunded commitments, examining anticipated calls month-to-month or quarter-to-quarter, may need to make more substantial adjustments.
In the near term, market dynamics require investors with steady-state programs to think through how to manage net cash outlays that may exceed base case scenarios, as well as how to manage the numerator effect that may result from net distributions lagging projections. A common goal is to make smaller adjustments to stay within governance parameters without major disruptions to the program.
To that end, many LPs updated their asset allocation policies in the wake of the global financial crisis after suffering from the denominator effect, broadening the target allocation ranges for private markets investments and introducing “grace periods” within which to rebalance back within range.
Increasingly, LPs have been turning to the secondary market to manage their allocations and cash flows, as well as to free up capacity to invest in new vintages. Options vary from an outright sale of a full or partial fund position, to structured and preferred equity transactions that allow the LP to retain some future upside while receiving cash in the near term. The right approach will vary by LP and should consider the LP’s specific objectives, such as pricing, liquidity, and NAV management. LPs should be aware that not all assets are viewed the same by secondary buyers: some may be more salable that others. They should also keep in mind that these processes take time and are often subject to GP approval.10
LPs should also understand their options when it comes to continuation processes for assets in their portfolios. Often, these processes are initiated when the GP believes that a high-quality asset can benefit from additional time in the portfolio to build and realize value. The LP has the choice to roll over their commitment to the new vehicle or to realize liquidity. The LP’s decision is multifaceted and should consider both liquidity considerations and constraints around the organizational resources available to evaluate the proposed transaction within the allotted timeframe, as well as the best allocation of its resources between existing and new investments. Recent data suggests many LPs have been choosing liquidity this year, perhaps as a response to the slow-down in fund realizations: “Limited Partners sold approximately 90% of the time in continuation fund transactions during the first half of the year.”11
Today’s environment can be an opportune time for LPs to reassess and potentially recalibrate their future long-term commitment strategy. Global equities are down around 25% off their 2021 peak; global investment grade bonds are down more than 20%.12 Return expectations across asset classes for the next decade are widely forecasted to be below those experienced over the past two decades. As such, the trajectory for the quantum of overall assets may have shifted for many portfolios, and the pacing of private markets commitments may need to be adjusted accordingly in order to maintain the allocation within policy ranges in the future. LPs may also take an opportunity to revisit their approaches to commitment planning, potentially introducing more sophisticated forecasting methods that may offer better or more information in an increasingly uncertain market environment.
Making drastic changes in the near term is not prudent – such an approach is tantamount to market timing and can have implications for the evolution of the portfolio value and cash flow profile in future years. Research has shown that while private equity performance has been cyclical, efforts to time the market result in modest to no gains over the long term due to the unpredictability of the timing of underlying fund investments and exits.13 A drastic decrease in investing activity can also impact the LP’s relationships with its preferred GPs and affect the job satisfaction of the LP’s investment team. On the other hand, the experience of LPs ahead of the global financial crisis shows the drawbacks of over-indexing the other way. Ahead of the crisis, capital was coming back ahead of anticipated pace, and some LPs made commitments ahead of pace, in order to maintain their private markets investment levels. As a result, they ended up over-allocated to vintages that underperformed in hindsight.
However, periodically recalibrating longer-term targets and commitments in light of the evolution of the value of the overall portfolio is a prudent exercise. If a decrease in future commitments is called for, the LP needs to decide whether to maintain the current number of GP relationships and decrease commitment levels to each, or to partner with fewer GPs but maintain existing commitment levels to each. Both approaches have benefits and considerations dependent on each organization’s goals and resources.
Source: Goldman Sachs Asset Management.
Going forward, the task of modeling private market cash flows is likely to grow more complex. GPs are leveraging a growing tool kit to solve for their fund objectives. These objectives, however, rarely mirror the portfolio construction objectives of a particular LP. This means that CIOs need to actively manage their private markets portfolios, assuming full ownership of cash flow management for their portfolios. In many cases, these portfolios are becoming more complex as well, incorporating a wider range of strategies with differing cash flow profiles. LPs need to be proactive in adapting to a changing environment, as the ongoing integration of new financing tools and fund structures alters historical patterns. Part of the answer may lie in using new analytical approaches, metrics, and datasets to better understand the potential range of outcomes in an increasingly unpredictable world.
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