Liquidity Planning

When managing portfolios with alternative investments, managing liquidity risk becomes crucial. You need enough liquidity for:

• Periodic payments to beneficiaries.
• Rebalancing the portfolio or funding new asset manager mandates.
• Meeting commitments to private investment funds when they call for capital.

Before starting an alternative investment program, address its unique liquidity challenges. Private investments are the least liquid. They usually need an 8-15 year horizon. Capital is invested over a few years, with distributions coming later. Challenges include:

• Maintaining the desired allocation.
• Handling capital calls.
• Preparing for unexpected events.

Achieving and Maintaining the Strategic Asset Allocation

Investors often use capital pacing models to predict capital calls and distributions. Let’s illustrate this with a hypothetical example: a $100 million capital commitment to a 12-year fund.

First, we model capital contributions. Let’s assume 15% is contributed in the first year and 50% of the remaining commitments in each subsequent year:

\(\text{Year } 1: \$100 \text{ million} \times 15\% = \$15 \text{ million}\)

\(\text{Year } 2: (\$100 \text{ million} − \$15 \text{ million}) \times 50\% = \$42.5 \text{ million}\)

\(\text{Year } 3: (\$100 \text{ million} − \$15 \text{ million} − \$42.5 \text{ million}) \times 50\% = \$21.25 \text{ million}.\)

The investor reviews this pacing model regularly, updating it with actual commitments and transactions and refreshing future assumptions.

Mathematically, capital contribution can be shown as follows:

$$ \begin{align*} \text{Capital Contribution} & = \text{Rate of Contribution} \times (\text{Capital Commitment} \\ & – \text{Paid-in-Capital})\end{align*} $$

The next step is modeling distributions, the return of capital to investors.

$$ \begin{align*} \text{Distributions} & = \text{Rate of Distribution at time t} \\ & \times [\text{NAV} \times (1 + \text{Growth Rate})] \text{ NAV at time } 1 \\ & = \text{prior NAV} \times (1 + \text{Growth Rate}) \\ & + \text{Capital Contribution} – \text{Distributions} \end{align*} $$

Investors can use charts with expected distribution rates based on assumptions for more accurate modeling of distributions.

$$ \begin{array}{c|c|c|c|c|c|c|c|c|c|c|c|c}
\textbf{Year} & \bf 1 & \bf 2 & \bf 3 & \bf 4 & \bf 5 & \bf 6 & \bf 7 & \bf 8 & \bf 9 & \bf 10 & \bf 11 & \bf 12 \\ \hline
\text{Rate } \% & 0 & 1 & 3 & 6 & 11 & 18 & 26 & 36 & 50 & 66 & 88 & 100
\end{array} $$

An essential point to observe is the rising distribution rate. This assumption is typical because of how capital flows in alternative investments.

Cash flow and pacing models assist investors in efficiently handling liquidity, establishing achievable commitment goals for desired asset allocations, and managing overall portfolio beta.

Managing the Capital Calls

Capital calls require investors to have funds available within 30 days, as stipulated in the initial agreements. This should be factored into their asset allocation plans. Unallocated capital, called but not yet invested, is also a consideration. Private equity funds might temporarily invest such funds in public equities.

Preparing for the Unexpected

Bear markets can disrupt well-laid liquidity plans. Running analyses with various assumptions and scenarios is advisable. In bear markets, General Partners may accelerate capital calls or slow down distributions, affecting investors relying on liquidity.

Question

A Canadian family office is considering buying into a private equity fund. Assume that 25% is contributed to a fund in the first year and that 50% of the remaining commitments are contributed in each of the subsequent years. If the initial commitment is CAD 75 million, the contribution in the third year is closest to:

1. $14 million.
2. $19 million.
3. $28 million.

Solution

The correct answer is A.

Assume that 25% is contributed in the first year and that 50% of the remaining commitments are contributed in each of the subsequent years:

\(\textbf{Year 1: } \$75 \text{ million} \times 25\% = \$18.75 \text{ million} \)

\(\textbf{Year 2: } (\$75 \text{ million} − \$18.75 \text{ million}) \times 50\% = \$28.125 \text{ million} \)

\( \begin{align*} \textbf{Year 3: }& (\$75 \text{ million} − \$18.75 \text{ million} − \$28.125 \text{ million}) \times 50\% \\ & = \$14.06 \text{ million} \end{align*} \)

Beginning in year two is the ‘remaining amount to be contributed’, represented by what is in the brackets. The investor has already contributed $18.75 million based on the 25% first-year rate and the total commitment of $75 million. These leaves ($75 million − $18.75 million) remaining, and half of that is $28.125 million.

Similarly, in the third year, ($75 million − $18.75 million − $28.125 million) is the remaining contribution, and half of that is $14.06 million.

Portfolio Construction: Learning Module 3: Asset Allocation to Alternative Investments; Los 3(g) Discuss the importance of liquidity planning in allocating to alternative investments