Early in his career, one of us was responsible for cash flow forecasting and liquidity management at a large multiline insurance company. We gathered extensive historical data on daily concentration bank deposits, withdrawals, and balances and developed an elementary but fairly effective model. Because insurance companies receive premium payments from and pay claims to many thousands of individuals and small companies, we found we could base reasonably accurate forecasts on the quarter of the year, month of the quarter, week of the month, and day of the week, taking holidays into account. This rough-and-ready approach enabled the money market traders to minimize overnight balances, make investment decisions early in the morning, and substantially extend the average maturity of their portfolios. It was an object lesson in the value of proactive cash management.
It is not such a trivial matter for investors in private capital funds to forecast the timing and amount of capital calls and distributions. Yet maintaining adequate liquidity to meet obligations as they arise means accepting either a market risk or an opportunity cost that might be avoided. The market risk comes from holding domestic large-cap stocks that will have to be sold quickly, whatever the prevailing price, when a capital commitment is unexpectedly drawn down; the opportunity cost comes from adopting a defensive posture and holding cash or cash equivalents in excess of the amount needed for ongoing operations, especially when short-term interest rates are very low.
FRG is undertaking a financial modeling project aimed at forecasting capital calls and distributions. Our overall objective is to help investors with outstanding commitments escape the unattractive alternatives of holding excess cash or scrambling to liquidate assets to meet contractual obligations whose timing and amount are uncertain. To that end, we seek to assist in quantifying the risks associated with allocation weights and to understand the probability of future commitments so as to keep the total portfolio invested in line with those weights.
In other words, we want to make proactive cash management possible for private fund investors.
As a first step, we have formulated some questions.
- How do we model the timing and amount of capital calls and disbursements? Are there exogenous variables with predictive power?
- How do the timing of capital calls and disbursements correlate between funds of different vintages and underlying types (e.g., private equity from venture capital to leveraged buyouts, private credit, and real estate, among others)?
- Do private funds’ capital calls and distributions correlate with public companies’ capital issuance and dividend payout decisions?
- How do we model the growth of invested capital? What best explains the returns achieved before money is returned to LPs?
- What triggers distributions?
- How do we allocate money to private funds keeping an eye on total invested capital vs. asset allocation weights?
- The timing of capital calls and distributions is probabilistic (from #1).
- Diversification among funds can produce a smooth invested capital profile. But we need to know how these funds co-move to create distributions around that profile (from #2).
- Confounding problem is the growth of invested capital (from #3). This growth affects total portfolio value and the asset allocation weights. If total exposure is constrained, what is the probability of breaching those constraints?
We invite front-line investors in limited partnerships and similar vehicles to join the discussion. We would welcome and appreciate your input on the conceptual questions. Please contact Dominic Pazzula at [email protected] if you have an interest in this topic.