Achieving Private Equity Allocation Goals

By M. Isi Eromosele

A commitment strategy that allows an investor to consistently achieve and maintain a specific, targeted private equity exposure can be just as important as deciding on the initial allocation.

Optimized private equity target allocations are designed to reduce portfolio risk through diversification and boost performance. But if these allocations are not achieved and maintained, investors may not fully realize the benefits of adding private equity to a portfolio.

There are three central questions commonly faced by new and experienced private equity investors alike:

• As a new private equity investor, how should I size and pace my commitments to reach my target allocation?
• What future commitments will I need to make to maintain my proportional private equity exposure over time?
• How should I manage my long-term private equity commitments in the face of short-term market volatility across the rest of my portfolio?

Commitment Strategy

Institutional investors in search of improved returns and greater diversification are increasingly turning to private equity investments as they shuffle and refine their portfolio allocations.

Once the decision to invest in private equity is made, investors need to develop an appropriate target allocation based on their liquidity, risk tolerance and performance needs.

Estimating the future exposure or net asset value (NAV) of private equity investments continues to be very difficult. That’s because investors have no control over the timing of the contributions towards their commitment that will build NAV. Nor can they control distributions from underlying investments that will reduce NAV.

This lack of control results from private equity funds typically calling capital from investors as portfolio company acquisitions are made, and then distributing capital back to investors as investments are exited.

The majority of capital calls occur early in the life of a fund (typically years one through three), while most distributions occur later in the fund’s life (typically years four through ten). Over time, these cash flows form a pattern that is often referred to as the “J-curve.

An investor seeking to reach or maintain a specified allocation to private equity needs to understand exactly where their portfolio sits on the J-curve. In other words, the investor must understand the maturity of the portfolio relative to its overall lifecycle. Only if investors are armed with this essential information can they make effective future commitment decisions.

Commitment decisions are important in an effort to achieve strategic targeted private equity exposure. This could mean reducing that exposure by liquidating private equity interests on the secondary market, or increasing it by ramping up commitments (potentially via a secondary purchase).

Estimating Future Exposure

There are many critical factors that affect the unpredictable nature of private equity cash flows. These include:

Market Conditions 

Cash flows may be influenced by the market for private equity transactions in general. If markets are strong, and deals can be exited quickly, private equity investors may experience sooner-than-expected capital calls and distributions, while sluggish markets may delay portfolio company investments and/or require managers to hold portfolio companies for longer than expected time periods. This can delay both capital calls and distributions.

Strategy Considerations 

The strategy of a private equity fund may also affect cash-flow timing. For example, venture capital managers often must put substantial time into their portfolio companies over a series of investment rounds. Consequently, these investments often have longer lives and a greater time horizon from capital calls to distribution than their buyout counterparts.

Fundraising Cycles 

The timing of fundraising cycles for individual managers and the market as a whole,

can also impact when private equity investors have the ability to make commitments. This can affect the overall timing of future cash flows.

Manager-Specific Factors 

Each manager and each fund are impacted by numerous market and transaction-specific variables that impact cash-flow timing. This idiosyncratic element leads to different cash-flow patterns among funds, even for the same or similar managers.

These and other variables make predicting individual private-equity-fund cash flows a difficult task. Unfortunately, investors’ commitment-planning efforts can stall as a result.

Projecting Private Equity Cash Flows

• Having a private equity commitment strategy designed to achieve a target allocation is critical to sound portfolio management.
• In developing a new private equity program, capital commitments to private equity must be “upsized” to achieve a targeted exposure. In addition, frontloading commitments and/or making a secondary investment can help to reach an allocation target much faster.
• Maintaining a target private equity allocation is not simply a matter of increasing commitments at the growth rate of an investor’s broader asset base.
• An ongoing assessment of the composition, maturity and performance expectations of the underlying private equity assets is required to develop an appropriate commitment plan.
• Adjusting a private equity commitment strategy on the basis of short-term market movements has consequences for investors. Inconsistency in commitments can lead to both greater volatility of projected exposure and potential performance losses.

Private equity investors need to consider a strategic commitment plan to achieve allocation targets as much as they consider setting the targets themselves.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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