The Management of Liquidity for Private Equity / Venture Capital Funds-of-Funds - Challenges and Approaches
The above article has recently been published by EIF Head of Division, Risk Management and Monitoring, Dr. Thomas Meyer. A summary of the article is below:
Investments in private equity funds have proven to be risky for a number of reasons, especially the long time frame of the investment and the lack of liquidity. Issues discussed in this article are applicable to private equity funds in general. However, the high degree of uncertainty regarding timing of cash flows renders venture capital funds an exceptional challenge. Estimates for cash flows are based on historic data such as experience from existing deals. Modelling such investments is an important part of the management process.
For the purpose of this publication fund-of-funds' liquidity is seen in a wider context: it is not sufficient to only consider questions associated with typical treasury management (that are not specifically touched upon). The management of undrawn capital - i.e. capital in form of commitments and repayments temporarily not invested in private equity funds - is critical for achieving a high total return on the resources dedicated to private equity investment. As it is a challenge to keep fully - or even close to fully - invested in private equity, a significant share of the dedicated resources will remain idle. To optimize their use, a trade-off between generating a good investment return while maintaining a reasonable degree of liquidity needs to be found.
The management of a private equity fund portfolio's liquidity needs to take into account interdependencies among the overall investment strategy, the management of the undrawn capital, the available resources and timing aspects. Therefore, achieving a high total return for the overall investment programme is a complex task that requires not only quantitative modelling and financial engineering skills, but also a high degree of judgment and management discipline. There is no quick fix for this, and only a disciplined approach can lead to small improvements that eventually add up to have eventually a significant impact.
So far little is published on this subject and the importance of the associated problems appears to be underestimated. For large institutional investors with mature portfolios of diversified private equity fund investments this indeed may be less of an issue; their programmes are typically already cash generating and well diversified over time; as we see in the following, this also aids the liquidity management. Often for such large investors private equity forms only an immaterial part of the balance sheet, and other assets can always be reasonably quickly turned into cash. Whether in this situation private equity can have a sufficient impact on the efficient frontier of the portfolio of all assets under management may be a different question. They are also able to supplement their private equity holdings with other asset classes with a matching statistical draw down / re-payment pattern, such as hedge funds.
But for institutions trying to set up a significant private equity investment programme from scratch, the associated complexity and risks can become a high entry barrier. As a result, it is likely to take many years before this investment programme is able to reach sustainable high total return levels. Mistakes made at an early stage of the investment programme may have severe con-sequences in the medium term. It is a difficult task to steer between putting money efficiently at work and maintaining a balance in the portfolio composition and the quality of the individual fund investments. There is anecdotal evidence that in recent years fund-of-funds have been struggling with this issue. The objective of the publication is to describe the various approaches to managing liquidity for a private equity fund investment programme, and their risks and trade-offs.