Portfolio Management is a process of making investment decisions about asset mix, policy, and buy/sell disciplines in order to meet individual and institutional investors’ specified financial objectives, risk tolerance, investment horizon, and the optimize the risk-return relationships.
Since 1952, Markowitz’s basic principles of portfolio construction, which were published in the Journal of Finance, have been widely applied to the investments of all asset classes. His approach was basically to combine assets that behave in fundamentally different fashion to optimize the risk-reward tradeoff. However, its relevance to PE investments was overstated, as this category is unique in the lack of data and the non-normality of return patterns. Moreover, PE funds have experienced dramatic fluctuations in investment activities in line with the broad financial markets over the past several years, put in another word, PE performance co-varies positively with both business cycles and stock-market cycles.
“It is almost impossible to use standard risk-return optimization models to determine the right allocation to private equity because of the difficulty in estimating the correct risk premium for private equity and the appropriate correlation with other asset classes.” — Helen Steers
In private equity, the key performance drivers are portfolio design, management of liquidity, and fund manager selection.
Due to its nature, PE portfolio design should place an emphasis on balancing portfolios by the type of fund, location of fund, and the respective vintage year.
- Types of PE fund – PE covers different types of funds known as stages, including buyout, VC, growth capital, special situations, etc.
- Geographic focus – In order to effectively manage smaller holdings and leverage the PE managers’ skills, most PE funds are industry agnostic but they have a geographic focus.
- Vintage year – Investing in PE has a lot common with winemaking. As with making wine, some vintage years will be disastrous, while in other years, people will see very well-stocked wine cellar.
An interesting white paper by PineBridge Investments addressed some central questions commonly faced by new and inexperienced PE investors. PineBridge illustrated through a few simulated cases and introduced its approach to PE portfolio design, which focuses on its so-called “commitment strategy.” The rationale for the “commitment strategy” is fairly simple and straightforward: committing too little, the investment may never capitalize the impact that it is expected to be; committing too much, investors may face significant liquidity issues.
In PE investing, the majority of capital is called early in the life of a fund, while most distributions occur later. Therefore, PE investments tend to deliver negative returns in early years and gain positive performance in the outlying years. Over time, these cash flows and return fashion form a pattern that is often referred to as the “J-curve.” The depth and length of a J-curve depends on several factors, including management fees, types of transactions, and investment styles of the PE manager, being conservative as opposed to aggressive.
Source: Embracing the J-Curve
Step 1: Understanding the J-Curve. As PineBridge mentioned, the investors who are seeking to reach and maintain a specified allocation to PE need to first understand and identify where their portfolios sit on the J-curve. With this essential information, they can further their future commitment planning.
Step 2: Estimating Future Exposure. It is fairly difficult at this stage, because it is almost unlikely to accurately forecast how PE exposure will actually evolve over time based on prior or future commitments, since PE cash flows are highly unpredictable. The cash flows depend on many factors, which include but not limited to market conditions, strategy considerations, fundraising cycles, and manager-specific factors.
Step 3: Planning Commitment. Capital commitments to PE funds must be upsized to achieve a target allocation. It is important to note that making a secondary investment sometimes allows for more efficiently optimizing an allocation target.
Step 4: Monitoring. Last but foremost, an ongoing assessment of the portfolio holdings, maturity, and return expectations of the underlying PE investments is required.
Please keep in mind that adjusting a PE commitment strategy based on short-term market movements has severe consequences for investors. Any inconsistency in commitments may lead to both greater volatility of PE investments exposure and performance loss.
The Management of liquidity
Due to the long-term horizon and lack of liquidity, investing in PE is much riskier than most asset classes. Therefore, modeling the cash flows of investments is one of the most important steps of the liquidity management process. A well-designed PE cash flow schedule is helpful in that LPs can have a better picture of when cash is going to be called and when it will be returned.
A variety of cash flow models have been introduced since PE managers realized this need, and most of these frameworks can effectively improve the efficiency for undrawn capital, project an economic value given an appropriate discount rate, and monitor the cash flows and risk-return profiles of a portfolio of PE funds.
- In Modeling the Cash Flow Dynamics of Private Equity Funds, Axel Buchner, Christoph Kaserer and Niklas Wagner presented a continuous-time approach to modelling the typical cash flow dynamics of PE funds. The model consists of two independent components. The first one is a mean-reverting square-root process which is to model the rate at which capital is drawn over time; the second is for capital distributions which are assumed to follow an arithmetic Brownian motion with a time-dependent drift component that incorporates the typical time-pattern of the repayments of PE funds.
- Alternatively, the Partners Group, a global private markets investment management firm with over EUR 30 billion under management in private equity, private debt, private real estate, and private infrastructure, developed approaches that take a series of inputs into consideration: actual and empirical data, investment advisory, and quantitative management. The model differentiates strategic and tactical commitment level.
- In the spring of 2010, Northern Trust released Managing Liquidity in the Private Equity Market in its Point of View and introduced a PE liquidity model. This model can be customized to forecast an LP’s probable range of near- and long-term capital calls. It takes into account factors specific to each partnership, such as type, vintage year, commitment amount, capital called, and distributions to date. This liquidity model is now being viewed as a vital part of Northern Trust’s risk management.
Besides an effective cash flow schedule, the management of liquidity of a PE portfolio should also focus on the sources of liquidity. Most of the time, commitments are met through cash flows, while sometimes they can be supplemented by other assets and companies’ capacity to borrow. It is important to know that the maturity structure of these assets to fund PE commitments have to match that of the respective PE fund.
In addition, PE managers and investors should broaden their knowledge and approach to manage undrawn capital. The J-curve suggests that commitments are drawn down as needed; in situations where large positions of undrawn capital cannot be avoided, the portfolio can be enhanced by a small exposure to some high-yielding asset classes.
Another consideration related to liquidity management is that during the life of a PE fund, the net cash outflow will not be as high as the initial commitment, and the timing and size of the cash flows will not be known until the PE managers call. Investors need to develop approaches in order to minimize the opportunity cost. Implementing an “overcommitment strategy” can help to reach target allocation level.
Overcommitment Ratio = Total Commitments/Resources Available for Commitments
To achieve an ideal overcommitment level, the LPs’ portfolios need to be diversified over several vintage years, otherwise all PE funds would achieve their maximum investment level simultaneously. Over-aggressive strategy would potentially leave LPs short of liquidity or default on capital calls.
Fund Manager Selection
If you look at the historical performance of the Yale Endowment’s PE portfolio, you may realize that the key difference in terms of performance is between funds; investing in the right categories is not nearly as critical as getting into the right funds. The inefficiency of overall PE market allows skilled PE managers to earn superior returns.
In the paper Returns, Persistence, and Cash Flows, Kaplan and Schoar conducted a set of regression analyses and discovered that there is a high likelihood that the follow-on funds of a given partnership stay in the same performance bracket. Specifically, 1% boost in past performance will translate to 0.77% boost in the next fund’s performance. Therefore, manager selection is among the keys to sustainable outperformance in this asset class.
The manager selection process requires industry knowledge, experience, resources to conduct fund research, due diligence, and also a significant investment in time:
1) Establish Criteria. Before screening, PE investors will need to specify the characteristics and criteria for potential investment opportunities, such as firm history, organization structure, background of the investment team, quality of the performance record over full market-cycle, fund structure, industry or geographic focus, key terms, etc.
2) Deal Sourcing. Having an extended network of industry contacts is critical in accessing good deals. PE is a closed community in which past relationships provide access to the funds in high demand, while newcomers are often turned away. A narrow investment focus may result in inadequate deal flow if the industry is not doing well.
3) Due Diligence. Unlike most other asset classes, in the evaluation of PE investments, there are no rating agencies, no standard documentation, no comprehensive published measures of individual fund’s performance, or investable indices. In this case, PE investors will have to assess a basket of factors, both quantitative and qualitative, and it also depends on the investor’s comfort level with investment managers in general:
- People – The assessment of the PE manager’s investment team, personnel turnover, organization, any violation in the industry, investment professionals’ experience, and compensation structure.
- Investment Process – The assessment of the PE manager’s deal sourcing, due diligence, monitoring and exit process.
- Investment philosophy – The assessment of the rationale and feasibility of the fund strategy and its consistency.
- Performance – The assessment of the PE manager’s track record and its sustainability.
4) Legal Due Diligence. A thorough review of the terms and conditions of the Limited partnership agreements (LPA) is a vital part of the final due diligence. Since LPAs often incorporate unique terms and unique rules, they need to be drafted and interpreted by experts, and more importantly, taking investors’ concerns into account.
5) Investment Decision. Due diligence conclusions are used as inputs for investment decision-making process. However, for investment purpose, not only should investors consider the quality and sustainability of the strategy and process, but also the portfolio composition and overall target allocation.
The art of managing a PE portfolio lies in that it requires an appropriate balance between a superior selection that drives returns and an effective allocation of capital that drives exposure. Being highly selective and investing only in a few top-quality funds could maximize the expected returns but neglect the impact of undrawn commitments; being highly diversified could smooth cash flows and lower overall risk, but at the meantime it also limits upside potential. All in all, an effective PE portfolio construction and management requires a wealth of specialized skills, investment experience, and disciplines.
- Achieving Private Equity Allocation Targets: Eliminating The Guesswork by PineBridge Investments 2013
- The Private Equity J-Curve: Cash Flow Considerations from Primary and Secondary Points of View by Christian Diller, Ivan Herger, Marco Wulff, Capital Dynamics 2009
- Modeling the Cash Flow Dynamics of Private Equity Funds by Axel Buchner, Christoph Kaserer and Niklas Wagner February 2009
- What Drives Private Equity Fund Performance By Ludovic Phalippou and Maurizio Zollo November 2005
- The Guide to Private Equity Fund Investment Due Dilignece by Private Equity Interntional 2005
- Beyond the J Curve by Thomas Meyer, Pierre-Yves Mathonet 2005
- Returns, Persistence, and Cash Flows by Kaplan and Schoar 2005
- Urs Wietlisbach Partners Group, 2002