How to navigate cash flow forecasting challenges

Increasingly, private market funds are playing a key role in limited partners’ (LPs) portfolios. Drawn to diversification benefits, a growing number of PE and VC investment opportunities and potentially higher returns than public market alternatives, many LPs have started to boost their private market allocations—with many allocating 15%, 20%, even 30% or more of their portfolio to private market funds.

But while the prospect of boosted returns is enticing, the unique structure of private market funds and their cash flow profile pose a series of challenges for LPs trying to achieve a private market allocation. Here, we explore the basic components of private market cash flows and examine how LPs can navigate their unique characteristics.

Exploring the cash flow cycle of private market funds

When LPs invest in publicly listed securities or other public market vehicles, they can usually put their capital to work immediately and exit their investments within days of deciding to do so. However, private market investments are closed-end—a much different structure that requires portfolio forecasting considerations. The lifecycle of a private market fund can be described by some key phases:

• An LP commits a certain amount of investment dollars to a private market fund based on a variety of factors related to their risk/return and allocation targets
• The GP of that fund sources and identifies investment opportunities, requesting and deploying that “committed capital” from LPs throughout the fund’s investment period
• The fund manager enhances the value of their investments during the hold period, which typically ranges from 5-7 years
• The GP exits and liquidates each position as a buyer or exit is identified providing returns or “distributions” to their LPs over several years

What are capital calls?

When limited partners (LPs) commit to invest in a private market fund, they agree to provide a certain amount of capital across the fund’s lifespan and are contractually obligated to provide this “committed capital” when requested by their fund manager—typically with seven to ten days’ notice.

When GPs request committed capital from LPs, they do so by making what is referred to as a capital call. These capital calls only occur when GPs have sourced an investment—typically a portfolio company—and are ready to deploy capital to that investment. This investment selection and capital deployment structure occurs over a fund’s “investment period,” which most commonly transpires within the first five years of a fund’s life.

Capital will be called down at varying rates and amounts depending on a variety of factors, such as fund strategy, size, age and dry powder. For example, if an LP commits to a private debt fund, they could expect a high concentration of capital calls within the first few years of the fund, whereas a private equity or venture fund may experience a slower calldown pace during the investment period. Venture capital funds tend to make more investments than private equity—usually more than 30—so on a percentage basis, the calls may be lower and more predictable compared to PE, where under 20 investments is not abnormal. Dry powder plays a role, too—unsurprisingly, GPs with more dry powder tend to make larger capital calls.

It’s important to note that capital calls will occur many times over a fund’s investment period, and LPs are often committed to many private market funds at any given time, meaning there is a steady flow of capital calls coming at them that they must be ready to fund.

Baseline profiles for capital calls and distributions by strategy

What are distributions?

As a fund matures, GPs will begin to exit their investments, providing returns to LPs in the form of distributions until the net asset value (NAV) of the fund winds down to zero with the liquidation of the last investment position. This distribution structure means that each time a GP exits an investment, an LP’s allocation to the private markets declines while their cash allocation increases. Therefore, in order to maintain or grow a target allocation, these distributions must be reinvested by LPs.

Like capital calls, there is a great degree of variability in distribution profiles across private market strategies. For example, private debt and real assets funds usually have income-producing elements and tend to begin distributing returns and reach full liquidation faster than other strategies.

Distributions tend to be much more variable in size and sporadic in frequency than capital calls, which are somewhat controlled by the initial commitment size and parameters in the limited partnership agreement. Additionally, distribution profiles tend to be more correlated with broader macroeconomic conditions than capital calls. PitchBook research shows that in economic downturns, the rate of capital calls stays relatively unaffected whereas the pace of distributions tends to slow significantly, illustrating a logical desire by GPs to continue investing when assets are at a discount but avoid selling their positions when prices are depressed.

This capital call and distribution framework can be described with a standard J-curve graph, showing the generalized pattern of net cash flows for private market funds. This unique cash flow structure poses significant portfolio forecasting challenges for LPs—namely, creating an accurate cash flow forecast to maintain a proper private market allocation and maximize returns requires an intentional strategy.

The naïve cash flow of a private equity fund

What causes cash flow forecasting problems for LPs? Exploring cash flow forecasting challenges in private market funds

Introducing, maintaining or growing a private market allocation brings distinct challenges to a portfolio. LPs investing in the private markets must determine how much to commit to private market funds in order to achieve allocation targets, and they must also forecast how those commitments will play out to ensure they have adequate cash on hand for capital calls, while minimizing capital parked in low-return investments. As described above, there is a great deal of nuance surrounding the timing and quantity of contributions and distributions, posing additional challenges in creating a cash flow forecast for various investments. Each of these elements introduces complex workstreams and considerations that need to be navigated by LPs.

Cash flow forecasting challenges with capital calls

While LPs need to have cash on hand to fund capital calls, they don’t want unnecessary capital left sitting around underinvested. This dynamic creates a series of dilemmas. Allocating too little cash to highly liquid assets runs the risk of defaulting on a capital call, which is accompanied by serious financial and reputational penalties. Alternatively, placing too much capital in low-yielding assets, such as a short-duration fixed income portfolio or cash, reduces expected investment returns. Yet, placing uncalled capital in riskier, higher performing assets, such as small cap equities introduces its own problems. Liquidating those investments to meet a capital call when the market is down would certainly not be ideal for an LP.

In short, LPs would like to know with some confidence the maximum amount that they should keep on hand for capital calls at any given moment, so they can thread the needle of parking just the right amount of capital in stable but probably low-return assets to meet capital calls.

There are varying schools of thought surrounding where LPs should place their capital while it is waiting to be called down, and ultimately the best strategy for handling the cash flow forecasting challenges of capital calls will vary depending on a specific LP’s risk tolerance and their broader portfolio goals and need for liquid assets. For example, an insurance company that must be able to quickly pay out money in a disaster will have different liquidity needs than a foundation investing with a perpetual capital mindset.

Cash flow forecasting challenges with distributions and maintaining a private market allocation

Distributions create their own set of cash flow forecasting challenges for LPs. The inherent nature of distributions in private market funds add a level of complexity for LPs trying to determine the appropriate size of a commitment in order to reach a specific allocation target. For example, if an LP was trying to reach a $100 million private equity allocation at some point in the future, they would need to make an upfront commitment greater than the $100 million target, as the $100 million commitment would never get called down in its entirety before they started to receive distributions.

A popular approach to this dilemma is to apply an overcommitment ratio, in which an LP commits more than the target allocation, expecting early distributions to act as a backup to any concerns of funding capital calls. But determining the right ratio is essential—set this ratio too high, and an LP could find themselves with funding and overallocations risks. Set it too low, and an LP could find themselves struggling to ever reach their allocation target.

As previously noted, the distribution framework means that each time cash is returned to LPs, their private market portfolio exposure decreases, making it essential to reinvest distributions to maintain a target allocation. Attempting to reach a state where distributions are funding contributions is an iterative process that requires forecasting of cash flows and planning the pacing of new commitments. Once this state is attained, funding risks are minimized, and allocation targets can be reached and maintained.

How to mitigate the cash flow forecasting challenges of private market funds
Cash flow forecasting and commitment pacing models are the primary tools LPs can use to navigate portfolio forecasting challenges, gain a heightened understanding of cash flow patterns and achieve their private market allocations. However, not all models are created equal. By leveraging probabilistic cash flow forecasting models based on a robust historical data set, LPs can better plan for capital calls and distributions and optimize returns by keeping a smaller allocation of their uncalled commitments in low-yield, liquid assets.

Commitment pacing models are an equally vital tool for reaching a target allocation along with timing and estimating future commitments. Through leveraging a commitment pacing model, LPs can reach their allocation target at a pre-specified time, and layer in schedules for future commitments to maintain or grow that allocation. In the best scenarios, combining an effective cash flow forecast and commitment pacing exercise can help LPs design a portfolio that will lead to distributions funding upcoming contributions.

In all, implementing an intentional strategy to navigating cash flow forecasting challenges is essential for LPs with private market investments. When LPs improve cash flow forecasting of their investments, they can effectively reach, maintain or grow allocation targets, time the size and frequency of capital calls and distributions and minimize the capital they house in low-return investments.

Cash flow forecasting challenges are just one pain point for LPs—learn how to navigate other common obstacles

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