Analyst Q&A: What is Portfolio Forecasting and why is it important?

Limited partners (LPs) face plenty of hurdles when it comes to making effective private market allocations—from the unique makeup of private market funds to outdated or otherwise ineffective cash flow forecasting solutions.

Diving deeper into the latter, decision-making around capital calls, fund distributions and maintaining target allocations can all present barriers for LPs and others who are banking on big returns. Current market conditions impact everything, too—and cash flow forecasting models and commitment pacing strategies are no exception.

In early 2022, LPs and other allocators were building their models in anticipation of high capital call rates. Oh, how things change. Less than a year later, the world is reeling from simultaneous crises—sky-high inflation and interest rates and a war in Ukraine that continues to rage, to name a few. These realities rattle the market landscape, adding a layer of complexity on top of challenges inherent to allocation decision-making. Market shifts over recent quarters have invalidated many of those early 2022 models, spurring LPs to reexamine their strategies from the ground up and creating more demand than ever for new cash flow forecasting software solutions.

Before we get into PitchBook’s newest tool, Portfolio Forecasting, let’s set the stage on cash flow forecasting, why it’s important and whose roles encompass managing strategies and decisions related to this crucial function.

A refresher on cash flow forecasting

Cash flow forecast definition

The standard definition of a cash flow forecast is an attempt to estimate the amount of cash that will be coming in and going out of a business—or fund—to predict future cash balances. Cash flow forecasting models for LPs were traditionally built using a simple J curve, but present day LPs are eager to incorporate more modern tactics. However, the historical data, statistical analysis and probability simulations necessary for more robust modeling can be difficult to come by. Many allocators use a template to create their cash flow models, either built in-house or purchased from a third party, and most take shape as an Excel document that can be updated monthly, quarterly and/or annually.

Why is cash flow forecasting important?

Cash flow forecasting is important because it helps LPs navigate a fundamental issue they all face—finding the right balance between the amount of cash kept on hand to avoid capital call defaults and avoiding unnecessary capital allocations to low-return, liquid assets. LPs need to know, at any point in the future, how much is likely to be needed to fund capital commitments. If they do it right, they can plan out their future fund commitments, so that eventually the winding down fund distributions will pay for the newer funds’ capital calls.

Effective cash flow forecasting models empower LPs to make more accurate predictions about capital call timing and amounts, paving the way for fewer missteps and reducing exposure to less-than-ideal returns.

How to forecast cash flow

Many LPs will create rough models to estimate how their fund commitments will be called down and how the capital will come back. They assume about 20% per year will be called down from a fund, the fund will start giving back capital around years four or five, and the rate will increase beyond that before declining in the last few years of the fund. This back-of-the-envelope approach to modeling can feel about right, but it’s not driven by real data. To truly understand an entire portfolio cash flow scenario, LPs need their models to reflect nuance. Layering in new fund commitments adds complexity and requires a different model altogether, a commitment pacing model. These rough models and the third-party, black-box solutions that spit out unscientific projections and recommendations are why PitchBook is launching its latest feature, which we’ll dive into further below.

Who is responsible for cash flow forecasting?

In the private markets, limited partners are often the professionals at the helm of generating actionable cash flow forecasting models. It can be a highly collaborative process too though, involving input and insight from a firm’s VP, analysts, associate directors and others. For a variety of reasons, some firms choose to outsource their cash flow forecasting needs to external service providers. Those service providers may include LP consultants, financing advisories and investor relations teams at investment banks.

What is commitment pacing?

Commitment pacing is the process by which LPs, and all allocators, plan out future investments in funds with the goal of maintaining allocation targets—part of an overarching investment strategy that balances opportunity and risk.

Closely related to cash flow modeling, commitment pacing aims to balance timing expectations for reaching and maintaining the target vintage year diversification and setting a realistic target allocation that moves the needle on performance/risk but does not lead to undue cash management stress from capital calls and illiquidity. By creating successful commitment pacing models—used in tandem with cash flow forecasting models—LPs can be more data-informed in their pursuit of reaching target allocations and diligently planning future commitments.

Introducing Portfolio Forecasting from PitchBook

The roadblocks LPs experience when they set out to make allocation decisions, the pressure they’re under to get it right, and the current market conditions, all speak to the need for more robust cash flow forecasting software solutions.

That’s where Portfolio Forecasting from PitchBook comes in.

What is Portfolio Forecasting?

Portfolio Forecasting is a PitchBook Platform tool designed to anticipate and model portfolio and commitment pacing data. The tool uses a top-down approach to cash flow forecasting models and commitment pacing to help clients determine a pace for deploying capital through fund commitments to reach a target allocation and forecast cash flow profiles.

Originally built as custom cash flow forecasting models for individual PitchBook clients looking for one-off support, our research and product teams are pleased to launch a more broad and accessible iteration—Portfolio Forecasting. This new feature empowers all of our clients to make informed allocation decisions leveraging forecast and scenario analysis models built on historic cash flow data and with our in-house methodology.

What are the benefits of Portfolio Forecasting for LPs and other allocators?

Simply put, this feature streamlines the entire cash flow forecast modeling and commitment pacing process for LPs and other professionals making allocation decisions. It paves the way for efficient cash flow management, more allocation targets hit and more strategic liquidity events.

More specifically, with Portfolio Forecasting, LPs can:

• Quickly and easily leverage PitchBook’s models and and customize to their needs
• Incorporate data and visualizations into their cash flow modeling
• Accurately forecast their cash flows and pace their commitments
• Plan and maintain an allocation strategy for existing portfolios
• Understand where to focus future commitments to meet allocation targets
• Minimize and monitor liquidity risk due to outsized capital calls

How does Portfolio Forecasting help LPs build better cash flow forecasting models?

Traditional approaches to cash flow modeling use J-curve analyses, and sometimes historical data—if the LP has access to it—to account for variables in private market funds. Effective cash flow modeling is vital for LPs, who rely on their knowledge of cash flow patterns to better plan for capital calls and distributions while maximizing returns.

The issue with more conventional attempts to model cash flows is that a straightforward J-curve cannot account for the nuances intrinsic to private market funds. Like a house built on shaky foundation, LPs who build their understanding of cash flow patterns on imperfect J-curve data aren’t always set up for longer-term success.

Portfolio Forecasting pairs our platform’s industry-leading historical data and a new cash flow methodology developed by the PitchBook team so that LPs can more accurately and efficiently create and manage their cash flow models. Take that, traditional, non-data-informed J-curve.

Additionally, Portfolio Forecasting allows PitchBook clients to upload fund commitments, set commitment pacing and generate cash flow analytics. Importantly, users of the platform can adjust cash flow forecasts and set commitment pacing schedules based on average NAV profiles to better manage their cash, increase returns and minimize risk.

Q&A: Portfolio Forecasting with PitchBook’s Zane Carmean and Kristina Linova

Lead Quantitative Research Analyst Zane Carmean, part of PitchBook’s Institutional Research Group, was instrumental in the development of the platform’s new Portfolio Forecasting offerings. In this Q&A with Zane and Senior Product Manager Kristina Linova, we aim to go beyond what the new functionality provides and into the why.

When it comes to cash flow forecasting models, what are the biggest pain points facing allocators?

Zane Carmean: If you’re an allocator looking to build an allocation for a private market investment, it’s tough. Usually it takes several years after you make a commitment to a private fund for it to actually be put to work, and then you may not know the timing of the capital calls or when you’ll see distributions back. On top of that, you’re trying to look at your portfolio holistically—so you’re comparing your private market portfolio to your public one. Maintaining an allocation while private markets are slow to move valuations compared to publicly traded assets makes the private fund allocation experience as much an art as it is a science. For allocators who have never experienced the denominator effect like many are now, thinking about how they want to set up their commitment schedules can be tough. Striking that balance between how to manage your allocation, and then setting expectations for cash coming in and cash going out—that’s a challenge.

How are cash flow forecasting models impacted by irregular markets like what we’re currently experiencing? What utility does it serve in these types of markets?

Zane: For the cash flow forecasting component, we’re just looking at historical data without a view on the cyclicality of those cash flow profiles. We’ve smoothed out the impacts of a downturn and the upcycle, so the advantage there is that we get to look at profile historically, the average across time horizons. The caveat is if you want to really stress test a particular scenario, it’s a bit tougher without making some manual inputs to the upload itself within the platform on the commitment pacing side.

Early in 2022, when we were having these conversations with clients, some would argue distribution profiles are too slow and the capital call rates were too low—but now six months later, it’s gone in reverse. As a long-term allocator, thinking five-to-ten years in the future is a better way to do it than trying to use market time and basing your cash flow forecast on the environment that you think that you’re going to be in a year from now.

Many LPs build their cash flow models in house or use LP consultants, why did PitchBook decide to build a Portfolio Forecasting tool for clients?

Kristina Linova: We realized cash flow forecasting issues are common in the institutional investor space, and there weren’t any players that have truly solved for this. So we saw a gap, and we knew that PitchBook’s historical cash flow data, institutional research, plus the product capabilities are our differentiators and would allow us to compete in that space and potentially solve those problems.

How did PitchBook go about building the methodology for this tool, and how is it different to existing models, like the Yale model developed by Dean Takahashi and Seth Alexander?

Zane: We are using our historical fund data, which allows us to make projections more grounded in reality. Normally, when looking at any one fund individually, there’s a lot of idiosyncrasy to it, but what we can do is kind of average those fund profiles, with profiles across many years, across funds over time, to generate more or less what an average profile looks like.

From there we can do a lot of manipulations to it, we can really peel back layers as far as what funds underpin those cash flow profiles. We can then look at cash flow profiles within different strategies.

What are some of the primary ways you envision allocators might incorporate the Portfolio Forecasting tool into their workflows?

Kristina: Based on the allocation workflows we saw, our primary goal was to create a tool for capital allocators—something that would allow them to build and manage better private fund portfolios. The drawdown structure of these vehicles makes reaching and maintaining target allocations an uncertain exercise. It takes time to get money into the strategies, as you wait for fund managers to call capital for investment. And then as capital is returned through distributions it needs to be redeployed into new commitments. LPs needs to know how much cash they should expect to commit year-to-year to not under- or overshoot their allocation targets and what their cash flow profile forecast may look like.

Our Portfolio Forecasting tool is now available to PitchBook clients. Is there anything you’re particularly excited about in terms of the tool’s longer-term future?

Zane: I’m looking forward to expanding on the initial product release. For example, I know clients will want more inputs—like being able to model management fees, leverage assumptions and stress-test a market environment where, for example, everything falls between 20% and volatility rises 50%. What we’ve released to date is a noteworthy starting point and can address our clients’ most common use cases, and we can build on top of that in the future.

Kristina: We have a healthy roadmap of opportunities based on client-generated feedback. I’m looking forward to using that feedback combined with findings from usage analytics to iterate on the tool. We’ll be implementing a mix of features we have already identified as potential opportunities, like portfolio sharing, collaboration and additional forecast insights, along with improvements that emerge through our data and qualitative metrics.

Best practices for cash flow forecasting models webinar

On October 20, 2022, Lead Analyst Hilary Wiek and Zane Carmean, who was featured in this Q&A, hosted a webinar on cash flow modeling. During that discussion, they also went into detail on Portfolio Forecasting methodologies, data and best practices. Watch the full recording below.