Private Equity Asset Allocation: How to Recommit? (Digest Summary)

Private equity funds require long-term capital commitments, yet investors generally do not obtain full exposure of their targeted allocation because disinvestments begin to reduce invested capital even before the capital commitments are fully called. The investment degree (ID) is the amount of capital actually invested—which is the true exposure to private equity—and not the amount of capital commitments. The author examines three prior recommitment strategies and their shortcomings and then presents a superior alternative strategy. Using historical US private equity fund data from 1983 to 2013, he demonstrates that his strategy outperforms other recommitment strategies.

The author’s proposed recommitment approach substantially improves on prior methods in terms of the ID. In a hypothetical 50–40–10 public equity–bond–private equity portfolio, target asset allocations are reached within a few years and reasonably maintained thereafter.

The prior literature is very limited. In one article, researchers discuss a strategy that bases new commitments on distributions and uncalled capital but contemplate only a 100% private equity portfolio rather than a diversified portfolio. Cardie, Cattanach, and Kelly (Journal of Wealth Management 2000) suggest committing the entire private equity allocation to a new fund of funds every other year or half the allocation every year, which ignores any private equity positions or developments and seems to require a liquidation and reinvestment every year or every other year. Another strategy focuses on committed capital and assumes constant rates of distribution and contribution, which is not realistic. The prior approach most similar to the author’s proposal uses the same recommitment mechanism but simplistically assumes a 100% private equity portfolio.

The author’s recommitment strategy invests cash distributions in new funds each year, but the amount invested is inversely proportional to the ID. When the ID is low, a greater proportion of distributions are reinvested in new private equity funds so that the ID increases. The author adds prior commitments not drawn after six years (therefore, not expected to be drawn) to the investment pool to increase the ID further.

The recommitment strategy is essentially an ongoing multiperiod optimization—balancing overcommitment (relative to target allocation) against the risk of a portfolio liquidity shortfall. A simulation using historical data shows only one year (2003) when the ID exceeds 1.0 (i.e., capital calls exceed the targeted asset allocation, requiring additional funding) at 30%–50% overcommitment levels. This strategy would make sense to institutional investors with portfolios containing other liquid assets that might be used to cover such a temporary funding need.

Data are from Thomson Reuters’s private equity module (ThomsonONE) and include quarterly drawdowns, distributions, and net asset values for a total of 680 private equity buyout funds started between the first quarter of 1983 and the end of 2013. Reported cash flows are net of fees and costs. Constant residual values (i.e., “living dead” investments that should be liquidated) are written off and regarded as a cash inflow after a fund reaches Year 12.

The author assumes no active management strategies—investments are spread across all possible funds—and the allocation to private equity is fixed at 10%. To preserve good relationships with fund general partners, minimum annual recommitments are set at 15% of the total private equity portfolio allocation. Initial allocations are spread over four years to obtain some diversity of vintages. The initial overcommitment is set at 180% (the inverse of the 55% average ID), with rebalancing and recommitments beginning after five years. Five portfolios are simulated beginning every other year for 1983–1991. The ID reaches between 0.7 and 0.8 after the run-up period, and the IDs exhibit the expected countercyclical pattern during boom-and-bust economic cycles.

Overall, the strategy may be an improvement over prior ones, but I believe it requires more development. Although the case for investment in private equity is often believed to depend on access to top-performing funds, active strategies that target the top-performing funds are outside the scope of this research. The ID of the top-performing funds may differ from the average ID of all funds. It is unreasonable that any institutional investor will invest in every single new fund raised just so it can increase its ID.

After more than 30 years of practice, why have private equity fund managers not adapted to using capital commitments more fully? For portfolio managers, is there any relationship between ID and the returns from a fund?