Building and Maintaining a Private Market Portfolio: Inroduction to Private Market Portfolio Management
Private market investments are a core tenet of CTC Consulting’s strategic allocation policy for clientsseeking to build lasting wealth. The private market asset class is unique not only in the investmentopportunities it offers, but also in the process and mindset required to manage a portfolio of these fundcommitments. What follows is an introductory guide to private market portfolio management. The goalof this paper is to provide a basic education on the cash flow characteristics of private market funds,explore why reaching and maintaining a target allocation is an ongoing long-term process anddemonstrate the importance of committing capital to the asset class consistently over time to build awell-diversified portfolio.Private market investing is driven by consistency and patience. Through a recession characterized byvolatility, uncertainty and a fear of illiquidity, investors have struggled to maintain a disciplined level ofprivate market investment. Over the past two years, many investors chose to “wait out” the downturnand indefinitely avoid illiquid investments. This behavior has the potential to present multiple longlasting negative consequences pertaining to portfolio performance and risk, most notably theabandonment of vintage year diversification. Somewhat ironically, by freezing private marketallocations under the guise of fiduciary prudence, investors are in fact acting imprudently. Not only willpotentially better performing recessionary vintage years funds be an opportunity lost, but thecommitment gap will also significantly delay investors in reaching the goal of a self-funding portfolio.1Only by sustaining a steady pace of new commitments can investors reach and maintain their targetprivate market allocation while diversifying the portfolio by vintage year and private market strategy.Before discussing private market portfolio management, it is important to understand the structure andcash flow characteristics of private market funds.2 In a private market fund, Limited Partners (“LPs”)make an upfront commitment to invest a specific dollar amount into an illiquid partnership. Theentirety of the principal amount committed to the fund is not transferred upfront as is the case withmost traditional (long-only equity and fixed income) and hedge fund investments. Rather, it is typically“called down” incrementally by the fund manager over a term of 10-12 years as needed to makeinvestments in portfolio companies and to pay fees and expenses. The majority of capital is calledduring a pre-defined “investment period,” which generally consists of the first 3-6 years of thepartnership. Capital is then returned to LPs in the form of distributions generated from investmentexits, dividends, recapitalizations and other income.Below is an example showing the expected cash flows, driven by calls and distributions, for a $10 millioncommitment to a private equity fund with a 12-year term.31 Self-funding: When the annual fund distributions received are, at a minimum, sufficient to meet all capital callsfor the corresponding year.2 Private market funds include private equity (buyout, venture capital and special situations), private real estateand private tangible assets (energy, commodities (ex-energy), infrastructure).3 This hypothetical model investment represents a net IRR of 10.7% and a TVPI of 1.65x. TVPI = Total Value to Paid-in Capital, or (NAV + distributions)/contributions. For example, 1.65x represents a 65% cumulative return.
Figure 1 - Model Private Equity Fund Annual Cash Flows $12,000,000 $10,000,000 $8,000,000 $6,000,000 $4,000,000 $2,000,000 $0 1 2 3 4 5 6 7 8 9 10 11 12 ($2,000,000) ($4,000,000) ($6,000,000) J-Curve ($8,000,000) Year in Fund Life Contributions Distributions Annual Net Cash Flow End of Period NAV Total Net Cash FlowWhen analyzing Figure 1, it becomes clear why private market portfolios need to be evaluated from along-term perspective. For instance, the point at which the LP is most exposed to the underlyinginvestments does not occur until the sixth year of the fund’s life. Exposure, measured by net asset value(“NAV”), is achieved as managers deploy capital and reflects any change in the value of underlyinginvestments. This example underscores the difficulties investors encounter when reacting to short-termmarket dynamics by attempting to rapidly acquire private market exposure. In other words, once theinvestment community takes note of the attractive current performance of private market funds it isoften already too late to participate in the upside. Funds issue capital calls for new investmentsthroughout the three- to six-year investment period, generally with multi-year holding periods.Consequently, the environment into which an LP is committing capital is not necessarily representativeof the environment during which the fund will invest or provide maximum private market exposure.In Figure 1, the blue dashed line (total net cash flow) is labeled “J-Curve.” J-Curve is a term used toillustrate the tendency of private market funds to exhibit negative cash flows in their early years ascapital is called while few distributions are expected. In the later years, capital calls diminish and a fundwill accumulate positive net cash flows4 as it exits investments and distributes capital to LPs. Chartingthe net cash flows over the life of the fund produces a line resembling the letter “J,” hence the term J-Curve.This graph illustrates another salient point of private market investing: making a $10 millioncommitment is not the same as achieving $10 million in private market exposure. In fact, there are onlythree years of the 12-year fund life where the exposure from this fund is at or above the commitmentamount. Over 12 years, the average exposure is just 53.1% of the total commitment, or $5.31 million inthe case of Figure 1. Excluding years 11-12, when there is typically very little remaining value, averageexposure is still just 63.6%.4 Assuming the fund produces a positive net return.
As a result, to be “fully exposed” to private markets, it is necessary to look beyond the commitmentamount and adjust commitment levels to account for the actual underlying exposure which is attained.In essence, LPs need to commit a greater amount to the asset class than it appears would be called forby their strategic allocation. This approach is often referred to in private markets as an “over-commitment” strategy. In most situations, the term over-commitment is used interchangeably withover-allocation. However, within a private market context, when looking at new commitments over afive-year period, it is necessary to commit a larger percent of the total portfolio than the investmentpolicy target allocation would suggest. Specifically, if the strategic allocation is 15%, one shouldgenerally commit 10-40%5 more than this amount over the subsequent five years to sustain the targetallocation, as shown in Figure 2. This five-year allocation target is referred to as the “target exposure” inthe CTC Implementation Plan.6 Figure 2 - "At Allocation" Portfolio: Annual Commitments As % of Total Portfolio Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Average 5-Yr Total Target Over-Commit 3.6% 3.5% 3.6% 3.6% 3.5% 3.6% 17.8% 15.0% 1.19xFigure 2 represents a sample client with a strategic private market allocation of 15.0%, who is currentlyat this target after ten years of following a consistent annual investment pace. It shows the client’srecommended total annual private market commitment in each of the next five years as a percentage oftheir total portfolio at the beginning of the respective year. Over the next five years, the sample clientwould commit approximately 17.8% of the respective total portfolio value to new private market fundinvestments in order to maintain the strategic allocation of 15.0%. To quantify over-commitment, takethe five-year total and divide by the strategic allocation, or 17.8%/15.0% in this example. For the “atallocation”7 portfolio shown here, the recommended over-commitment would be roughly 1.2x theirstrategic target.So how is the correct over-commitment amount determined? This “right-sizing” of the commitmentamount is generated from CTC’s proprietary implementation model,8 which predicts the cash flowactivity of various private market asset classes. As noted, the purpose of the model is to create a roadmap that assists CTC clients in reaching and/or maintaining their target allocation through a diversifiedprivate market portfolio.When analyzing private market exposure within an investor’s total portfolio, there is no such thing as ashort-term allocation decision. The effects of decisions made today have little impact initially but5 Will vary based on portfolio assumptions.6 The CTC Implementation Plan is a presentation produced for clients to serve as a road map to reaching theirprivate market allocation. It includes annual recommended private market commitments by strategy and amountbased on analysis of the current portfolio and assumptions from the Investment Policy Statement.7 An “at allocation” private markets portfolio is one where the current private markets portfolio value as apercentage of the total client portfolio equals the strategic allocation.8 Uses the “Yale Model” as a framework, developed and customized by CTC Private Markets Group. CTC’sproprietary customized model is the source of all modeling done in this paper. The Yale Model paper wasoriginally published by Dean Takahashi & Seth Alexander of Yale University in 2001.
amplify over a longer period of time. For example, let’s look at an investor who forgoes making aprivate market commitment in order to increase short-term liquidity. This decision will actually havevery little effect on cash flows during the time in which it is intended. Referencing Figure 1, only 16.1%and 13.5% of the fund commitment would actually be called in the first and second years, respectively.The increase in liquidity resulting from a foregone commitment would be more pronounced in yearsthree and four, when a total of 39.9% of the fund commitment would be called. With roughly 16% ofthe commitment being called in year one, there is a limited benefit to curtailing new commitments forinvestors looking to maximize short-term liquidity.While some investors might be glad to have their immediate cash flow obligations slightly reduced,doing so is likely to create challenges in future years if the goal is to ultimately create a diversified self-funding portfolio. As a result, investors could be forced to utilize capital from liquid strategies to meetcapital calls. In addition, a commitment gap puts at risk the benefits produced through vintage yeardiversification. Because performance has historically been greatest for fund investments made duringtimes of uncertainty, investors risk foregoing commitments during the most attractive vintage years. Tomitigate this effect, those with liquidity concerns would be much better off reducing commitment levelsduring uncertain periods rather than cutting them off completely.The following sections present two scenarios which aid in the understanding of why it is crucial toadhere to a consistent private market commitment pace.9 The two scenarios contrast a matureportfolio at its strategic allocation with a portfolio with no previous private market investmentsattempting to build exposure for the first time. In the first section, we will demonstrate that cutting offcommitments for two years leads to a private market portfolio which is below its strategic allocation andseverely delayed in reaching a self-funding state. In the latter section, we will show why it is crucial tobe patient and consistent with commitments in order to build out a new private market portfolio.Portfolio at Strategic AllocationFor a diversified private market portfolio at its strategic allocation, the hard work has already beendone. As illustrated by Figure 5 in the following section, it takes years to properly attain this allocation.However, once the strategic allocation is met, unlike other asset classes, an investor must continue tomake new investments in the form of additional private market fund commitments. New commitmentsare necessary because as distributions are made, the private market portfolio NAV will decline. Capitalcalls from newer commitments are intended to replace this exposure, but if no new investments aremade, then exposure will decline. Further, as discussed below, a commitment gap will also result in areduction of future distributions and create cash flow imbalances. For these reasons, a private marketportfolio which deviates significantly from its recommended commitment levels can have long-termnegative consequences on the overall portfolio allocations.109 Assumptions: 1) 15.0% target allocation to private markets; 2) 6.0% net after tax growth rate for non-privatemarkets portfolio; 3) current short- and long-term assumptions used for private markets with regard to returnsand cash flow expectations based on CTC’s proprietary implementation plan.10 Similar to a portfolio at allocation, over-allocated portfolios also need to continue making new commitments.
Below we see an example of a mature diversified portfolio which reaches its target allocation at timezero (“t0”). In this instance, “Yr 4” in Figure 3, for example, would represent the fourth year after t0. Theorange line represents adherence to the model-based commitment recommendations. The green linerepresents an investor who makes no private market commitments in years one or two after obtainingthe target allocation at t0 and then follows the model-based recommendations starting in year three.The blue line represents the target allocation, which is static at 15.0%.Figure 3 illustrates how making no new commitments for just two years can have significant effects onallocations. In this case, even when following the recommended commitment pace after year two, thecommitment gap creates a private market portfolio which will take more than eight years to rebalanceand at its low will be approximately 30.0% below its strategic allocation. Figure 3 - Private Market Allocation For Portfolio "At Allocation" In t011 20.0% Private Market Allocation 15.0% 10.0% 5.0% 0.0% Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Strategic Portfolio Allocation Model-Based Investing No Commitments Years 1-2, Model-Based Investing Years 3-10The consequences that the commitment gap has on cash flows are shown in Figure 4. The blue and redbars show the net annual cash flows for the portfolios shown in Figure 3. Instead of having a self-funding private market portfolio, skipping two years creates a portfolio that will later require somecapital calls to be funded from the investor’s liquid portfolio. While the model-based commitment pacemaintains a self-funding portfolio, the portfolio that made no new commitments in years one and twowill produce negative cash flows in years eight through ten. The negative cash flows occur because thecapital calls in years eight, nine and ten would likely have been paid in part with the distributions fromfund commitments made in years one and two. Since these private market commitments did not occur,there is a shortage of distributions with which to pay capital calls. 1111 Due to structure of CTC Implementation Model, precise full data not available in years one and two.
Figure 4 - Annual Net Private Market Cash Flow For Portfolio "At Allocation" In t 012 Net Cash Flow As % of Total Investor Portfolio 2.0% 1.5% 1.0% 0.5% 0.0% Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 -0.5% -1.0% Model-Based Investing No Commitments Years 1-2, Model-Based Investing Years 3-10 12New PortfolioFor those more familiar with the public markets, it is a common misperception that private marketexposure can be quickly attained. In the public markets, one could theoretically increase a portfolio’slarge cap equity exposure, for example, from 0% to 15% in one day by purchasing shares in the openmarket. This quick tactical change in exposure simply cannot be done in the private markets. Instead,the focus should be building a portfolio over several years to reach a long-term strategic allocation.In Figure 5, an investor with no private market exposure decides to develop a diversified portfolio.Following the model-recommended commitments, it takes 9.5 years to reach the investor’s 15% targetallocation. Also visible is the rate at which private market exposure can be increased. During yearsthree to eight when exposure is growing most rapidly, the private market allocation increases by anaverage of 2.01% per year, with a peak of 2.35% in both years five and six. Figure 5 - Building a New Private Market Portfolio $100 16% $90 14% $80 Private Market Allocation 12% $70 Value (millions) 10% $60 $50 8% $40 6% $30 4% $20 2% $10 $0 0% Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Yr 11 Target Private Market Value Model-Based Private Market Value Target Private Market % Model-Based Private Market %12 Due to structure of CTC Implementation Model, precise full data not available in years one and two.
Patience is clearly a crucial requirement in building a self-funding portfolio from scratch. As shownbelow in Figure 6, this private market portfolio does not become cash flow positive until the tenth yearof the program. Once the portfolio becomes net cash flow positive, or self-funding, in year ten, it willcontinue to be in perpetuity if the model-based commitments are adhered to.13While not the focus of this paper, secondary funds have historically provided an avenue to reach thestrategic allocation for a new private market portfolio in a shorter timeframe. These funds purchaseinterests in existing funds across a broad range of previous vintage years. This essentially provides back-dated exposure that could not be attained otherwise, allowing investors to get a jump start on buildingout their private market portfolio. Figure 6 - Annual Net Private Market Cash Flow For New Portfolio 1.00% Net Cash Flow As % of Total Investor Portfolio 0.50% 0.00% Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Yr 11 -0.50% -1.00% -1.50% -2.00% -2.50%In managing a private market portfolio, investors need to consider the following points: In private markets, there is no such thing as a short-term allocation decision as it takes years to increase or reduce exposure to this asset class. A $10 million commitment is far different than gaining $10 million of private markets exposure – the commitment is called over several years, with the average exposure over the first ten years of a fund’s life approximately 65% of the original commitment. Over-commitment, in private market terminology, does not mean over-allocating to the asset class. Rather, in order to reach their strategic allocation, investors must commit an amount over a five-year period which in aggregate is greater than the strategic allocation.13 Assuming that the portfolio assumptions as determined in the Investment Policy Statement and the CTCimplementation model hold true.
In CTC’s opinion, the best way to create a properly allocated and diversified private market portfolio is through a consistent annual investment program. While implementation can be challenging in terms of managing cash flows and exposure, it is extremely critical that discipline is maintained through various economic environments. Waiting long periods between commitments can have long-lasting negative effects on portfolio allocation and cash flows.The conclusions stated above are crucial for investors who want to build a diversified, self-fundingprivate market portfolio and maintain an allocation as close as possible to their target. These investorsmust make the decision to be patient, consistent and look past short-term market trends towards thelong-term goal.By Brooke Pollack, CTC Private Markets Research Analyst
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