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Investing in Private Equity – Capital Commitment Considerations

Journal 34: Cass-Capco Institute Paper Series on Risk

Sameer Jain

This paper explores capital commitment and cash-flow management issues in private equity fund investing. It provides a theoretical framework to structure private equity capital commitment issues in a formal manner, and defines variables, inter-relationships, and boundaries in such a way that the problem can be worked upon. The paper’s findings suggest that achieving a targeted level of allocation to private equity is a function of the pace of capital deployment as well as dependent upon the desired amount of targeted exposure. It is also dependent on the spread of realized re-turns in private equity versus other asset classes, as well as on timing and realization periods for capital already invested.

Private equity fundraising and deployment is referred to as making “commitments” because not all funding is made available immediately to the fund vehicle. Rather, funds are called up as projects covered by the private equity vehicle’s mandate become available. When committing to a private equity fund, the commitment is typically to provide cash to the fund on short notice from the general partner. General partners of a fund draw down capital from the limited partners as and when they make investments. General partners call down capital only as they require it, rather than in preset amounts according to a rigid timetable. If an investor fails to fund a capital call from a fund when due, the fund may exercise various remedies with respect to such investors to forfeit, or sell, all or a portion, of its interest in the fund or require that the investor immediately pay up the full amount of their remaining capital commitment.

Investors are typically required to fund only a small percentage of their total capital commitment at the outset. This initial funding is followed by subsequent capital draw-downs (the timing and size of which are generally made known to the investor a few days in advance), as needed by the fund to make new investments. Just-in-time draw-downs are used to minimize the amount of time that a fund holds uninvested cash, which is a drag on fund performance.

All of this introduces uncertainty in the cash flows of private equity investments. The unpredictability of cash flows applies to both capital calls, which the investor must fulfill at earlier stages, and distributions to the investor at later stages. In both cases the amount and timing of cash flows is at the discretion of the fund manager. Hence, the importance of carefully considering cash flow needs in portfolios and planning for commitments that have already been made.

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