Surveying the wreckage across the institutional investment landscape, the manager of a major endowment says he has come up with a new theory for the troubles that now beset private equity investors, and notably his peers at other US university endowments. With the benefit of hindsight, he says, no one paid enough attention to the risks of cash management in private equity.
Over the past decade, I have repeatedly explained the basics of the private equity industry to new employees, friends and family members. Among the most curious features of our market, these newly enlightened people discover, is the long-term ebb and flow of money between parties.
Unlike almost any other type of investment product, private equity “funds” start with nothing more than legal obligations among a diverse group of investors to send in money when it is called for. If they're lucky, they'll eventually get back more than they sent in, but this won't be apparent until possibly a decade after the birth of the fund. Talk about convoluted.
With hedge funds, by contrast, you send in your money and the manager immediately puts it to work, even if that means parking it in a money market account until the right merger-arb opportunity comes along, or whatever the strategy may be. In private equity, the limited partners are given the responsibility of minding their own cash until the cash is needed.
An outsider might assume that an LP who has committed, say, $50 million to a fund would first set aside that $50 million in a “lock box” and draw from that over the life of the investment period. But that's not how it usually works.
Sometimes LPs rely on assumptions of cash generation across the entire portfolio and plan on drawing from that pool when the capital calls come in. Many LPs make assumptions about cash distributions from existing private equity funds. Pretty much no one makes the assumption that someday asset prices will collapse around the world, dividends will halt, fixed income will break and all private equity exit activity will screech to a halt.
Models for cash management vary across the LP market, ranging from Yale's highly scientific approach to sizing and pacing commitments, to the “willy-nilly model”, employed by an unknown but evidently large percentage of the LP population.
Given the severity of the downturn, even Yale, which set forth its model for cash management in a 2001 paper called “Illiquid Alternative Asset Fund Modeling”, has found itself short of cash lately. A report on its endowment performance through June of last year shows that it had a negative 3.9 percent cash position. And that's more than a year ago.
Near the end of the paper, Yale's senior investment directors describe their model in action: “Recently, Yale considered its options in making a commitment to a new fund … Despite the seemingly large size of the commitment, the model was helpful in showing that the growth in the Endowment and future projected sales from older funds justified a significant step-up in the new fund.”
The giant commitments made during 2006 and 2007 were similarly based on projected growth rates of overall portfolios and on the assumption that private equity distributions would come in at a reasonable rate. Instead the opposite scenario unfolded, but the commitments remain outstanding, like huge monuments built in a bygone era.
My endowment source says he is sometimes frustrated at the uneasy way that private equity is made to fit within the mainstream portfolio: “We're judged based on valuation, but nobody looks at how much cash you are using or generating. It's a confusing set of metrics to try to coordinate. The valuation is independent of cash.”
He says he has spoken with endowment peers who aspire to be self-funding – in other words, who want to pay for new capital calls with incoming distributions. The problem with that, he says, is that “if you're in a programme that is growing, you by definition cannot be self-funding”.
“The risks of private equity are about the same as public equity,” says the endowment manager. “But I can show you how private equity has outperformed public equity over the past 10 years. So where's the extra risk? Finance 101 says there's no such thing as a free lunch. Now I think the risk is in the cash management. People didn't realise the level of risk that involved.”