Unfunded commitments are a staple of private equity; for many registered PE funds this means cash drag and/or over-commitment.
The pace at which capital is called from unfunded commitments can be modeled, but is highly variable and dependent on market conditions.
An unfunded commitment isn’t leverage, but like leverage, defaulting on an unfunded commitment has an asymmetric downside.
Just as it limits the use of leverage, the SEC may (and should) limit the use of unfunded commitments by registered funds.
Registered PE funds need a structural solution to eliminate cash drag without over-commitment and the SEC may soon put that solution within reach.
Unfunded Commitments, Cash Drag and Over-Commitment
Given the extended identification and due diligence processes for private market assets, as well as their illiquid nature, episodic availability and the complexity associated with purchasing such assets, institutional private equity investors typically entrust the timing of private market transactions to fund sponsors (i.e. general partners) with the requisite knowledge and experience to make informed decisions regarding investing in private companies. Thus, most private equity funds (aka "vintage" funds) are subscribed via an unfunded capital commitment to be called over a defined, variable investment period. The capital commitment is funded by the institutional investor over time in response to calls from the PE vintage fund, and capital is returned to the institutional investor by the vintage fund when an investment is harvested. On average over the 15 year life span of a typical vintage fund, given the peaks and troughs of its capital use, only 30% - 50% of the committed capital is deployed.
In contrast to vintage funds, some private equity fund of funds targeted for use by individual investors have been structured as evergreen funds. Evergreen funds engage in continuous, simultaneous fund raising, investment and harvesting. The evergreen fund makes multiple private equity investments, including in underlying vintage funds, on an on-going basis, blending their diverse cycles of capital use and return. An individual's investment in an evergreen fund is fully funded by the investor at the time of share purchase/subscription. As a consequence, a PE fund of funds structured as an evergreen fund must maintain an amount of liquid assets adequate to meet potential capital calls from underlying vintage funds. While liquid assets can take many forms, most evergreen funds have generally left liquid assets in cash and cash equivalents to avoid incurring investment risk other than that associated with the "headline" private equity investment strategy. Significant balances of cash and cash equivalents held by PE funds of funds will dampen the return generated by underlying PE vintage funds, reducing the benefit of PE investments and creating "cash drag."
As a tool to reduce their liquid assets on hand and the resulting cash drag, PE evergreen funds of funds have employed an "over-commitment" strategy, which entails making unfunded commitments in excess of the assets available within the evergreen fund to meet the commitments. The success of this approach depends on the ability of the PE fund of funds to align the capital use cycles of the underlying vintage funds in which they invest, so that the peak capital use of some vintage funds corresponds to the lowest capital use of other vintage funds.
Capital Call Models and Market Conditions
Institutional PE investors have harvested massive amounts of data regarding the historical use and associated timing of capital called and returned by many private equity general partners, including the most prominent and many smaller players. Using this historical data and the distribution of their capital commitments to specific underlying funds of specific vintages in their portfolio, experienced institutional PE investors can model the calls expected to be issued by underlying funds drawing capital against their commitment.
There are a number of factors that impact any capital call model. Among these factors are:
- the distribution of unfunded commitments across vintage years,
- the rate at which capital is called against the commitments,
- the rate at which capital is returned, allowing the capital to be re-applied to a subsequent call, and
- the percentage of the unfunded commitment that will ultimately be called in aggregate.
To illustrate the impact of these factors, I've developed a simple model of an evergreen private equity fund of funds. In this model, the PE fund of funds allocates $1M in unfunded commitments spread over 15 vintage years and, when a vintage year ages off, it's replaced with a same size commitment to a new vintage. I've evaluated the model under three scenarios, using three distributions of unfunded commitments across vintage years (see Fig. 1), two capital call schedules with one capital return schedule (see Fig. 2), and three levels of aggregate unfunded commitment called (Table 1).
Source: Author's model data assumptions
Source: Author's model data assumptions
Table 1 - Pct. Of Unfunded Commitments Called in Aggregate
Sc. 1 - Typical Capital Called
Sc. 2 - More Capital Called
Sc. 3 - Most Capital Called
Source: Author's model data assumptions
As one would expect, this simple model shows how these factors interact to impact the expected concentration and size of capital calls (see Figs. 3 and 4). In Scenario 1, a relatively smooth allocation of commitments to vintages, of which 85% of the commitment is called in aggregate, results in consistent capital calls year after year, of approximately 20% of currently unfunded commitments. In Scenarios 2 and 3, concentrations of unfunded commitments and a more condensed call schedule create peaks and troughs of expected capital calls.
Source: Created by the Author's model using the data in Figs. 1,2 and Table 1
Source: Created by the Author's model using the data in Figs. 1,2 and Table 1
In a quiescent market, the Scenario 1 capital calls would be funded with available liquid assets corresponding to approximately 18-20% of then currently unfunded commitments. Stated differently, unfunded commitments corresponding to 500% - 550% of the available liquid assets could be supported. Under comparable market conditions, Scenario 2, a more concentrated set of unfunded commitments with a greater expected aggregate call amount, might require available liquid assets of approximately 25-30% of then currently unfunded commitments (i.e , unfunded commitments corresponding to 333% - 400% of the available liquid assets could be supported.) Finally, Scenario 3, the scenario with the most concentrated unfunded commitments and greatest expected aggregate call amount, might require available liquid assets of as much as 60% of the currently unfunded commitments (i.e. unfunded commitments corresponding to 165% of available liquid assets could be supported).
Of course, in each scenario, available liquid assets should exclude assets expected to be applied to fund operating expenses, as well as any liquidated gains awaiting an IRS required distribution.
A market distortion could significantly impact these scenarios, possibly resulting in an underlying fund drawing more rapidly on unfunded commitments and reflected in greater than expected capital call amounts. It's important to note that such a market distortion could be created by negative (e.g. portfolio companies needing more capital to survive) or positive (e.g. having more/larger than anticipated investment opportunities) market conditions impacting underlying funds. Thus, like a long term weather forecast, there are limits to the predictive value of any capital call and return model. Just as coastal homes should be built to withstand hurricanes, a PE fund of fund's capital model and unfunded commitments should be constructed to survive potential market distortions that could occur more than once within the 15 year life of a typical PE vintage. This means planning to have access to a greater amount of liquid assets than the model would otherwise require.
Not Leverage, but with an Asymmetric Risk of Default
Section 18 of the Investment Company Act of 1940 provides well defined limits for the use of leverage by registered investment companies. These limits were instituted to protect investors from the potential downsides of extensive leverage, including the acceleration/magnification of losses and the potential forfeiture of assets resulting from a default. Over time, the investment community has found ways around the '40 Act limitations on leverage, primarily through the use of cash settled, derivative instruments. In 2015, the SEC attempted to address and limit use of the embedded leverage associated with derivatives through proposed Rule 18f-4. Within that proposed rule, the SEC also addressed what they referred to as "Financial Commitment Transactions", aka unfunded commitments. At that time, many respondents to the proposal explained that Financial Commitment Transactions should not be governed by Section 18 leverage restrictions, as such transactions are not a form of leverage, given that they entail no borrowing and don't accelerate gains or losses. The SEC ultimately accepted these explanations and, primarily due to the on-going debate around the method by which derivative exposure should be measured, Rule 18f-4 (as proposed in December 2015) was not enacted by the SEC.
Despite the SEC's agreement that unfunded commitments are not a form of leverage, it's important to keep in mind that in one significant aspect, the use of leverage and the use of unfunded commitments have a common downside: asset forfeiture. When a fund borrows to create leverage, it provides the lender with assets as collateral against the loan. If the fund defaults on the loan, the lender may claim the collateral. When an investing PE fund of funds defaults on a capital commitment to an underlying fund, the underlying fund may claim the fund of funds' partnership interest in the underlying fund (like a bank foreclosing on a homeowner who's defaulted on their mortgage, but without requiring the involvement of the courts). For example, the Model Partnership Agreement of the Institutional Limited Partner Association states that an underlying vintage fund's General Partner may "determine that the Defaulting Partner must forfeit up to 100% of its Interest in the Fund without payment or other consideration therefor." So, as it is with the excessive use of leverage, the potential downside risk of an excessive unfunded commitment is asymmetric to the potential upside reward.
The SEC is taking another look at Unfunded Commitments
Since shortly before the SEC first proposed Rule 18f-4, a number of private equity fund of fund investment companies have been launched. These funds include: the CPG Carlyle Master Fund, which invests in underlying private equity funds sponsored by Carlyle Group (CG); the Altegris KKR Master Fund, which invests in underlying funds sponsored by KKR (KKR); the Pomona Investment Fund, operated by a subsidiary of Voya Financial (VOYA); and the AMG Pantheon Master Fund, operated by a subsidiary of Affiliated Managers Group (AMG). As recently as March 2018, these funds carried significant balances of liquid assets in support of their unfunded commitments to underlying private equity funds. In most cases, these balances were held in cash or cash equivalents such as T-Bills and money market funds. As expected, these lower return assets created "cash drag", reducing overall fund returns. In their response to reduce cash drag, these PE funds of funds generally purchased additional underlying vintage fund interests with associated unfunded commitments, increasing their degree of over-commitment. Doing so had the effect of both reducing the relative size of their liquid asset balances (Fig. 5) and increasing the relative size of their unfunded commitments (Fig. 6).
Source: Annual (N-CSR), Semi-Annual (N-CSRS) and Quarterly (N-Q) filings from sec.gov
Source: Annual (N-CSR) and Semi-Annual (N-CSRS) filings from sec.gov
In November 2019, the SEC proposed a revised version of Rule 18f-4. The newly proposed version of the rule again addresses the topic of unfunded commitments. The SEC's proposal states:
"First, the proposed rule would require a fund to take into account its reasonable expectations with respect to other obligations (including any obligation with respect to senior securities or redemptions)…
Second, the proposed rule would provide that a fund may not take into account cash that may become available from the sale or disposition of any investment at a price that deviates significantly from the market value of those investments…
Finally, the proposed rule would provide that a fund may not consider cash that may become available from issuing additional equity."
The proposal goes on to note that registered funds could borrow (within the bounds of the '40 Act) to address capital sufficiency. However, as a practical matter, PE fund of funds are presented with three issues when attempting to borrow on a long term basis:
- given their illiquidity and embedded leverage employed, underlying fund interests undergo a sizable haircut (50% or more) in value when considered for use as collateral,
- given the control that general partners exercise on the underlying funds, it is difficult to provide lenders with a "perfected interest" in the collateral, which results in a further haircut, and
- the PE fund of funds would be employing leverage as a matter of necessity (not a matter of choice) and, as a result, may have difficulty identifying willing long term lenders.
It's my opinion that, just as the use of leverage is limited in the '40 Act on the basis of fund assets (i.e., a fund must have assets of at least 300% of all amounts borrowed), the SEC should limit the use of unfunded commitments on the basis of a fund's liquid assets that are available to satisfy the commitments. For example, a fund should have liquid assets corresponding to at least 40% - 50% of its unfunded commitments, which corresponds to unfunded commitments of no more that 200% - 250% of available liquid assets. By this measure, three of the funds identified in Fig. 6 would currently be out of compliance.
Structural Solution to Eliminate Cash Drag Without Over-Commitment
Given the long-term nature of PE investment, and the absolute necessity that adequate liquid assets be available in support of that investment, it would be ideal for PE evergreen fund investors to be able to select and revise their chosen liquid asset investment strategy periodically, as their individual outlooks and market conditions change. Providing this periodic choice to individual investors, will eliminate cash drag without requiring over-commitment and its attendant risk.
In December 2018, the SEC proposed Rule 12d1-4. In a nutshell, this rule would provide closed end funds (such as PE evergreen funds of funds) the flexibility that mutual funds currently enjoy with regard to investing in other mutual funds and ETFs. I've already developed and filed a pending patent on fund administration processes and technology which, when coupled with the flexibility of proposed Rule 12d1-4, will provide PE evergreen fund investors with a range of liquid investment strategies to be employed at their discretion, on their behalf.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have an equity interest in a parent of the sponsor of the Altegris KKR Commitments Master Fund.