Read this article and learn about:
- The challenges of forecasting cash-flows
- The perils of relying on Excel
- How to harmonize liquid and illiquid management
- The need for IT solutions that allow institutions to safely manage substantial allocations to illiquid assets
Thomas Meyer, LDS Partners
In the second part of a two article series, we look at cash-flow forecasting and the challenge of marrying liquid and illiquid assets in a multi-asset investment management system.
Financial regulators tend to view private equity through the prism of tradable assets and follow approaches suitable for liquid markets. For instance, much focus is placed on valuations, to the detriment of commercially more pertinent concerns – such as the proper quantification of risks, strategic asset allocation and asset liability management. For the vast majority of the private equity industry, we are dealing with non-tradable assets where investors face great uncertainty with regards to the timing and amounts of cash-flows.
Investors in private equity rarely, if ever, get into problems because of declining valuations but because the cash-flows were not in line with expectations and liquidity requirements thus not met. That lies in the nature of limited partnership funds where not everything which is committed to a fund is immediately invested. Here, the timing and size of capital calls, or so-called contributions, on committed capital are unknowable in advance. In times of market crisis, capital calls slow substantially but distributions of funds in their disinvestment period tend to fall even faster as exit markets are closing.
A further difficulty is that investment limits (i.e. 10% allocation to private equity, 20% to hedge funds, 10% to real estate, etc.) are at the center of regulators’ attention and an integral part of an institutional investor’s prudential apparatus. This is hard enough for liquid assets but causes additional headaches for illiquid assets where portfolios cannot be changed or only at prohibitive costs. Practically, the focus in portfolio and risk management moves from precise pricing, in order to transact, to planning ahead within given tolerances.
Private equity investors need to find solutions to forecast cash-flows, NAVs exposure and impact on the P&L within a two to five year horizon. This is not trivial and, in fact, there is some skepticism as to whether such solutions do work or even if they work at all. The common perception is that nothing is sufficiently reliable and proven to work. However, this often comes down to unrealistic expectations regarding the trade-off between precision and level of confidence of forecasts, often confusing the purpose for which forecasts are to be used. One main user group is responsible for treasury management and is primarily interested in tactical cash-flow forecasting, i.e. over the short-term and a high level of precision. Statistical models require a high level of diversification and therefore are of little use for this purpose; instead, tactical cash-flow forecasting turns into a data collection exercise (mainly contacting fund managers) in order to provide the necessary precision – something that in any case is only valid over short time horizons.
This contrasts with what could be called strategic cash-flow forecasting where a regular and systematic collection of such data would overwhelm any organization. Instead, strategic cash-flow forecasting aims to provide guidance over longer time horizons, which can only be done based on statistical modelling.
Organizations new to the private equity world are faced with a Catch-22 situation: the initially limited allocation to the asset class does not justify a high IT budget while lack of suitable IT tools make them shy away from larger allocations. The treatment of traditional assets is the template for financial regulation, strategic asset allocation (dominated by tradable assets), methodologies, processes, and, as a result, for IT systems. Private equity is viewed as a troublesome exception and many institutions feel that dealing with its specifics and implications resembles the tail wagging the dog. In order to address private equity specifics in an apparently pragmatic manner, staff quickly start developing smaller (and larger) Excel spreadsheets.