Private Equity’s data technology puzzle – The illiquidity challenge (2/2)

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. 

Forecasting cash-flows

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.

Information technology

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.

The most dangerous software on the planet

Indeed, nearly all players in the industry are currently relying on Excel, which has been called ‘the most dangerous software on the planet’.  Spreadsheets can be very powerful, but rapidly become so complex and are handled in such a slapdash manner that no one can really follow what is happening. Inputting and maintaining data is cumbersome and leads to often severe mistakes. 

Excel applications tend to be used by only a few ‘power users’ as ease of use was not the main design priority. Nevertheless, once end-users have embarked on this route it is difficult to change tack. There is always the argument that ‘we already have a better tool in-house’, any alternative will be rejected arguing that it could not do what the available tool allegedly already does, triggering a vicious circle where budgets to improve IT are not made available because only a few are working with such systems anyway. Even system houses often went the easy route of integrating with an existing Excel-based application instead of developing a solution from scratch.

Third-party solutions to the rescue?

It is likely that the IT use in private equity will follow the same trajectory as previous applications: Excel-spreadsheets are gradually turned into in-house developments, and then these are complemented with standalone third-party solutions for alternative assets, before being finally replaced by embedded solutions that cover all assets, liquid and illiquid. 

Actually, already a number of system houses provide specific solutions for managing private equity and real assets, notably for fund administration, portfolio management, risk management, customer relationship management and data analytics. About 15 years ago – after the first boom in private equity ended with the bursting dot-com bubble – I was managing the introduction of a third-party IT system for administrating a portfolio of private equity funds. At the time, about 20 software houses – mainly start-ups – answered the tender. When repeating the exercise in 2015, the majority of these players had vanished – probably because they found the market too difficult to enter, because they struggled to survive in this quite narrow niche, or because they pivoted into other and more promising areas. As in nearly all industries what is left are a few larger players. However, so far, no integrated solutions for managing multi-asset portfolios comprising tradable as well as illiquid assets are in the offering.

Harmonizing liquid and illiquid management

In fact, the interaction of liquid and illiquid assets is particularly complex to manage and poses the greatest challenge both from a conceptual and an IT perspective. For illustration, investors with a long-term focus should have an advantage in private equity, but many increase their allocations when it is ‘hot’ and therefore expensive. During market downturns, the prices of liquid assets fall and the value of the overall portfolio shrinks. On the other hand, the NAVs reported by funds hardly change as write-downs in their valuations lag those of quoted asset classes. As a result, the percentage actually invested in illiquid assets looks much higher than the targeted allocation. This suggests that private equity assets should be sold down (in what is known as the denominator effect), in a situation which quickly becomes close-to ‘fire sale’ conditions. Investors effectively overpay when trying to sell into a secondary market where, in this situation, buyers hold all power – largely because they are bound by their own rule-book. 

Moreover, a silo-mentality where liquid and illiquid assets are dealt with by separate teams has led to a narrow focus on specific analysis rather than integrated investment process, resulting in a limited impact of private equity allocations. This is both a reason for, as well as a result of, different IT platforms and the lack of an integrated IT tool. The benefits of an IT architecture that breaks down barriers between illiquid and liquid assets and allows managing a multi-asset portfolio are realized over the short-term. But they can be substantial as multi-asset strategies offer an improved risk/return relationship compared to a portfolio of purely listed assets. They offer better returns for increasing diversification and reducing portfolio and investment risk.

The way forward 

There is a clear and growing need for IT solutions that allow institutions to safely manage substantial allocations to illiquid assets. To achieve this objective, investment processes, notably those related to risk management, asset liability management and investment monitoring, must be better integrated. IT solutions have to be able to model portfolio dynamics over the long-term in order to assure compliance with regulation and mandate-adherence. They need to support what-if-scenarios, integrate various data sources, project cash-flows and calculate values.

While it is tempting to approach these challenges by developing workarounds in-house, the savings from such ad-hoc IT developments are elusive and the implementations quickly become unmanageable. Experience in the industry has shown that IT complexity surpasses internal development capacity and skills of most institutional investors. The time has come to look at what third-parties can provide as standard solutions for this purpose.