Monday, August 12, 2013

What To Do With My Unfunded LP Commitment Before Capital Calls?

I got an interesting question the other day from a client about what to do with the unfunded portion of his LP commitment.  It was the first time I got the question from an LP but have actually been thinking about it myself quite a bit.  Of the LP capital commitments I have to date, the unfunded portion is sitting all in cash. Over the past several quarters I've realized, that the time value of money on that cash just sitting with my bank is really unexciting given how well the public markets are performing of late.  So I asked myself the same question the LP did of me, what should I do with the unfunded cash I have set aside?  Being a naturally conservative person, I've always thought I should hold everything in cash so that I never have capital call timing issues.  That may be the conservative reformed lawyer in me or the worry wart, but I think a lot of people simply keep their unfunded commitments in cash.  With a fund-of-funds structure, its capital calls are much more predictable and easier to manage on an individual LP looking to commit roughly 15-20% a year of the LP's capital commitment during the first 3-4 years with it tapering in later years.  

But, do I need 100% of the unfunded commitment amount in cash?  I probably don't and probably shouldn't because a 0.01% interest rate from J.P. Morgan isn't beating any PME (including inflation)!  As such, I've made a tactical decision to reserve one year's forecasted capital call needs in a money market fund and then have the rest of the unfunded/unreserved capital commitment be invested in mutual funds without early redemption penalties, just to be extra safe.  

No one talks about the real return on your money in private equity if you commit $100,000 in Year 1 and then only have $50,000 drawn by the end of Year 3 and $50,000 continues to sit in cash.  A good portfolio manager should be thinking about what to do with your entire capital commitment, both unfunded and funded.  Obviously, an adviser should be helping you pick good funds (the funded piece) and then be helping you maximize your all-in net return by eking out a few hundred basis points of alpha by actively (or passively using mutual fund indexes) managing your unfunded commitment.  The goal in private equity should be to outperform the public markets by 300-500 basis points, and the all-in net performance of the unfunded commitment should be part of this calculation as well.  Obviously, it will vary from LP to LP with no two LPs having the same asset allocation of their unfunded commitment, but I don't think it's a topic that is often discussed and I'm glad I woke up and made a change which should hopefully allow me to eek out a few extra basis points of alpha with the clarity of mind that I'll always have cash to meet capital calls. 

Curious what others think though and welcome feedback/advice!


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