Cash Flow Planning for Private Fund Investments

Discover the intricacies of cash flow planning for private fund investments, from fund life cycles to techniques for modeling uncertain cash flows. Essential insights for investors navigating alternative assets.

As more private investors look to gain exposure to alternative assets, many focus on private funds as their preferred access point. Funds offer investors exposure to a pool of opportunities and provide expertise in conducting due diligence, negotiation, execution, and ideally harvesting returns. Effective asset allocation and risk management within these funds are crucial for optimizing returns. But many investors commit large balances to funds with unknown capital call and repayment structures that make cash flow planning over longer time horizons increasingly difficult.

This introduction is intended to provide an overview on the prototypical construct of private funds and ways to model the uncertainty of the corresponding cash flows.  

Fund Life Cycle Overview

Fundraising and Commitments

The initial fundraising period of private funds depends on the size and complexity of the fund, the relative attractiveness of the opportunity, and general market conditions at the time of the raise. This period typically lasts from 6-12 months (or longer in recent periods) as the general partner (GP) works toward a total commitment amount consistent with their strategy and objectives. Investors sign limited partnership (LP) agreements that commit them to funding up to a certain threshold that can be called at the manager’s discretion until the end of the investment period. Management fees are also due by investors periodically (ex. quarterly) on the aggregate committed balance which counts against their total capital commitment.

Investment Period

The investment period is the timeframe during which investor commitments can be called by the manager; it’s structured as a multi-year term with optional extensions if the fund has been unable to deploy capital over that initial period. While some managers stick to a set capital call schedule that is known prior to investor commitments, most will draw capital opportunistically as investable opportunities arise as part of a strategy to maximize time weighted IRR return calculations of the fund.  

Capital call schedules are correlated with macroeconomic conditions, as more robust fundraising environments allow managers to deploy capital more quickly, where economic downturns often suppress investment activity. Called capital can also be returned to investors during the investment period if early distributions or yields warrant it, but these early returns of capital are often paid in the form of recallable distributions credited against committed capital (meaning they can be called again by the manager).

Portfolio Management and Distributions

Once the investment period ends, managers work to maximize the value of portfolio companies and find exit opportunities to create liquidity. This period of the fund life cycle tends to last an additional ~4-6 years, with potential extensions. Distributions during this period are volatile as exits provide lumpy and uncertain payout schedules to investors, who receive distributions on an after-fee basis once certain return thresholds have been met.

Cash Flow Planning Techniques

Regarding cash flows, investors in private funds are concerned with two primary questions: When will I have to make good on my capital commitments (outflows) and when will I receive repayments or returns on my investments (inflows)?  ‍

Capital Outflows – Fixed Management Fees

Fixed management fees are the simplest part of cash flow planning for fund investments. Fee structures are set at a specified percentage annually based on the committed capital amount for the life of the fund. More recently, many managers have elected to structure funds with step-down fee structures where the annual management fee is reduced following the end of the investment period where there is less of an administrative burden of deploying capital.

Fixed management fees can either be called separately from larger capital calls according to a specified fee schedule or held in reserve as excess that will periodically be credited to the manager as the fees are earned. From cash flow planning perspective, the key question to ask the fund manager prior to committing is if the fixed management fees will be called at a regular cadence or simply withheld and credited over time, with the former being more administratively burdensome but easier for investors to plan around.

Capital Outflows – Capital Calls

The size and timing of capital calls often fall outside of investors’ control. However, with a quick read of the partnership agreement and a few questions of management, investors can put together a rough estimate for an individual fund that should suffice. These techniques become even more accurate when conducted across a portfolio of funds.

Straight Line Assumptions: The simplest method for estimating capital calls is assuming a straight-line periodic call schedule over the life of the investment period. The only inputs required are the length of the investment period, the committed capital balance, and assumptions around periodicity of calls (quarterly, semi-annual, annual).  

Manager Estimates: Often the most accurate method for estimating capital calls within the investment period is to ask the fund manager to provide forward-looking estimates and to update those expectations over time.

Quantitative Methods: Many institutional investors use sophisticated models to estimate capital call schedules based on assumptions around the type of fund, the investment period, the life of the fund, growth rate of assets, yield, etc. One such model, the Takahashi-Alexander Model, was developed by two analysts at the Yale Endowment and variations are still widely employed today.  

Capital Inflows – Distributions  

Finally, the timing and magnitude of distributions can be the hardest to estimate of all. With the longer possible return period and an infinite range of possibilities for return profiles, many investors just cross their fingers and hope for the best. And while there is no perfect way to approach cash flow forecasting for distribution schedules, there are a few ways that can provide more rigor to the estimates.

Straight Line Assumptions: Most fund managers have target IRRs and MOICs for investment underwriting. The post-investment period is also already known based on the fund terms. Therefore, a simple forecast is that the fund will repay the target MOIC (net of fixed and performance fees), in equal installments every year from the end of the investment period to the end of the life of the fund.  

Manager Estimates: This method will not be very effective at the inception of the fund, as fund managers will have just about as little insight into the exit potential of their prospective investments as the investors. However, once the investment period has finished and the portfolio has been fully baked, it is likely that portfolio managers will have some more granular forecasts as to the size and timing of the likely winners and losers in their portfolio. Checking in with management annually is an effective way to achieve a more accurate estimate over time.

Quantitative Methods: Like with capital call schedules, institutional investors tend to use more sophisticated quantitative methods that are averaged across larger allocations of managers. Models like the Takahashi-Alexander Model use assumptions around growth rate of assets, portfolio concentration, distribution curves, etc. to put back-tested rigor that optimizes for historical accuracy at the forefront of their cash flow planning.

Across both capital calls and distributions, these techniques have advantages and disadvantages, so it is up to individual investors to choose which is most suitable for their given circumstance. Often, a weighted average of the different outputs is the best approach that hedges against any bias or inaccurate assumptions.