Managing uncalled capital commitments is an important aspect of private equity (PE) investing. This article aims to provide a strategic framework for effectively managing these commitments.
Understanding Uncalled Commitments
Uncalled capital commitments represent the amount of money that an investor has committed to a PE fund, but which has not yet been called by the fund managers. These commitments are legally binding and can be called upon at any time within the fund’s investment period, usually with short notice.
The challenge for investors lies in managing – or parking – these commitments in such a way that maximizes the potential for high overall returns while maintaining sufficient liquidity to meet capital calls as they arise: Holding too much of the uncalled capital in safer assets, such as short-term fixed income, will likely decrease the overall portfolio return because PE investments are fundamentally (leveraged) bets on equity performance. However, parking all of the uncalled commitments in public equities runs the risk of having to liquidate these assets when markets are down to fund capital calls. What makes things worse, top quartile PE managers tend to have a higher propensity to call capital in down markets than the average manager. That is the risk of getting a capital call when public equities are down is greater with top managers.1
Strategies for Managing Uncalled Commitments
We recommend that investors take a balanced approach to managing uncalled commitments. As a rule of thumb, investors should hold safe assets to cover capital calls that are expected over the 6-to-12-month horizon while the remainder of uncalled capital can be invested in riskier assets, including public equities.
The following strategies can help further enhance the management of uncalled commitments:
1. Cash Flow Forecasting and Communication with Fund Managers. Open lines of communication with PE fund managers can provide investors with insights into the timing and size of future capital calls, enabling better liquidity management.
2. Diversification of Commitments. By diversifying commitments across different vintages, strategies, and funds investors can spread out their capital calls over time, reducing the impact on liquidity at any given point.
3. Commitment Pacing. Investors need to pace their commitments carefully, considering their investment horizon, expected capital calls, and distributions from existing investments. A single PE fund will provide a bell-shaped exposure to the underlying private assets; to smooth out this exposure over time, a private equity program that invests in multiple funds is needed.
4. Line of Credit. Some investors may opt for a line of credit as a backstop for liquidity needs. With this approach, investors can hold a greater share of their uncalled capital in equity-like assets but it requires careful management to avoid excessive interest costs.
Conclusion
Effective management of uncalled capital commitments is a dynamic and integral component of private equity investing. By employing strategic liquidity management, diversification and pacing of commitments, and maintaining open communication with fund managers, investors can navigate the complexities of capital calls. This not only ensures compliance with commitment obligations but also optimizes the potential for higher returns in the long run.
1 David T. Robinson, Berk A. Sensoy, Cyclicality, performance measurement, and cash flow liquidity in private equity, Journal of Financial Economics, Volume 122, Issue 3, 2016, Pages 521-543.
Important notice: The information presented here is solely for informational purposes. Fundco does not offer investment advice. Any content provided should not be interpreted as legal, tax, investment, financial, or any other form of advice. If you have uncertainties, it is recommended to seek guidance from an authorized financial advisor. Past performance does not guarantee future returns. Investing entails risk, and you should only invest funds you are willing to potentially lose entirely. Private equity investments carry high risks, and there may be limited protection in case of adverse events. Eligibility criteria apply.