Show how investors in private markets come to face different risks and judge how those risks can be measured.

FRM® Part II · Risk Management and Investment Management · Private Markets Investing (up to section 3.3.10) · FRM2.IM.11.d

The idea

Private market investors face the market, credit and operational risks of any investor, plus risks created by the structure. Liquidity and funding risk arises from unfunded commitments. Capital calls arrive on the GP's schedule, often when public assets have fallen and distributions have dried up. This can also push the portfolio above its target weight, which is the denominator effect. Valuation risk arises because net asset values are appraisal-based and lagged. Reported returns are smoothed, so volatility and correlation are understated. The smoothing coefficient a is the weight on the previous reported return. True volatility is roughly reported volatility times the factor below. Factor = √((1 + a) ÷ (1 − a)). Other risks are manager and key-person risk, concentration, leverage, vintage-year risk and the J-curve. Measurement relies on unsmoothing, commitment-based cash flow models, liquidity stress tests and exposure counted as NAV plus unfunded commitments. In the cash flow models, calls are a fraction of unfunded commitment and distributions are a fraction of NAV.

Formulas

True volatility from smoothed private equity returns

σtrue = σreported × √((1 + a) ÷ (1 − a))

σreported: volatility of the reported, smoothed returns
a: the smoothing coefficient, the weight on the previous reported return

Holds for returns smoothed on last period's reported return with independent true returns. Forgetting the square root, or swapping numerator and denominator, is the usual slip.

Cumulative capital called in a commitment-based cash flow model

Called = Commitment × [1 − (1 − k)ⁿ]

Commitment: the total amount committed to the fund
k: the fraction of the still-unfunded commitment called each year
n: the number of years

Calls are a rate times the remaining unfunded commitment, so they decline over time. Applying k to the original commitment each year overstates calls.

A practice question

From the question bank, with the reason each wrong option is wrong.

Why do unfunded commitments expose a private market investor to liquidity risk?

Commitments are fully paid at closing, so the investor loses access to the cash it still ownsWhy not: Commitments are not paid at closing; they are drawn over time, which is the source of the risk.
Calls can arrive when public assets are down and distributions slow, forcing sales of other assets at a loss - correct
The investor chooses when each call is made, so poor timing is the investor's own decisionWhy not: The general partner, not the investor, decides call timing.
Unfunded commitments are a liability of the general partner, so the investor has no obligation to fund themWhy not: Commitments are binding on the limited partner, and a default brings severe penalties such as forfeiture of the interest.

The LP has a legally binding obligation to fund calls on short notice, whereas the timing is set by the GP. In stress, calls often continue while distributions fall and the liquid portfolio shrinks, creating funding strain.

A harder one

A balanced portfolio holds USD 700 million in public assets and USD 300 million in private equity net asset value, a 30 percent target weight. Public assets fall by 25 percent. Because of valuation lags, the private equity NAV is unchanged. The private equity share of the portfolio is closest to:

30.0 percentWhy not: Assumes the weight stays at the target; ignores that the public assets have shrunk (the denominator effect).
54.5 percentWhy not: Adds unfunded commitments of USD 150 million to the numerator, which measures total exposure rather than the NAV share.
57.1 percentWhy not: Divides by the public assets alone (300 / 525), leaving the private equity out of the denominator.
36.4 percent - correct

Public after the fall = 700 x 0.75 = 525. Total = 525 + 300 = 825. Share = 300 / 825 = 36.4 percent. The portfolio breaches its target weight without any private market change, and risk managers should also track exposure including unfunded commitments.

The hardest tier

A portfolio holds USD 40 million of cash, USD 600 million of public assets, and private equity with unfunded commitments of USD 150 million. In a stress scenario public assets fall by 20 percent, private equity distributions stop, and the GPs call 60 percent of the unfunded commitments, which the investor pays from cash and public assets. The ratio of liquid assets remaining after paying the calls to the unfunded commitments still outstanding is closest to:

4.3xWhy not: Uses the pre-stress liquid assets (640) and the original unfunded amount (150), so none of the stress is reflected.
2.9xWhy not: Divides by the original 150 instead of the 60 that remains outstanding.
7.2x - correct
8.7xWhy not: Forgets to deduct the USD 90 million of calls paid out of the liquid assets.

Liquid after shock = 40 + 600 x 0.8 = 520. Calls paid = 0.6 x 150 = 90, leaving 430. Unfunded remaining = 60. Coverage = 430 / 60 = 7.2x. Liquidity stress tests must combine asset shocks, calls and the loss of distributions.

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