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Explain what investors gain and what obstacles they meet when they reach private markets by way of a pooled vehicle like a private equity or private debt fund.

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

The idea

Reaching private markets through a pooled vehicle, such as a private equity or private debt fund, lets an investor delegate sourcing, diligence, structuring and monitoring to a specialist GP. It also gives access to deals and managers the investor could not reach alone, diversification across many companies or loans with a modest ticket, and no need for an in-house team. The costs are fees: a management fee on commitments plus carried interest, with an extra layer in a fund of funds. The investor also meets a blind pool, where commitments are made before investments are known, little control over decisions, and long lock-ups with no exit except the secondary market. Cash flows are uncertain too, because of capital calls and distributions. Fees charged from the start create the J-curve: reported value falls below paid-in capital early on. The exam point is that the net return, not the gross return, is what the investor earns.

Formulas

Commitment needed to reach a target private equity NAV

Commitment = Target NAV ÷ peak NAV ratio

Target NAV
the NAV the investor wants to hold
peak NAV ratio
the peak NAV of a typical fund as a fraction of its commitment

Because capital is called gradually and distributions start early, NAV never reaches the commitment, so investors overcommit. The cost is more liquidity risk when calls come together.

A practice question

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

In a private equity fund, the term blind pool means that:

  1. Investors cannot see the fund's net asset value, which is hidden from themWhy not: The NAV is reported, though with a lag; blind refers to the investments.
  2. Investors commit capital before the general partner has identified most of the investments - correct
  3. The general partner invests only in companies with undisclosed financial statementsWhy not: Disclosure of the targets is not the issue; the point is that the targets are not yet chosen.
  4. Investors cannot withdraw their commitment, but they can see all of the fund's holdingsWhy not: Mixes the lock-up with the notion of full transparency; the holdings are not yet known at commitment.

A blind pool is a commitment made on trust in the general partner's strategy and track record, since the portfolio is assembled after the investors have committed. That is one cost of reaching private markets through a fund.

A harder one

A fund has a commitment of USD 100 million from an investor. In year 1 the investor pays in USD 20 million, of which USD 2 million is the management fee and USD 18 million is invested. The investments are carried at cost, so NAV is USD 18 million, and there have been no distributions. The TVPI at the end of year 1 is closest to:

  1. 1.00xWhy not: Divides NAV by invested capital (18 / 18) and ignores that fees are part of paid-in capital.
  2. 1.11xWhy not: Inverts the ratio (20 / 18), so the shortfall shows up as a gain.
  3. 0.18xWhy not: Divides NAV by the commitment of USD 100 million instead of by paid-in capital.
  4. 0.90x - correct

TVPI = (0 + 18) / 20 = 0.90x. Fees are charged from the start while investments are held at cost, so the fund looks as though it has lost 10 percent. This is the J-curve, which is a feature of fund structure, not poor investment performance.

The hardest tier

An investor wants its private equity fund NAV to reach USD 100 million. From experience, a typical fund's NAV peaks at about 60 percent of the commitment, because capital is called gradually and distributions begin before all of it is drawn. The commitment required is closest to:

  1. USD 100 millionWhy not: Assumes that a commitment will be fully reflected in NAV, which ignores the gradual drawdown and early distributions.
  2. USD 160 millionWhy not: Multiplies the target by 1.6 rather than dividing by the 60 percent ratio.
  3. USD 167 million - correct
  4. USD 60 millionWhy not: Multiplies the target by 0.6, which underestimates the commitment and leaves the NAV short.

Commitment = target NAV / peak NAV ratio = 100 / 0.6 = USD 166.7 million. Investors overcommit to reach a target allocation, but overcommitment adds to the liquidity risk when calls come together.

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