Private Equity Recommitment Strategies for Institutional Investors

Institutional investors must deal with irrevocable commitments, cash flow uncertainty, and illiquidity when making new commitments to maintain their portfolio exposure to private equity funds. This study develops a dynamic recommitment strategy to preserve the strategic allocation to private equity. For each period, the level of new commitments is determined by characteristics of the existing private equity portfolio, including received distributions, uncalled capital from old commitments, and the current allocation relative to its target level. Today, private equity is included in the investment portfolios of many endowments, foundations, pension funds, and insurance companies. These institutional investors typically target a specific allocation to private equity as part of their strategic policy portfolio. The large majority of institutional investors fulfill this allocation indirectly through private equity funds. The unpredictable cash flows, in combination with the illiquidity of the market and irrevocable commitments, challenge institutional investors to achieve and maintain this strategic allocation. In 2008, the liquidity crisis and its aftermath showed that investors can become significantly overinvested by making commitments that are too large. Consequently, a liquidity shortfall may occur when investors do not have the cash available to honor a new capital call. In that case, the investor typically risks involuntary liquidation such that the economic value of her existing fund investment is instantly lost and distributed among the other participants in the fund. Clearly, investors will do their utmost to avoid this situation and would rather sell their fund investment in the secondary market at a (very) large discount. Although an efficient investment strategy mitigates liquidity shortfall, in the case of overinvesting, and opportunity costs, in the case of underinvesting, recommitment strategies for institutional investors who allocate to private equity funds have received very little attention in the literature. In this article, we present a dynamic recommitment strategy that enables institutional investors to maintain a private equity fund portfolio that matches their strategic target allocation. We argue that these investors face a multiperiod dynamic portfolio optimization problem in which each period requires a decision on new commitments that affects the level of investments in all future periods. The solution of the corresponding single-period problem forms the basis of our recommitment strategy. The key feature of our strategy is that the level of new commitments in a given period depends on the characteristics of the current private equity portfolio. In particular, new commitments are set equal to the received distributions and the uncalled capital from old commitments, scaled by the ratio of the target allocation to its current allocation. Using the Thomson Venture Economics database over 1980–2005, we empirically evaluated our recommitment strategy by means of historical simulations. Our main finding is that our dynamic recommitment strategy is capable of maintaining a stable investment level that is close to the allocation target (86% realized versus 100% target) while keeping the probability of being overinvested limited (8%). In addition, our sensitivity analyses showed that this strategy remains equally successful when the portfolio is restricted to a certain private equity segment (buyout or venture capital), a specific region (the United States or Europe), or varying fund manager experience (first-time or follow-on funds). Furthermore, we found that achieving the target exposure is possible only when commitments during the buildup phase of a new portfolio are 30% higher than the desired strategic allocation (overcommitment). This finding can be explained by the fact that disinvestments occur before the final investments are made and that, on average, 10% of the committed capital is never invested by the private equity fund. Finally, an investor with enough liquidity for a (temporarily) higher allocation should also consider overcommitment in recommitment plans.