CHAPTER 1
Introduction

This book is about commitment pacing for private capital. As Preqin describes, what now is termed 'private capital' originally emerged as an offshoot of private equity.1 It comprises a wide range of assets that are not available on public markets and, therefore, are highly illiquid. This also includes, but not exclusively, venture capital (VC), private debt, real estate, infrastructure, commodities, timberland, and other natural resources. The organised market for this asset class is dominated by funds as principal financial intermediaries. Private capital has a long history, from an institutional investor perspective starting with the leveraged buyout boom in the 1980s.2

Practically, commitment pacing is the most relevant way for managing the exposure to private capital. It is the process by which an investor plans the timing and size of future commitments to funds, and the choice of the funds' strategies to reach and maintain a targeted allocation. Jeet (2020) stated that a 'good commitment pacing plan is often seen as the lynchpin of a private capital program and can account for much of the dispersion in performance across LPs'.

SCOPE OF THE BOOK

A lot has been written about investing in this asset class, particularly private equity, so let us start with clarifying what this book is not about. It is not dealing with the question whether it is now a good time to increase or decrease allocations to private capital. Like in all markets, there are boom and rather depressed periods, limits to growth, etc. This will not be discussed here. Investing in private markets is here to stay.

It is not dealing with financial returns and the attractiveness of private market strategies, like what returns are buyouts delivering, or whether their risk-return ratio is better than that of VC. All data decay over time, and it is dangerous to rely on outdated market trends. We are, therefore, not discussing current market statistics, as results are likely to look different in other periods and economies anyway.

This book will also not deal with the question of how to select funds. Rather, it takes as core assumption that an individual limited partner (LP) has no systematic advantage in selecting funds. This will raise eyebrows, but the famous claim 'we only invest in first-quartile funds' requires the belief that an investor is better than others in selecting funds. Investors need to ask themselves the (uncomfortable) question how much better their selection skills can be than that of the average institutional investor who has experienced professionals and established a proper due diligence process as well?

The focus of this book is the methods for commitment pacing and the reasoning behind them, to demystify this process and to describe a state-of-the-art approach to building up and maintaining allocations to private assets. The book aims to strike a balance between not taking a view that is too broad and not getting bogged down in more detail than is needed.

The figures and examples are for illustrative purposes only. Unless specifically pointed out, all examples are based on expected contributions, distributions, and net asset value (NAV) projections. The examples' assumptions may not be realised, and thus, cash flows and valuations of a real investment programme may significantly differ from the projections presented here.

QUICK GLOSSARY3

When referring to 'investors' in this book, we mean institutional investors - like insurers, pension funds, banks, endowments, sovereign wealth funds, and family offices - and the organisational entities they have set up for managing allocations to private capital. These investors either employ professionals as 'investment managers' to directly invest in private assets or invest through funds where professional management is provided by intermediaries.

'Funds' in the private capital context are usually structured as a limited partnership and are investment vehicles for pooling capital. Here, institutional investors mean the fund's 'LPs' who commit a certain amount to the fund and do not take an active role in its management. The term 'general partner' (GP) refers to the firm as an entity that is legally responsible for managing the fund's investments in private assets and has unlimited personal liability for its debts and obligations. Such 'fund management firms' regularly raise funds.

'Fund managers' are the professionals involved in the fund's day-to-day management. They form the fund's management team that includes the carried interest holders, i.e. those employees or directors of the GP who are entitled to share in the carried interest of the super profit made by the fund.

An LP's 'commitments' are drawn down as needed. There is little, if any, opportunity to redeem the investment before the end of the fund's lifetime. A significant part of the capital remains as 'undrawn commitments' in the hands of the LP. This capital waiting to be called is also referred to as 'dry powder' and carries opportunity costs. When and how much of these commitments are called, invested in what private assets, and when these investments are exited and the resulting proceeds returned to the LPs, is decided by the fund managers only.

THE CHALLENGE OF PRIVATE CAPITAL

After unabated 'triumphalist money making' since the 1980s, in the 2020s, private capital firms worldwide were sitting on about $2 trillion worth of dry power committed by their LPs but not invested. With more and more capital being allocated to private assets, returns increasingly have been coming under pressure. The 'first quartile' label attached to 'institutional quality' firms ceases to make sense.4 The ability of private equity investors to turn a company they buy and improve its efficiencies is, in the words of one industry observer, largely illusory: 'This is, after all, the leveraged-buyout industry, and not the operational wizard-genius industry'.5 This may be exaggerating, but in all industries that are coming of age, successful practices spread and are adopted by companies outside the industry as well. As a consequence, the number of attractive investment opportunities appears to be in decline.

Institutional investors fear - not the first time in the industry's history - that future returns on private capital will be mediocre and again some LPs accept high discounts when selling to the secondary market.6 Crises like COVID-19 and the wars in Ukraine and the Middle East look like Black Swans,7 events of the highest improbability but with large consequences in the financial markets, that look as if they would change the industry's dynamics forever.

However, over the past decades, private capital regularly has survived Black Swans and thrived despite or maybe even because of them. There are no indicators why the real economy's core dynamics that drive private market - entrepreneurship, innovation, technological obsolescence, industrial restructuring, and societal change - should not continue to be of relevance in the future. Private capital will continue its long-term outperformance compared to public markets.

Risk and uncertainty

Since private capital, by definition, does not regularly trade on an open market and is held over several years, there is typically no recent third-party-determined quotation by which to calculate a fund's market value and that of the private asset it holds. When talking about 'risk' in this context, we are mainly looking at situations of 'uncertainty' in the definition of University of Chicago economist, Frank Knight, where there is no valid basis for quantifying the probabilities of outcomes.8

Volatility, therefore, is a controversial indicator for private equity risks. In the (relatively) early days of private equity, The Economist once quipped 'to say that private equity is less volatile and thus less risky is a bit like saying that the weather does not change much when you stay inside and rarely look out of the window'.9

For private capital, the fund managers' reaction to an adverse market environment will be different than in the case of hedge funds or traditional assets. Funds structured as limited partnerships essentially protect companies from adverse market developments by giving them a lifetime in the form of the funds' dry powder.

All transactions in private markets are negotiated, and any reaction to short-term market developments cannot be instantaneous. When the market is in crisis, funds hold on to their portfolio companies as long as possible until it has recovered. There are no early redemptions, and rather than selling at lower price, exits are delayed, often significantly for years.

To keep with The Economist's witty analogy, fund managers are looking out of the window, see the rain, and decide to stay inside. In fact, the funds' limited partnership structure can be viewed as the response to uncertainty rather than risk.10 For forecasting and measuring risks, uncertainty is an undesirable characteristic of the process to be assessed, but in the real economy, the domain within which private capital investing is taking place, it is considered a necessary condition for profit, and here, the assumption that the...