Right Now All Of My Wealth is in Stocks / Cash.

How Do I Build Out a Portfolio of PE Funds?

Let’s say you’re ready to take the leap into private markets and want to start investing into private equity funds. You might be wondering…

1. How much should I invest in a single fund?

2. How many funds should I invest into?

3. What time period should I invest over?

4. How much of my total assets / net worth should I target investing into private equity?

We hope to answer these questions and more this week as we dive deep into building out a diversified portfolio of private equity funds.

Today, we will run through key the questions below:

1. intro (what you read above already)

2. what are the main objectives for constructing a portfolio of PE funds?

3. what do the cash flows look like for a PE fund?

4. what is the right amount to allocate to private equity in a portfolio?

5. how do I design a plan to build my PE portfolio?

6. what would an example of my plan in action look like?

7. how do I predict when my capital will get called by a PE fund?

8. how do I reach my targeted PE allocation?

9. what does my overall portfolio look like over time?

10. what do the institutional investors do to hit their PE targets?

11. once my PE portfolio has matured, how do I maintain my target allocation?

(questions above align with topics in the table of contents below)

Table of Contents

1. Introduction

2. Private Equity Portfolio Construction Objectives

3. Private Equity Fund Cash Flows

4. Benchmarking Private Equity Portfolio Allocations

5. Designing a PE Portfolio Plan

6. Detailed Example

7. Capital Calls Forecasting

8. Reaching Target Allocations in Practice

9. Thinking About Overall Portfolio Construction

10. How Do Institutional LPs Hit Their "Target" Alloca …

11. Mature Portfolios — Maintaining Target Allocations

Private Equity Portfolio Construction Objectives

Portfolio construction is definitely a mix of “art & science”. 

There’s a few key areas to consider as we think about building out a portfolio of PE funds:

1. Target portfolio allocation to Private Equity

   • Key Question:

     • how much of my portfolio should I invest into private equity?

   • TLDR:

     • this may be something like 15 - 25% of total assets (per family offices benchmarks)

2. Deployment Timeline / Commitment Pacing

   • Key Question:

     • cool, so I want to invest 15 - 25% of my assets into private equity. Over what time period should I plan to do this?

   • TLDR:

     • we want to “commit” to funds over several years for vintage diversification. We also need to be mindful of how long it will take to ramp up to our target allocation (more on this to come)

3. Diversification across PE GP / Investment Strategy / Sector / Company Size

   • Key Question:

     • OK, I get it, I want to invest into funds over a number of years. How should I think about which funds to invest with? How do I construct a diversified portfolio?

   • TLDR:

     • Invest in funds from different GPs

     • Invest in different strategies

       • (e.g. distressed buyouts vs. “buy-and-build” platforms vs. growth equity vs. venture capital)

     • Invest in different sectors

       • (e.g. industrials vs. software vs. healthcare)

     • Invest in different fund sizes / company sizes

       • (e.g. lower middle market buyout vs. large cap buyout vs. seed stage venture)

Private Equity Fund Cash Flows

The lifecycle of a fund certainly varies, so all of the below is illustrative.

Funds typically have 10 year lives that can be extended (at LP discretion).

For "capital calls", private equity funds do not draw down committed capital all at once.

Instead, capital calls occur gradually over the fund’s investment period (often the first 3–5 years).

The fund will then start seeing distributions after a few years with the main “harvesting” period kicking in years ~ 5 - 10. Distributions might peak around years 7-8.

Investors may see “break even” where the cumulative distributions received exceed cumulative contributions (capital calls) to a fund around years 6-7 (of course this varies by fund…).

An example fund investment might look something like this (all illustrative):

In general, capital calls and distributions are irregular and occur in line with the fund investing into or exiting from deals... which of course, is very hard to predict as an LP.

Lately we have also seen some funds using “lines of credit” to fund early investments. In a couple of scenarios, we’ve seen funds complete their earliest deals using the line of credit.

This pushes out when they actually call capital from LPs (initial large capital calls may occur a year later, for example, than we'd normally expect).

In other cases we've seen funds make large capital calls right away after closing the fund... so, again, it varies widely.

And we want to be over-prepared for any liquidity needs (vs. over-extended and in a liquidity crunch).

Benchmarking Private Equity Portfolio Allocations

Typically we see individuals / family offices who want private equity exposure target anywhere between 15 - 25% of total assets allocated to private equity.

Some folks may go more or less aggressive than that range depending on personal preferences.

A big factor is usually whether there are any near-term liquidity needs since our money is tied up in the illiquid PE fund once capital is called.

When thinking about that 15 - 25% allocation, the benchmarks we see show family offices and endowments in the range of 25% of a portfolio allocated to “private equity”.

Some of the top endowments like Yale, Stanford, Harvard are closer to 38% in private equity.

“Private equity” for benchmarking purposes below includes buyouts + venture capital / growth equity (see breakdown below).

Designing a PE Portfolio Plan

Once we decide on a target allocation to private equity…

let’s say we target 20% of total assets as an example…

then the main decision points are how we should build a diversified portfolio of private equity funds:

1. Diversify Across Vintages

   • e.g. over how many years should we commit to new funds?

2. Diversify Within Vintages

   • e.g. how many funds should we invest into within a single vintage?

To use a concrete example, let’s say we decided we wanted to commit to funds across 3 years / vintages, targeting 3 funds per year.

This would get us exposure to 9 underlying funds.

There isn't a magic number for the number of managers to target.

A few factors that might influence the target number of managers for a portfolio include:

1. Only wanting to invest in funds we find highly attractive...

   • I don’t invest in a fund just because my "plan" said I needed to invest 3 funds this year

   • Being agile and deploying more if there are more attractive opportunities in a certain environment

   • In practice, we want to stay flexible and this may mean we choose to adjust our pacing each year

2. Market environment

   • Depending on how the public markets and private markets are performing, we may want to accelerate or decelerate the pacing of allocating into private equity

3. Minimum check size / number of K-1 tax filings / sizes of capital calls

   • Every investment means more K-1 tax filings and more capital calls

   • So there's definitely a concept of not trying to over diversify to the point where there's lots of small capital calls that get tedious and painful to manage

   • It also takes work to look at funds and make investment decisions… so we have to consider what our capacity is for looking at opportunities, diligencing them to the right level of comfort, and making a decision

Detailed Example

To make up some numbers and put an example together, let’s say we had $450K we wanted to commit to private equity.

Let's say we are targeting deploying into 9 total funds — committing to 3 funds per year over 3 years.

That equates to deploying $150K per year over 3 years.

Or $50K per fund, 3 funds per year, across 3 years.

Our schedule for commitments to new funds each year would look like this:

Capital Calls Forecasting

Of course, just because we commit to a fund, doesn’t mean we hand over the total committed capital immediately.

As shown in the earlier chart with capital calls and distributions timing, a fund might call the committed capital over a 3 - 5 year period.

For the purposes of our example, let’s assume that each fund call the capital over 5 years, with 20% called per year.

This means that each fund we invest into will call $10K per year over 5 years.

Our annual capital calls might look something like this:

$10K is called per fund per year. As we continue to commit to new funds, those capital calls start to ramp.

We see our peak capital calls in years 3 - 5 as we have $90K called per year across 9 different funds.

Reaching Target Allocations in Practice

In practice, there are a number of factors that might prevent us from actually reaching our “target” portfolio allocation for private equity (e.g. 20% of portfolio in private equity).

One of the main drivers of this is the fact that the PE funds themselves will start distributing cash flows back to us even before our full commitment to a fund has been drawn down.

This means our net invested exposure to the PE fund may not reach the full amount we’ve committed to the funds.

This of course varies by fund.

We certainly want to be overly conservative vs. too aggressive with our commitments.

The last thing we want is to get stuck in a liquidity crunch or overallocated to illiquid PE funds…

...but its still good to be aware of this phenomenon.

The illustrative chart below reflects this concept:

In practice, at a fund level, this means that we might not ever have our “net invested” exposure to a fund reach our total commitment.

And at the portfolio level, this means we might fall short of reaching our target % allocation to private equity.

Thinking About Overall Portfolio Construction

So back to our hypothetical example, let’s say we targeted getting 20% exposure to private equity.

In our example, if we allocated $450K we wanted to invest into private equity, that would imply we have $2.25M of total assets.

To keep things very simple… if we assume that all of the non-PE liquid assets don’t appreciate (or depreciate) in value…

…then in our example, our PE investments don’t reach 20% of our overall portfolio until year 7.

In practice, there are a number of other factors that might prevent us from actually reaching our target allocation of 20% of our assets in private equity:

1. Our total assets grow from:

   • appreciation of liquid assets (stocks / cash going up)

   • other sources of income (job income, non-PE investment distributions, etc.)

2. Its unlikely that our “net invested” exposure to our private equity investments will reach our “total committed” exposure at any point of time

   • the point discussed earlier

How Do Institutional LPs Hit Their "Target" Allocations?

For some added context, institutional LPs often practice an “overcommitment” strategy.

This means they commit more to a fund than the actual targeted net invested exposure that want to achieve… with the assumption that they won’t ever get their full commitment fully drawn down.

For individual investors, that’s certainly a much riskier approach to take when there’s not billions of dollars of liquid assets to play with and smooth things out… so we certainly not suggesting that for an individual investor.

But its good to be cognizant of this and take into account as we think about our target allocations and the likely path of getting there.

We want to be careful about over committing because things could go sideways in scenarios where:

1. distributions were slower from a fund

2. capital calls came faster than expected

3. overall market conditions changed for the worse (e.g. stock market drops and total assets are down on paper)

So we don’t want to have been too aggressive with overcommitments and end up in a liquidity crunch or overallocated to private equity.

Ultimately — its important to keep this context in mind given its likely that our actual dollars “invested” into private equity are unlikely to fully equate to our “committed” dollars at any point in time given the nature of PE fund cash flows.

Mature Portfolios — Maintaining Target Allocations

Again, private equity portfolio construction is definitely a mix of art and science.

We can simulate how a portfolio might evolve all we want, but ultimately, we need to see how the performance plays out as funds call capital and start distributing capital.

As a separate exercise, once we get closer to reaching out target allocation to private equity, we can start thinking about how we maintain our portfolio.

If things go well, we hope to see asset appreciation in our overall portfolio as:

1. our portfolio of private equity funds starts to mature and return cash distributions to us

2. our liquid investments grow

3. we receive income from other sources (jobs, etc.)

We then can start thinking about how we want to reinvest these various income streams and appreciating assets, including deploying into new private equity funds to keep our portfolio growing.

There’s no magic bullet — instead, its always a moving target and comes down to careful monitoring over time and balancing key considerations like:

1. personal liquidity needs

   • e.g. I want to buy a house

2. overall portfolio performance

   • e.g. my stocks are up or down

3. deploying from other sources of income

   • e.g. how do invest my bonus at work?

4. PE fund portfolio cash flows and investment performance

   • e.g. have funds been faster or slower to deploy and return my capital than expected?

5. reinvesting private equity distributions

   • e.g. should I reinvest my PE distributions into new funds?

6. the attractiveness of any given opportunity set of fund opportunities

   • e.g. we only want to invest in a new fund because its highly attractive investment…

   • ...but not because our "allocation plan" said we need to invest in X number of funds in a certain year

   • SO… do I like the funds I am considering for investment? Do I want to capitalize on any specific opportunities, even if not anticipated by my “plan”?

At Gather Capital, we curate a set of world class private equity opportunities enabling our clients to invest alongside elite family office limited partners.

If you’re interested in learning more about what we do, feel free to:

• swing by our website & create an account (if you haven’t already)

• grab some time on our calendar here

• shoot us an email

We’re looking forward to Talking Shop with you soon.

Sincerely,