Model Updates for FRG’s VOR PCF Ensure Continuous Improvement

FRG regularly launches new models that will enhance the predictive capability of our VOR Private Capital Forecasting (PCF) solution. Together with our partner Preqin, FRG launched PCF last year to help private capital investors better forecast cash flows. Since then, behind the scenes our Business Analytics team has been hard at work fine-tuning the models used to analyze the probability distribution of cash flows generated by private capital investments.

PCF uses next-generation modeling techniques allowing us to incorporate macro-economic data into cash flow models to better forecast the timing and magnitude of Capital Calls and Capital Distributions. This gives our clients the ability to stress test their portfolios for different economic scenarios.

FRG uses four models to forecast the cash flows important for private equity funds:

  • Probability of Call
  • Probability of Distribution
  • Size of the Call
  • Size of the Distribution

The models are assessed for fit and robustness quarterly, when data updates from Preqin are incorporated. But our team of data scientists is always working to make them better and more predictive.

Throughout the past year the team has specifically refitted the models to remove LIBOR dependent variables, recognizing that LIBOR availability will not be guaranteed past 2021. We further refined the models with our goal to improve the new models’ out of sample performance relative to the current models. Our model approval committee has concluded that these current models, like their predecessors, continue to outperform the Takahashi Alexander (Yale) model consistently for all vintages dating back more than 20 years.

For more information on our PCF tool, please visit our website.

Forecasting Capital Calls and Distributions

Early in his career, one of us was responsible for cash flow forecasting and liquidity management at a large multiline insurance company. We gathered extensive historical data on daily concentration bank deposits, withdrawals, and balances and developed an elementary but fairly effective model. Because insurance companies receive premium payments from and pay claims to many thousands of individuals and small companies, we found we could base reasonably accurate forecasts on the quarter of the year, month of the quarter, week of the month, and day of the week, taking holidays into account. This rough-and-ready approach enabled the money market traders to minimize overnight balances, make investment decisions early in the morning, and substantially extend the average maturity of their portfolios. It was an object lesson in the value of proactive cash management.

It is not such a trivial matter for investors in private capital funds to forecast the timing and amount of capital calls and distributions. Yet maintaining adequate liquidity to meet obligations as they arise means accepting either a market risk or an opportunity cost that might be avoided. The market risk comes from holding domestic large-cap stocks that will have to be sold quickly, whatever the prevailing price, when a capital commitment is unexpectedly drawn down; the opportunity cost comes from adopting a defensive posture and holding cash or cash equivalents in excess of the amount needed for ongoing operations, especially when short-term interest rates are very low.

FRG is undertaking a financial modeling project aimed at forecasting capital calls and distributions. Our overall objective is to help investors with outstanding commitments escape the unattractive alternatives of holding excess cash or scrambling to liquidate assets to meet contractual obligations whose timing and amount are uncertain. To that end, we seek to assist in quantifying the risks associated with allocation weights and to understand the probability of future commitments so as to keep the total portfolio invested in line with those weights.

In other words, we want to make proactive cash management possible for private fund investors.

As a first step, we have formulated some questions.

  1. How do we model the timing and amount of capital calls and disbursements? Are there exogenous variables with predictive power?
  2. How do the timing of capital calls and disbursements correlate between funds of different vintages and underlying types (e.g., private equity from venture capital to leveraged buyouts, private credit, and real estate, among others)?
  3. Do private funds’ capital calls and distributions correlate with public companies’ capital issuance and dividend payout decisions?
  4. How do we model the growth of invested capital? What best explains the returns achieved before money is returned to LPs?
  5. What triggers distributions? 
  6. How do we allocate money to private funds keeping an eye on total invested capital vs. asset allocation weights?
    1. The timing of capital calls and distributions is probabilistic (from #1). 
    2. Diversification among funds can produce a smooth invested capital profile.  But we need to know how these funds co-move to create distributions around that profile (from #2).
    3. Confounding problem is the growth of invested capital (from #3).  This growth affects total portfolio value and the asset allocation weights.  If total exposure is constrained, what is the probability of breaching those constraints?

We invite front-line investors in limited partnerships and similar vehicles to join the discussion. We would welcome and appreciate your input on the conceptual questions. Please contact Dominic Pazzula at info@frgrisk.com if you have an interest in this topic.

Risk Premia Portfolio Case Study

See how FRG’s VOR (Visualization of Risk) platform works for a major U.S. foundation: download a case study that explores how we customized VOR application tools to help them with their day-to-day portfolio management activities, as well as their monthly analysis and performance reporting.

The study shows how FRG was able to leverage its econometric expertise, system development capability and logistical strength to empower the foundation’s specialized investment team. Read the study, and learn more about VOR, here.

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