Case 073Alternatives and private marketsHard

A client wants 15% of his Rs 60 crore in private equity and commits Rs 9 crore to one fund. It draws 30%, 30%, 25% and 15% over four years and distributes from year four. Show his peak cash out and the cash plan needed to meet calls.

The situation

Rahul Sequeira has Rs 60 crore invested and wants 15% in private equity, so he commits Rs 9 crore to one fund. The fund will call 30%, 30%, 25% and 15% of the commitment in years one to four. Once invested, the value of his holding is assumed to grow 12% a year before exits.

The fund begins returning money in year four, paying out 10%, 25%, 40% and 60% of the holding's value in years four to seven and everything left in year eight. A call must be paid within ten business days; missing one can cost him much of what he has already put in.

Your task

How much cash is he out of pocket at the worst point, how much of his portfolio is ever actually in private equity, and how should he hold the money waiting to be called?

Quick check

What is the most cash Rahul is ever out of pocket?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

His cash out peaks at about Rs 7.89 crore in year 4, and he gets back about 1.58 times his money by year eight. The calls total Rs 9 crore over four years, but distributions start in year four. Invested value peaks at only 11.7% of his growing portfolio, so a single Rs 9 crore commitment does not deliver 15% exposure. He should keep the next twelve months of calls, about Rs 2.7 crore, in liquid funds, and the rest in a short-term debt ladder.

Step 1Why is a commitment not the same as an investment?

Booking a flat under construction commits you to the full price, but the builder asks for it in instalments as floors go up, and until each demand arrives the money is still yours to hold somewhere. A private equity commitmentA promise to pay a fund up to a fixed amount when it asks, with the fund calling the money in stages over several years as it finds investments. works the same way: Rahul promised Rs 9 crore, but the fund calls it over four years and starts paying back before the last call. So the number that matters for his cash plan is the peak cash out, not the commitment.

YearCalledDistributedNet cashCumulativeInvested value
12.700.00-2.70-2.702.70
22.700.00-2.70-5.405.72
32.250.00-2.25-7.658.66
41.351.11-0.24-7.899.95
50.002.78+2.78-5.118.35
60.003.74+3.74-1.375.61
70.003.77+3.77+2.402.52
80.002.82+2.82+5.220.00
Rs crore. Rahul pays Rs 9 crore of calls over four years and receives Rs 14.2 crore of distributions from year four, so his cumulative position bottoms at minus Rs 7.89 crore in year 4 and ends at plus Rs 5.2 crore.
Calls go out before distributions come back: the peak is the cash to plan for-8-4+4+80Yr 1Yr 2Yr 3Yr 4Yr 5Yr 6Yr 7Yr 8Peak cash out: 7.89 crore in year 4+5.2 by year 8capital calleddistributionscumulative net cash
Calls of Rs 2.7, 2.7, 2.25 and 1.35 crore go out in years one to four while distributions begin in year four, so Rahul's cumulative cash out peaks at Rs 7.89 crore in year 4 and turns positive by year 7.
Step 2How much private equity does he actually hold?

Less than he thinks. Invested value peaks at Rs 9.9 crore in year 4, but by then the rest of his money has grown too, to about Rs 85 crore if the whole portfolio earns an assumed 9%, so private equity is only 11.7% of it at the peak and averages 6.5% over the eight years. Early on the money has not been called; later it is being returned. Families that want a steady 15% invested usually commit more than the target and commit again every year or two, so new funds are calling while old ones are paying back. The cost is complexity and a larger total of unfunded promises to manage.

A commitment is not an investment: invested share of the whole portfolio5%10%15%20%the 15% he meant to holdPeak invested: 11.7%eight-year average 6.5%012345678Year (fund holding grows 12% a year; whole portfolio 9% a year)
Although Rahul committed 15% of his portfolio, his invested private equity peaks at only 11.7% of the growing whole in year 4 and averages 6.5% over eight years, because money is called gradually and returned from year four.
Step 3How should he hold the money waiting to be called?

Match each rupee to when it will be asked for. Keep the next twelve months of calls, Rs 2.7 crore, in liquid funds; hold the following two years' calls in short-term debt maturing around the call dates; and leave the rest invested as usual. Do not park the whole Rs 9 crore in equity waiting for calls: a 30% fall in year two could force him to sell at the bottom to meet a call he cannot miss. On these assumptions the fund returns about 1.58 times his money, an IRR of about 12.0%, but the 12% growth and the exit pattern are assumptions, and real funds call and distribute far less neatly.

Where candidates lose it

The common error is treating the Rs 9 crore as invested on day one, both for the cash plan and for the allocation. The cash need peaks lower and later; the exposure never reaches 15%.

The opposite error is keeping nothing liquid because calls are years away. A missed call can forfeit much of what has already been paid; the cash plan is not optional.

What the interviewer asks next

  • How much would he need to commit, and how often, to hold about 15% invested on average?
  • The fund calls 50% in year one instead. How does the cash plan change?
  • How would you explain the J-curve of early returns to him?

Company names and figures are illustrative.