Mastering Illiquidity: Risk management for portfolios of limited partnership funds

10

The Impact of Undrawn Commitments

As we have discussed in the preceding chapters, a number of LPs faced serious problems during the recent financial crisis because of the significant undrawn commitments they had made in their alternative investment portfolios. Their experience has caused increased interest from practitioners and academics alike in what has been coined “commitment risk” or “funding risk”. However, academic research into this type of risk is still in its infancy. For instance, in reviewing the (risk-adjusted) performance of private equity, Harris et al. (2012) note that:

“[…] investing in a portfolio of private equity funds across vintage years inevitably involves uncertainties and potential costs related to the timing of cash flows and the liquidity of holdings that differ from those in public markets. For instance, there is uncertainty regarding how much to commit to private equity funds to achieve a target portfolio allocation. This is due to the uncertain time profile of capital calls and realizations. Consequently, there exists ‘commitment risk’ when investing in private equity […] Estimating plausible ranges for a commitment risk premium is a subject for future research […]”

To the extent that academic research has begun to focus on commitment risk, it has typically approached it from the viewpoint of portfolio construction. For instance, Phalippou and Westerfield (2012) emphasize that

“[b]ecause these capital calls and distributions are stochastic, investors ...