Mastering Illiquidity: Risk management for portfolios of limited partnership funds

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Cash Flow Modelling

“Any halfway decent portfolio manager can pick a few investments and beat the other institutional-grade asset classes on a return basis. Very real risks are hidden away from the naïve observer because they exist before the capital is drawn down, after the capital is distributed and, of course, with allocation shortfalls.”

Kocis et al. (2009)

In this chapter we will discuss various techniques for generating cash flow samples for funds set up as illiquid limited partnerships. Such funds for assets like infrastructure, leveraged buyouts, VC, real estate and natural resources1 share many characteristics and therefore can be modelled quite similarly, but between the various asset classes there are also statistically marked differences.2 Rather than seeing limited partnership funds as an object that can be traded only with significant delays and at steep discounts, we see these vehicles as what could be called “cash flow assets”: instead of trying to model prices they could fetch in a market, we see understanding their cash flows as critical to the successful construction of portfolios. Here modelling has a number of objectives, such as:

• Commitment pacing, i.e. the process by which the portfolio manager reaches the desired allocation to the asset class (Kocis et al., 2009).
• Liquidity management, i.e. identifying excesses or shortfalls of capital, assessing the probability of becoming a defaulting investor and changing portfolios accordingly (Diller and Jäckel, ...