Empowering LPs: Maximizing Private Asset Value Through Cash Flow Modeling and Liquidity Management

by Emilian Belev, Head, Enterprise Risk Analytics, Northfield Information Services

In the world of investment management, the practice of liquidity management is often siloed away from risk and return forecast analytics and considered more of an accounting rather than an investment management task. Liquidity is often treated as return’s distant and awkward relative, assigned to the back room. This perspective can hinder a holistic understanding of an organization’s financial health, where risk and return analytics take center stage, pushing liquidity considerations to the background. In doing so, we may inadvertently prioritize return generation over a comprehensive grasp of liquidity dynamics.

The Siloed Nature of Liquidity Management

This view is an artifact of an environment where only public and liquid assets were part of an organization’s investment portfolio. The implicit assumption is that all return generated is liquid or can be readily made liquid by going through a robust public market. In a context where all assets are fully liquid, we can often forget that only liquid return can be used to buy goods and services, to pay liabilities, or in the case of most institutions, to pass on the return to its members.

The Illusion of Liquid Assets

Unlike public funds, the distribution of cash flows from private funds does not cater to on-demand requests from investors. Instead, the timing and magnitude of cash inflows heavily depend on the fund manager’s strategic decisions about liquidating portfolio holdings. Thus, accumulated value and returns housed within illiquid assets must gradually converted in portions, to liquid disbursements for investors, inherently blending returns of and returns on capital in the process.

The Impact of Strategic Decisions on Liquidity Timing and Magnitude

Furthermore, the net asset value (NAV) assigned to these illiquid investments can often feel like a mere number—an abstract figure devoid of real utility until it translates into future liquid distributions. That conversion occurs as the manager gradually turns the underlying portfolio into cash by selling investments to corporate acquirers, other funds, or the public markets. In this sense, then the notion of liquid distributions and fund returns are almost synonymous, because the distributions are how the fund generates returns over its life. The appraisal-based NAV number which investors receive in each quarterly statement is just a proxy of the present value of the future distributions which the investors will likely receive and which they actually care about. It becomes immediately clear then why private asset investors should be interested in forecasting the size and timing of that liquidity distribution stream as it will occur over time.

In contrast to distributions, fund contributions, reflects the investor’s liabilities in the private asset investing arena. A surface-level “unfunded commitment” snapshot may fail to capture the dynamic nature of future cash outflows. Hence, private asset investors must strategically assess their contributions over time—an essential practice in maintaining a clear picture of potential shortfalls in their liquidity.

The Need for Continuous Parameter Reassessment

The original Takahashi-Alexander work presented several fund examples alongside their model parameters. The analysis focused on buyout, venture capital, and real estate funds. This seminal model has had a significant impact on the way private funds have been analyzed since. While the original work by Takahashi and Alexander provided valuable insights using specific examples from the Yale Endowment’s portfolio, it inadvertently overlooked the broader applicability of the model parameters and evolving economic environments. The importance of adapting these parameters to suit a wider array of distinct fund groups and economic conditions is paramount, especially. As evidenced in the aftermath of the Global Financial Crisis (GFC) and the COVID-19 pandemic, distributions from funds can dramatically slow, underscoring the urgent need for ongoing parameter reassessment in response to changing market regimes.

Adapting to the Needs of Cash Flow Dynamics

The AYMS (Advanced Yale Model Service), solves all of these challenges for investors in a convenient and actionable workflow as implemented in the Dynamo Portfolio Management Module. By rethinking the integration of liquidity management within the framework of investment analysis, private asset investors can more adeptly navigate the complexities of their portfolios. As we forge ahead, blending rigorous analysis of liquidity with an acute awareness of market dynamics will undoubtedly empower investors, fostering a more balanced approach to achieving sustainable returns. View the AYMS Brochure.

This article first appeared on the Dynamo blog.