Wish List

I love the Christmas season.? While the lack of snow so far in Minnesota has made things feel a little less festive, other signs of the season abound.? The neighborhood is colorfully lit as we come home in the evening, Christmas cards are begging to roll in, and most importantly, there is the joy of opening the mailbox to see a crisp new toy catalog waiting to be paged through.?

Physical toy catalogs are less common these days, but I was happy that Amazon, Target, and the trusty Fleet Farm Toyland catalog all made it to our home this year.? As each one arrives, my youngest daughter will grab it from my hands, pick up a marker on the way to the couch, and get to circling stuff for her wish list.? By the time she is done, it is clear it would have been easier to just cross out the few things she didn’t want, rather than circling the vast majority of the toys within.?

This year when she handed the marker covered pages back to me, I said to her, “You remind me of a portfolio manager that has been assigned a new allocation to private markets and is tasked with picking from a vast and exiting array of investment opportunities and can’t help but want to invest in all of them!”? She stared back at me with what I assume is a look of admiration for this brilliant analogy, and then ran upstairs, probably to tell her sister about my ingenious comment.

Ok, I admit that scenario may have only happened in my mind, but the part about the portfolio manager happens all the time.?

In last month’s Nord, we talked about the high-level asset allocation decision and how to come up with an allocation target to private markets.? After that decision is made, the hard part begins, implementation.

Building a Private Market Portfolio

There are four important reasons to have a commitment model and forward calendar:

1. It helps determine how much to invest over time to reach and maintain a target allocation in private markets.
2. It helps determine the proper commitment size to each individual private fund added to a portfolio.
3. It refines and focuses manager selection.
4. For a financial advisor, a consultant, or an investment staff member, it makes the process of gaining approval of a specific fund opportunity from a client, investment committee, or CIO, substantially easier.

Target Allocation

A commitment model will include assumptions for the pace of contributions, the growth of net asset value, and the pace of distributions. When building a new private capital allocation, the model will show a higher level of calls than distributions early in the program.? This combined with valuation growth will cause the portfolio’s value to increase toward a target allocation. ?At a point in the future, early funds will have invested all their capital, and start distributing capital from the sale of investment. These distributions will begin to outpace capital calls and portfolio and valuation growth. The goal of the investor is to pace commitments over time in a way that flatlines that NAV growth near the target allocation.

Commitment Sizing

A commitment model helps determine the size of each individual commitment to each fund opportunity. ?I think it is a mistake to implement a static annual commitment budget, but it is a helpful starting point.? Using a generic private capital cash flow profile, an average level of annual commitments needed to reach a target allocation can be determined. Once you have an annual budget, you must then decide how many fund managers and investment line items you want to have in the portfolio.

For example, if targeting 12 GP relationships, and assuming that each is nearly fully invested and raising another fund every 3 years, you can plan on 4 fund commitments per year.? Yes, that is an oversimplification, but can be refined later. You can divide your annual budget by the 4 annual fund commitments, and you have an individual commitment size starting point.

Different strategies will have different cash flow profiles, which will result in different timing of investment, distribution, and peak net asset value.? By assigning an investment asset class and strategy to each of the 12 expected investments on your forward calendar, it can help you refine exactly how much to invest in each.? Next, the actual fund managers must be identified to fill the forward calendar slots.

Manager Selection

I personally believe one of the most important ramifications of maintaining a forward calendar is that it forces more thoughtful manager selection. ?Like my daughter with her toy catalogs, private market investors are inundated with interesting ideas daily.? Placement agents and investor relations professionals are incredibly good at telling their stories.? It would be fun to be able to say “yes” to so many more compelling investments.?

A forward calendar forces you to compare each of those exciting opportunities against everything that you plan on investing in the coming years.? By deciding to move forward with a new opportunity today, you must consider the impact it will have on your ability to commit capital as planned in the future. ?If this is a new line item, you will likely need to either reduce all future commitments by a small amount, entirely remove a future planned investment to accommodate a new one, or do neither and accept that you are more likely to overshoot your target allocation.?

In other words, a forward calendar forces you consider any new opportunity relative to other current opportunities, but also to all future opportunities on the plan.

Investment Approval

Anytime I have worked on the implementation of a new private market allocation, whether it be with a financial advisor and individual client, or an institutional investment committee, I have found it best to start with a model and plan, versus showing a specific investment opportunity.? Going forward, anytime you do bring the client fund recommendation, you can do so in the context that it is intended to fill a place on the existing plan, rather than it appearing as some new thing that may have just come across your desk.

For example, you might note to a client that there has been a placeholder for a buyout fund in 2024 since the plan was implemented years ago.? That placeholder has been on the forward calendar every quarter that you have reviewed it with the client.? During that time, you and the research team have scoured the small buyout fund landscape for what you believe to be top-tier fund managers.? Now you have identified a fund that is a perfect fit for this planned allocation.

That creates a much different discussion with the investment committee or client, than if you must re-explain the characteristics of private capital every time you bring in a new investment idea.? It also frames each investment correctly, as serving a role in a diversified portfolio, rather than viewing it as a stand-alone bet.?

Until Next Year

Thank you to all of you that have subscribed to my newsletter.? I wish you all the best as we roll through the holiday season into the New Year.?

Please reach out if you are interested in learning how Nord Associates can help you implement a private capital plan and forward calendar.