Langham Hall Spring 2012: How to Develop a Private Equity or Real Estate Fund Model as a Finance Tool

Welcome to our Spring 2012 newsletter

This quarter we discuss how a private fund's finance team can develop and use a fund financial model to manage the operations of the fund and deal with sophisticted operational questions.

The article is spilt into two parts as it is somewhat longer than our typical quarterly articles. The first part (permanent link here) is the main overview, while the second part (available from me by email if of interest) has more implementation details. I hope you find them useful.

How to Develop a Private Equity or Real Estate Fund Model as a Finance Tool

Private equity and real estate fund models are commonly built during the fund raising period, either to estimate the anticipated returns of a fund based on assumptions about the expected deal flow, or to “replay” the net performance of an historical deal-by-deal track record as if the deals had been done within a fund structure. A fund model can also be a very helpful tool for the finance function in managing the operations of the fund during its life. However in this case, the model needs to be constructed somewhat differently as it will be answering different questions.

Key objectives

Whilst the finance team will also be interested in estimating the expected overall performance of the fund and the likely returns to the LP’s and the GP, there are some more immediate questions to be addressed. For example:

  • In preparing budgets for the fund manager (e.g. the Cayman manager or the Hong Kong advisory company), what will the management fees be in the coming periods?
  • At future closings, what is the likely level of capital equalizations for current and new investors? How much premium are new investors required to pay?
  • When making investments, how much additional capital should be drawn down alongside the deal amount to provide for future monitoring and transaction costs?
  • What level of working capital reserve, if any, should the fund hold in cash on its balance sheet?
  • How can capital calls be planned so that sufficient undrawn commitments will be available after the commitment period to enable management fees and fund expenses to be collected from LP’s?

Strategy for building the model

Attempting to build a highly complex, fully automated fund model that can generate all outputs for any scenario at the touch of a button is not usually the best approach. Even surmounting the challenges of building such a model, the time and difficulty of debugging and maintaining all the inherent complexities are probably not a good use of effort for the finance team. A more effective strategy is to break down the challenge into separate pieces that can be maintained on a semi-standalone basis and linked together with some manual support as required. A typical set of separable components might be:

  • carried interest waterfall module that accepts as input an amount of distributable cash (and the total amounts of prior distributions) and operates the waterfall to find out the share to the LP and the GP.  A simple preferred return model is also needed as a supporting module.
  • fund cash module that analyzes the current balance of cash in the fund according to the use of funds for which it was drawn and projects forward according to budget.
  • Individual deal working capital module that track the transaction costs, monitoring costs, and structuring costs against budget deal by deal (this model may not be needed if all deal costs are captured in a single SPV for which accounts are prepared).
  • commitments module that tracks the contributions and distributions, and the balances of drawn, undrawn, and recallable capital for each LP’s.  This model should also include invested capital and is the main working for estimating future management fees.
  • An investment IRR module that summarizes the deal by deal cashflows and the end of period investment valuations for gross IRR and multiples estimates.

Populating the model

The Limited Partnership Agreement will be the key source for all of the rules that the model will need to implement. Since often the “devil is in the detail”, it is probably best to use the LPA directly as the “manual” for building the model rather than to try and create written summaries that may oversimplify or introduce inaccuracies. Experience in interpreting the LPA is therefore critical. As far as standing data is concerned, instead of trying to maintain a complete history of fund transactions within the model it is probably more efficient to use up-to-date sources such as the drawdown and distribution notices / management accounts prepared by Langham Hall as the latest inputs in many areas. These will summarize in an organized manner much of the needed information, and are prepared directly from reconciled administration records.

Deriving insights with the model

The carried interest waterfall module will be helpful in anticipating expected distributions and in confirming the required carried interest accruals in the Fund financial statements under US GAAP or IFRS.  Whilst it might be unusual to discuss potential distributions with LP’s ahead of time, it can be helpful for investor relations to have in mind likely scenarios for upcoming quarter by quarter calls and distributions.  Additionally, where a deal-by-deal waterfall operates, it is not uncommon for a GP to review the carried interest model and elect to defer their carried interest on early or small disposals.

The fund cash module is primarily used to ensure that the actual use of capital contributions by the Fund matches the stated purposes for which they were drawn.  For example if the final investment amount of a particular deal was more or less than the amount called, then depending on the level of anticipated future transaction expenses there may need to be a further call or return of capital.  Similarly for organizational expenses, in which case the fund cap must also be taken into account.

The deal working capital module enables tracking of the balance sheet of each deal, especially where ongoing monitoring costs (and ongoing capital expenditure in the case of real estate funds) need to be matched against available funds, again in case further capital calls are necessary.

The commitments module essentially models the lifecycle of the fund.  Alternative scenarios for future calls and distributions should be worked out with the transaction team.  One of the most critical sensitivities in this module is the assumed timing of deal divestments.  This will drive important insights as to how much capital the fund will have available for recycling before the end of the commitment period, and how much of a buffer of undrawn commitments needs to be kept at the end of the commitment period for management fees and fund expenses after that (since in many case distributions up can be added back to undrawn commitments to the level of drawn fees and expenses).

The investment IRR module can be used both to validate reports such as the EVCA return on investment note, and also generate commentary for the managers section of the quarterly report, as well as looking at potential exits and their resultant multiples and IRR’s.

A rigorous approach to answering these and other questions proceeds in two stages.  Firstly, the relative sensitivity of the key inputs is established by varying them in turn whilst holding the other factors constant.  Then some integrated scenarios are created that combine assumptions for the key inputs according to various business cases.   The timing of decision making is also important.  For example at the very start of the fund life it may be assumptions are necessarily very broad and the resulting model insights correspondingly so, yet by the end of the commitment period flexibility around investment drawdowns (and therefore the window of opportunity to take certain decisions) will be coming to a close.  Therefore a review of the fund model at least each quarter is important.

Conclusions

Building a fund model to support the finance function can be a very helpful management tool. A modular approach with separate units for carried interest, fund cash, deal working capital, commitments, and deal IRR’s is likely to prove most successful. Optimum value can be had from the model when it is reviewed an updated on at least a quarterly basis over the lifecycle of the fund. Various insights can be obtained by identifying key sensitivities and creating integrated scenarios around them.

The second part of this article focuses on more detailed implemention issues and is available by e-mail if of interest. Or feel free to give me a call.