Hidden in Plain Sight—The Impact of Undrawn Commitments

Abstract

Undrawn commitments are a critical characteristic of investments in largely illiquid limited partnership funds. They are the “dry powder” of cash reserves that fund managers have available to deploy when an attractive opportunity arises. Undrawn commitments are therefore not just a technical detail but one of the private equity model’s critical success factors. Nevertheless, their impact is still not fully understood. The key questions are whether undrawn commitments form part of the allocation to private equity, and, importantly, whether there are opportunity costs associated with them. In fact, many academics and most regulators do not view undrawn commitments as part of an allocation to the asset class. Auditors at least acknowledge the liquidity risk inherent in undrawn commitments, and under some audit conventions view them as hidden leverage. Market experience suggests, however, that undrawn commitments be of higher relevance than is widely perceived. This article proposes a framework to reconcile these differing perspectives. TOPIC:Private equity Key Findings • Investors in funds, that is, the limited partners, are exposed not only to the capital actually invested in private equity but also to the funds’ uncalled capital. While often neglected, this uncalled capital carries significant risks and opportunity costs. • Financial markets price the uncalled capital, for example, in the form of increased discounts for secondary sales, or subscription lines that use the capital as collateral for leverage to increase carried interest. • One way to model this economic reality is to view a fund in its entirety as one financial instrument and the uncalled capital held by the limited partner as a loan against this instrument.