The Hidden Risks of Unfunded Commitments: How to Protect Your Portfolio

An unfunded commitment is a futures contract to provide funding and is subject to certain conditions. It is a liability that is not yet recorded in the balance sheet.

• Unfunded portions of loans or loan commitments made by banks and other financial institutions. For example, if a bank approves a $100 million loan for real estate construction and only $20 million has been paid. You would have a $80 million unfunded commitment to the bank.
• Capital call obligations in private equity and venture capital partnerships. Investors commit a certain amount of capital upfront when joining a fund. This is a promise to provide cash when the general partner issues capital calls to make investments. The total unfunded portion is the investor's remaining commitment.
• Letters of credit issued by banks that guarantee a customer's payment to a third party. The bank has an unfunded obligation to pay if the customer cannot.
• Revolving credit facilities which allow a borrower to draw down funds up to a certain limit. The undrawn portion is an unfunded commitment of the lender. Unfunded commitments are an important consideration for financial institutions, investment funds, and any companies with off-balance sheet exposures. They represent future potential cash funding requirements as well as credit risk and require careful monitoring and management.

Unfunded Commitments in Private Equity

Private equity funds rely heavily on unfunded commitments from limited partners (LPs) to finance investments and fund operations through capital calls. When a private equity fund identifies an investment opportunity, it will issue a capital call to LPs for a portion of their unfunded commitment to provide the capital required. The capital call process typically works as follows:

• The private equity fund manager will determine the capital needed for a new investment or to support an existing portfolio company. This is based on the total equity investment required.
• Based on the LP's unfunded commitment percentage, the fund manager will issue a capital call and request contributions on a pro-rata basis.
• Limited partners must quickly fund according to their agreement. The timing requirements vary, but LPs usually have 10-30 days to wire their portion of the capital call to the fund.
• If unable to meet a capital call, the limited partner can have serious consequences, such as the forfeiture of their investment, reputational impacts, and potential restriction from future funding.

Private equity firms use unfunded commitments to mitigate timing risk between raising a fund and deploying the capital into investments. However, LPs also face risks from over-committing to funds or underestimating their future capital call obligations. Strategies LPs can use to prudently manage unfunded commitments include:

• Diversifying across multiple fund vintages and geographies to avoid concentration risk.
• Stress testing their portfolio for large, simultaneous capital calls across funds.
• Maintaining sufficient liquidity through cash reserves or credit facilities.
• Co-investing directly into deals to reduce unfunded commitment exposure.
• Limiting over-commitment past a reasonable level (e.g. 150% of investable capital).
• Monitoring investment pacing and being aware of capital call notices.
• Evaluating secondary market options to sell down a portion of commitments.

Proper unfunded commitment to asset management is now recognized as crucial for LPs to successfully meet their obligations to private equity funds when capital calls are made.

Unfunded Commitments in Venture Capital

VC funds are highly reliant based on unfunded commitments, especially through their limited partners as they are the capital investments over the life of a fund. When injecting more capital into the company, VCs make the investments in stages, starting with Series A rounds and increasing it as milestones are achieved.

This staging of capital reduces risk as VCs retain dry powder to allocate in follow-on rounds for their top performers while cutting losses on underperformers. To facilitate this staged investing approach, LPs commit more dollars upfront to reserve capital that can be "called" by the fund over time.

For example, an LP may commit $20 million to a VC fund, but only $5 million is funded upfront. The remaining $15 million is defined as an unfunded commitment, money that sits in reserves, available to be called by the fund for future investments. This gives VCs flexibility to scale investments in winners. However, maintaining adequate reserves to meet unfunded commitments carries risks. If an LP overcommits across too many funds, it may fall short when capital calls are made.

Similarly, holding reserves ties up capital that could be invested elsewhere. LPs must balance these tradeoffs carefully when constructing their venture portfolio. Proper planning of reserves ensures dry powder is available for follow-on funding rounds while avoiding the opportunity cost of excessive unfunded commitments.

Real Estate Funds

Unfunded commitments also finance development projects, requiring upfront capital until completion and revenue generation. Therefore, real estate funds are highly reliant on unfunded commitments to finance these investments. Managing unfunded loan commitments is essential for funding liquidity and pursuing investment opportunities. However, excessive unfunded commitments pose risks if investors cannot meet future capital calls.

Risks of Unfunded Commitments

Unfunded commitments and loans can pose several risks and liabilities for companies and investment funds that need to be managed carefully. The main risks include:

Liquidity Risk

If a capital call is made, the company must provide the cash within 10-30 days. So, having a lot of underfunded credit commitments can make the company illiquid. The company may need to sell off other assets or raise capital under duress if it cannot meet the obligation. Because of this, companies may need to sell assets at lower prices, leading to losses.

Capital Call Timing Risk

In addition to general liquidity risk, the timing of specific capital calls can also create issues. Capital calls often cluster around when investment funds are making new deals. If the market is facing turmoil during one of these periods, the company may struggle to raise the necessary cash precisely when financial and business conditions are tight. Proper planning and diversification are key to mitigating the risk around clustered capital call timing.

Market Downturn Risk

During an economic or financial market downturn, it can be very difficult to meet capital call obligations, especially for companies already facing liquidity issues. Having a large amount of unfunded loan commitments outstanding heading into a recession or crisis can exacerbate losses and force distressed selling of assets to raise cash for capital calls. Companies need to carefully stress test their ability to meet commitments in a downturn scenario. Reducing unfunded commitment exposure before market peaks can help mitigate this risk.

Managing Unfunded Commitment

Exposure Unfunded commitments can pose risks to investors if not calculated and managed properly. Here are some strategies investors can use to mitigate their unfunded commitment exposure:

Portfolio Construction

Investors can optimize their portfolio construction to account for unfunded commitments. This includes:

• Diversifying across vintage years, geographies, sectors, and fund managers to avoid concentration risk from capital calls at the same time.
• Investing in funds with differentiated drawdown schedules to smooth capital calls. First-time funds typically call capital faster than established funds.
• Building portfolio scenarios under different pacing assumptions. Faster drawing funds may require higher liquidity buffers.
• Limiting overcommitment at the total portfolio level based on liquidity projections. Most investors cap their total unfunded commitments.

Secondary Market Transactions

Selling private market assets on the secondary market is an option to reduce unfunded commitments. Some strategies include:

• Offering existing investments for sale when new commitments would push total unfunded exposure too high.
• Selling down recent vintage-year investments that still have large unfunded portions remaining.
• Structuring synthetic secondary deals to transfer unfunded commitments to a buyer.
• Exploring fund restructuring options to reduce unfunded commitments in exchange for other terms.

Co-Investments

Co-investing directly into companies alongside funds can provide more control over capital deployment than relying solely on fund investments. Investors can:

• Make co-investments to supplement fund investments, reducing the amount invested into funds.
• Invest in co-investments with no or low unfunded commitments as an alternative to fund investments.
• Negotiate co-investment terms with managers to optimize capital call timing and amounts.

Proactively managing unfunded commitment exposure allows investors to pursue private market investments while controlling portfolio risk. Secondary sales, co-investments, and portfolio construction are key tools to achieve this in the balance sheet.

Unfunded Commitment Ratios and Metrics

Unfunded Commitment Ratio

This ratio calculation measures total unfunded commitments divided by total committed capital. A higher ratio indicates the borrower has more outstanding commitments and capital call obligations. Many investors target a ratio below 30-40%.

Overcommitment Ratio

This gauges the amount of commitments compared to available capital. It's calculated as the value of total commitments divided by investable capital. A ratio above 1.0x essentially means commitments exceed available capital. Most investors limit this ratio to 0.70-0.90x.

Remaining Value to Paid-In (RVPI) Ratio

This assesses unfunded commitments relative to capital already committed or contributed. It's equal to remaining unfunded commitments divided by paid-in capital. Higher ratios signal the likelihood of more future capital calls. RVPI ratios above 0.50x merit close monitoring.

Industry Averages

Comparing ratios to industry benchmarks provides context on relative exposure levels. Average unfunded commitment ratios reported in 2020 were approximately 25% for private equity and 45% for venture capital. Overcommitment ratios averaged nearly 60-70% of available capital.

Tracking unfunded commitment liability ratios versus historical trends and industry averages enables investors to gauge if they have excessive exposure. Developing limits and guardrails for these ratios is an important part of managing risks. The specific thresholds depend on liquidity, risk tolerance and portfolio construction objectives. But maintaining discipline is key.

Best Practices for Unfunded Commitment Management

Managing unfunded commitments effectively requires robust policies, procedures, and risk management frameworks. Here are some best practices:

Implement Clear Policies Around Commitments

• Set guidelines on maximum commitment amounts per fund/manager based on portfolio construction targets. This helps avoid over-concentration.
• Establish policies on pacing of commitments over time to manage cash flow needs. Committing too much upfront can strain liquidity.
• Define eligibility criteria for managers to receive commitments. This ensures commitments go to top-tier managers.
• Create policies for re-ups and commitment increases to existing managers. Based on past performance and relationship.
• Institute approval processes and authority limits for making new commitments.

Build a Risk Management Framework

• Conduct stress tests to model performance in different economic environments. Gauge portfolio impact.
• Run scenario analysis on the timing of capital calls and sequence risk. Prepare contingency plans.
• Build sufficient liquidity buffers and credit lines to cover near-term capital calls.
• Monitor investment pacing by vintage to anticipate capital calls.
• Diversify across geographies, sectors, and strategies to mitigate concentration risks.
• Review manager concentration limits if over-committed to certain relationships.
• Use secondary sales to rebalance and manage unfunded commitments if needed.
• Negotiate longer investment periods, extensions, or restructuring if needed to manage cash flows.

By implementing robust policies, procedures, and consistent risk management around funded and unfunded commitments, investors can prudently manage their exposure. Stress testing commitments and maintaining liquidity are key.

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