FRM Part II · FRM Exam Part II · Private Markets Investing
A fund of funds holds private equity commitments and also maintains a credit facility. During a market downturn, public equity values fall 30% and the fund's distributions slow sharply while capital calls continue. Which risk best describes the combined pressure the investor faces, and what is the most appropriate management response?
The investor faces liquidity risk from binding unfunded commitments combined with slowing distributions. The appropriate response is to hold a liquidity buffer and stress test capital calls against lower distributions and NAV. Futures hedges or new commitments do not reduce call obligations and may worsen the cash squeeze.
- ALiquidity (unfunded commitment) risk; maintain a liquidity buffer and stress test calls against reduced distributions and lower NAVCorrect
- BBasis risk; hedge the portfolio with public equity futures to offset the fall in call amounts
- CReinvestment risk; increase commitments to new funds so that vintage diversification absorbs the calls
- DModel risk only; replace the cash flow model with the most recent reported NAV, which removes the call uncertainty
Explanation
Unfunded commitments are legally binding while distributions are discretionary and fall in downturns, so the investor may face a cash shortfall, or a denominator effect on allocation limits. Holding liquid reserves and stress testing calls against reduced distributions addresses this. Hedging with futures does not change call obligations, and adding commitments raises future calls.
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