This post is part 2 of a 2 part series. Click here to read the first post.
Managing the tradeoff between liquidity and performance is a central challenge for allocators and investment professionals. Building a Better Portfolio: Balancing Performance & Liquidity is a great resource for allocators and investors looking to systematically meet this challenge. In a previous post we summarized the five components of an asset allocation model that incorporates private market assets. In this post we’ll discuss a few more highlights from the paper.
A good private asset commitment strategy must balance several investment objectives. These include performance, risk and liquidity. Over the years academics and practitioners have developed a variety of models and heuristics to balance these objectives.
In How Large Should Your Commitment to Private Equity Really Be? Researchers propose a simple rule of thumb. Simply commit the capital allocated to private assets each year. This is a deterministic rule, and it does not make use of any currently available information. The goal is to build and maintain a desired allocation to the targeted asset class. Other possible methods include basing the allocation decision on the amount of uncalled capital, cash, NAV and recent distributions. The idea is to consistently commit a fraction of overall capital.
Another slightly more advanced framework is known as the Nevins commitment model.
Nevins Commitment Model
The Nevins Commitment model comes from a paper in the Journal of Alternative Investments: A Portfolio Management Approach to Determining Private Equity Commitments.
This model uses four parameters.
- Rate of capital calls
- Rate of Distribution
- Rate of Return on Public Assets
- Rate of Return on private assets
Since it requires input from external data sources, its a bit more advanced than simple rules of thumb. Nonetheless, it is much simpler to implement than more complex allocation models.
Three important questions for private asset investors
An asset allocator that makes commitments to private assets needs to balance many competing demands. As they build their process, they should always keep three questions in mind:
- How to formulate a private asset commitment strategy to manage private asset exposure and the uncertainty in timing and magnitude of their cash flows over time?
- What should be the desired allocations (public vs. private, public passive vs. public active) given the investor’s liquidity risk tolerance?
- How would various market scenarios impact the portfolio’s liquidity and performance?
Click here to read the GIC and PGIM paper that develops a framework for answering these questions.
Running Cash Flow Simulations
Best practices for allocators involve running simulations to see how various commitment strategies impact cash flows. By stress testing “:worst case scenarios” an investor can position the portfolio in a way that avoids a situation where they are forced to sell good assets at a discount to meet liquidity demands, while still allocating enough to illiquid assets to achieve desired returns.
Alternative investments are an important part of any asset allocation strategy. Used wisely, they can enhance returns and reduce risk. A key part of using alternative investments wisely involves balancing the tradeoff between liquidity and performance.
Closed end interval funds are a fund structure designed to force an elegant compromise between two extremes of liquidity structures. This fund structure can be used for a wide variety of strategies, and is becoming increasingly popular with both mass affluent and institutional investors.