Allocation to Private Assets in Open-Ended Funds: Capturing the Illiquidity Premium and Managing Liquidity Constraints

Abstract

Investment portfolios that include private assets can gain a number of potential advantages, including diversification, enhanced returns and less risk. Moreover, there is evidence of a growing number of private asset investment opportunities that can have a positive sustainable impact. However, such advantages also bring challenges. One is the illiquid nature of private assets which require locking up capital for several years. Another is that the capital allocated to a private asset fund is neither put to work immediately nor fully returned to the investor on a single future date. The cash flows associated with the capital calls and distributions from the allocation to a private asset fund that typically span numerous years thus need to be well managed. A further challenge is the minimum investment size often being too large for most investors, limiting either diversification or even any access to private asset funds at all. For these reasons, many investors would benefit from being able to invest in open-ended funds with a diversified and adequately managed allocation to private assets. In this paper, we propose a strategy for doing exactly that. The strategy is designed to create a fully invested target allocation of the portfolio to private assets which is kept constant over time by efficiently managing the associated cash flows of the underlying funds. We also investigate stress test scenarios that illustrate the impact of market shocks and redemption shocks on the size of the allocation to private assets in such portfolios, while assuming that no capital allocated to private asset funds can be redeemed. We show how the strategy needs to adapt during such events to bring the allocation to private assets back to target.

Keywords: Private assets, private equity, private debt, illiquidity premium, open-ended funds, mutual funds, internal rate of return

JEL Classification: G11, G12, G15