The allocation to alternative assets such as private debt and infrastructure has surged over the past decade, a trend extending beyond institutional investors to encompass wealth management clients. This shift is propelled by regulatory advancements, including the introduction of ELTIF structures in Europe and calls from the U.S. government to broaden access to private investments for individual retirement plans. Investors are drawn to private markets by the allure of higher expected risk-adjusted returns and unique opportunities for sustainable investing. However, this expansion necessitates a more sophisticated approach to managing increasingly complex portfolios. Building upon prior discussions on strategic asset allocation and implementation strategies, this article delves into the critical aspect of managing liquidity risk across various facets of the investment process.
Understanding and Quantifying Illiquidity Risk
Illiquidity risk, inherent in assets lacking deep secondary markets and characterized by lengthy purchase and sale processes, introduces significant uncertainty into the investment lifecycle. For asset owners, this impacts fundamental activities such as asset-liability management (ALM) studies. The absence of readily available market prices means that cash receipts and capital calls can fluctuate in size and timing, potentially leading to substantial over- or under-allocations to illiquid assets. This uncertainty also complicates the execution of de-risking strategies when market conditions demand agility.
A high proportion of illiquid assets inherently restricts an investor’s flexibility to reallocate capital between different asset classes. In practice, this can result in delayed rebalancing or transactions smaller than initially intended. The "denominator effect" exacerbates this challenge. During periods of significant market correction, such as the downturn experienced in 2022, the proportion of illiquid assets within a portfolio can swell considerably, even without new capital being deployed into these segments. Investors with a substantial allocation to assets with high interest rate duration, notably pension funds, are particularly vulnerable to the adverse consequences of this effect. The diminished capacity to rebalance can lead to significant deviations from the established investment strategy, potentially undermining long-term objectives.
Furthermore, the lack of robust secondary markets can lead to a disconnect between asset prices and their true transactional value. The reliance on valuation models for illiquid assets introduces model risk, meaning that underlying asset values may be impaired without this impairment being immediately reflected in the reported prices. This phenomenon, often termed "stale pricing," results in illiquid assets exhibiting lower volatility and lagging behind major market movements compared to their liquid counterparts. Consequently, evaluating traditional risk measures and correlations of illiquid asset classes with other segments of the market becomes challenging, often necessitating a greater reliance on qualitative judgment from asset owners.
Information asymmetry is another significant concern. Data pertaining to individual illiquid investments is frequently proprietary and not widely disseminated. This makes it increasingly difficult for asset owners to accurately assess asset quality, especially when external asset managers act as intermediaries. The bankruptcy of First Brands Group, for instance, caught some private market lenders by surprise due to undisclosed significant off-balance sheet liabilities. In such scenarios, asset owners cannot solely depend on asset managers for timely and accurate information regarding loan quality. Demanding transparency beyond standard reporting packages can prove difficult, particularly when investing with established managers overseeing substantial strategies.
Strategic Approaches to Mitigate Illiquidity
Addressing the multifaceted challenges posed by illiquid assets requires a proactive and comprehensive approach across the investment process. A combination of well-defined strategies can effectively mitigate, or at least manage, various aspects of illiquidity risk.
Integrating Illiquidity into Asset-Liability Management (ALM) Studies
Illiquidity must be an explicit consideration within the ALM framework. The artificial suppression of volatility and correlation with liquid asset classes, a consequence of stale and lagging pricing, can lead to unconstrained optimization models suggesting allocations to illiquid assets that expose the portfolio to higher risks than indicated by traditional metrics. Therefore, for real-world portfolios, imposing constraints on optimization is prudent. These constraints might include setting maximum allocations to specific asset classes or groups of asset classes. Employing stress tests is a best practice for informing these maximum allocation limits. For example, one could mandate that the proportion of illiquid assets does not exceed a predetermined threshold following a significant impact from rising interest rates or a sharp downturn in liquid markets.
The illiquidity factor can also be addressed by introducing a "liquidity penalty" into the optimization function. This could involve deliberately inflating the risk measures of illiquid asset classes beyond what is suggested by historical data or incorporating a penalty factor for these assets alongside risk and return metrics. Additionally, enforcing greater portfolio diversification can be achieved by penalizing portfolio concentration.
Correlation and risk metrics for illiquid asset classes can also be derived from comparable liquid asset classes. For instance, one might assume that over a suitable horizon, such as one year, direct lending spreads exhibit a high correlation with single-B rated high-yield bond spreads and senior bank loan spreads. The correlation of direct lending with other asset classes, like equities, can then be inferred from the correlation of high-yield bonds with equities.
Liquidity stress testing should also be an integral part of ALM studies. Asset mixes must demonstrate sufficient liquidity even under stressed market conditions. This is particularly crucial for investors managing portfolios with long durations, such as those employing interest-rate or inflation derivatives, as these often require liquid collateral to meet margin calls when real or nominal rates move adversely. It is best practice to pre-define a liquidity waterfall and apply haircuts to simulate the effects of forced selling under potentially stressed market circumstances. The U.K. gilt crisis of 2022 serves as a stark reminder that even highly illiquid investments like private equity can be liquidated rapidly, albeit at substantial discounts.
Strategic Implementation and Liquidity Planning
Given that capital deployment and repatriation in private market asset classes cannot be executed swiftly, investors incorporating these segments must establish a clear allocation plan for building, maintaining, and adjusting their positions. The investment team and external managers should possess a precise understanding of the capital to be deployed in each vintage year. Broadly speaking, this falls under liquidity planning, ensuring the capacity to meet capital calls and other potential payment obligations, such as pension payouts. Investors should position themselves to minimize the likelihood of becoming a forced seller, as liquidity can evaporate during market turbulence, leading to redemption fees, penalties, and gating mechanisms.
Consider a hypothetical investor with a EUR 1 billion balance sheet and an initial 20% allocation (EUR 200 million) to illiquid investments, which is also the target exposure. By the end of 2025, outstanding commitments necessitate capital calls, while anticipated distributions from the illiquid portfolio are uncertain. Initial projections at the end of 2025 suggest that expected distributions will outweigh capital calls, leading to a projected 17% allocation by the end of 2027 as the portfolio matures. In early 2026, a decision is made to commit an additional EUR 40 million to illiquid investments, with capital expected to be called over the eight quarters following the end of 2026.
If these plans unfold as expected, the middle panel of Figure 1 illustrates the portfolio’s development. With realizations aligning with end-2025 expectations, the allocation to illiquid assets reaches precisely 20% by the end of 2027, maintaining the target.
However, the bottom panel of Figure 1 reveals a different scenario if plans are disrupted. Assuming that after committing the EUR 40 million, the planned distributions for 2026 and 2027 are delayed by an additional year. Instead of addressing a projected 3% allocation gap (the 17% allocation if no new capital was committed versus the 20% target), the allocation to illiquid assets by the end of 2027 is expected to be 3% above the target. This highlights how unexpected delays in capital returns can exacerbate allocation imbalances.
Figure 1: Charts on the left depict the stock of illiquid assets and their mutations. Charts on the right illustrate the asset mix. The top panels reflect expectations at the end of 2025. The middle and bottom panels show the realization of these expectations when additional commitments are made to illiquid assets during 2026. The middle panel represents a base case scenario with distributions mirroring the top panel’s assumptions. The bottom panel illustrates the impact of a one-year delay in expected distributions.
The inherent unpredictability of capital deployment and return timelines in illiquid markets means that private equity firms, for example, can face challenges returning cash to investors when market conditions shift. While investors can rely on estimates from external asset managers or internal teams regarding deployment and repayments, supplementing these with stress testing and scenario analysis on expected cash flows is crucial. A second strategic imperative involves acknowledging in ALM studies that exposure to illiquid asset classes will naturally deviate from targets. Stress testing the asset mix under scenarios where both portfolio ramp-up and distributions significantly exceed or fall below targets is essential.
There is no single panacea for managing illiquidity. Asset owners are ultimately subject to external market forces when committing capital. However, through meticulous planning and the strategic use of stress testing to maintain adequate buffers, the inherent risks can be effectively managed.
Optimizing the Operational Setup
The operational demands of investing in illiquid alternative assets extend beyond complex modeling to day-to-day investment handling. The investment and back-office teams must be adequately staffed to manage the complexity of the respective portfolio. This may involve leveraging internal resources or engaging external partners, such as specialized investment consultants and reporting services. An organization requires robust systems and sufficient personnel to address pending capital calls. Larger asset bases or significant internal resources can facilitate the management of more intricate portfolios. As a general principle, organizations should align their asset allocation strategy with their size and available team resources, gradually building additional capacity as needed.
It is well-established that the dispersion of manager performance in illiquid asset classes can be substantial. Consequently, manager selection in alternatives is even more critical than in traditional asset classes. Investors must dedicate considerable time to developing a rigorous manager selection process. Diversification within asset classes, considering dimensions such as manager, sector, and vintage year, should also be a priority.
Conclusion: Navigating the Evolving Landscape of Alternative Investments
Over the past decade, the proportion of alternative assets within institutional and private wealth portfolios has grown significantly, leading to increased portfolio complexity and illiquidity. Asset owners are strongly advised to cultivate a clear understanding of their liquidity requirements. This understanding is the bedrock for defining appropriate quotas for illiquid asset classes within their strategic asset allocation. When implementing allocations to illiquid assets, liquidity planning and investment planning emerge as pivotal elements for building these asset classes and managing cash flows effectively. Within the realm of illiquid asset classes themselves, diligent manager selection and diversification across multiple dimensions are key strategies for mitigating selection risk.
Andreas Rothacher, CFA, CAIA, serves as the Head of Investment Research at Complementa AG, where he advises institutional clients on strategic asset allocation and manager selection. He is also a co-author of Complementa’s annual Swiss pension fund study, "Risk Check-up," and has authored numerous articles and publications. Mr. Rothacher is the Chapter Head of the CAIA Zurich Chapter and a member of the CFA Swiss Pensions Conference Committee. Prior to joining Complementa, he gained experience at a German family office and held various positions at UBS and Credit Suisse.
Richard Sanders, CFA, heads asset allocation and external manager selection activities at Coöperatie VGZ, a Dutch healthcare insurance organization. He is an experienced asset allocator with a focus on fixed-income portfolios for institutional investors. Mr. Sanders has advised sovereign wealth funds, pension funds, and insurance companies on manager selection and asset allocation, and previously managed the liquid investments of the insurance firm NN Group.
To learn more about the CAIA Association and to become part of a professional network shaping the future of investing, please visit https://caia.org/.
