The allocation to alternative assets, such as private debt and infrastructure, has surged dramatically over the past decade, extending beyond the portfolios of institutional investors to increasingly capture the attention of wealth management clients. This trend is underpinned by regulatory shifts like the introduction of ELTIF structures in Europe and governmental encouragement in the United States 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, yet they face the commensurate challenge of managing increasingly complex portfolios. While previous discussions have offered practical guidance on navigating these complexities, this analysis delves into the critical aspect of managing liquidity risk across various facets of the investment process.
Understanding the Nuances of Illiquidity Risk
Investing in illiquid assets fundamentally alters the traditional investment process for asset owners, beginning with asset-liability management (ALM) studies. The absence of deep secondary markets and the protracted nature of purchase and sale processes introduce inherent uncertainty regarding the timing and quantum of anticipated cash inflows and capital calls. This unpredictability can lead to significant over- or under-allocations to illiquid assets, complicating the execution of de-risking strategies when market conditions necessitate swift action. Furthermore, a substantial proportion of illiquid assets inherently constrains an investor’s agility in rebalancing their portfolio across different asset classes. In practical terms, this can translate into delayed rebalancing or smaller-than-intended transactions, potentially deviating from the strategic asset allocation targets.
The "denominator effect" is a related concern that exacerbates these challenges. 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 additional capital being deployed into these segments. This is particularly perilous for investors with a high proportion of interest-rate-sensitive assets, such as pension funds, whose liabilities often have long durations. The diminished capacity to rebalance effectively can result in substantial divergences from the established investment strategy.
Compounding these issues is the risk that asset prices in illiquid markets may not accurately reflect their true value in an arm’s-length transaction. The prevalent reliance on valuation models for illiquid assets introduces model risk. Consequently, investors may find themselves in a situation where an asset’s value has genuinely diminished, but this impairment is not yet reflected in its reported price. This phenomenon, often termed "stale pricing," means that the prices of illiquid assets tend to exhibit lower volatility than their liquid counterparts and lag behind major market movements. This divergence complicates the evaluation of traditional risk measures and correlations between illiquid asset classes and other segments of the market, compelling allocators to increasingly depend on qualitative judgment.
Information pertaining to individual illiquid investments is frequently proprietary and not widely disseminated. This scarcity of data makes it increasingly arduous for asset owners to ascertain the quality of their underlying assets, especially when external asset managers act as intermediaries. The bankruptcy of First Brands Group, for instance, caught some private market lenders off guard due to significant off-balance-sheet liabilities. In such scenarios, asset owners cannot solely rely on the asset manager to provide timely and accurate information regarding loan quality. Demanding transparency beyond the standard information packages, particularly when investing with established managers and substantial strategies, can prove challenging for investors.
Strategic Imperatives: Integrating Illiquidity into Investment Frameworks
Addressing the inherent challenges of illiquid asset investing requires a multi-pronged approach, integrating mitigation strategies at various stages of the investment lifecycle. A combination of these measures can effectively manage, or at least attenuate, the impact of illiquidity risk.
Incorporating Illiquidity into Asset-Liability Management (ALM) Studies
The ALM process must explicitly account for the presence of illiquidity. The characteristic "stale" and lagging pricing of illiquid assets can lead to artificially low correlations with liquid asset classes and understated volatility. In an unconstrained optimization framework, this might result in allocations to illiquid assets that expose the portfolio to substantially higher risk than suggested by traditional risk metrics. For real-world portfolios, imposing constraints on the optimization process is often prudent. This can involve setting maximum allocation limits to specific asset classes or groups of asset classes. Employing stress tests is a valuable practice to inform the setting of these maximum allocations. For example, one might stipulate that the proportion of illiquid assets should not exceed a defined threshold even after factoring in the impact of rising interest rates or a sharp decline in liquid markets.
The illiquidity aspect can also be addressed by introducing a liquidity penalty into the optimization function. This might involve deliberately adjusting the risk measures of illiquid asset classes upward, beyond what is suggested by historical data, or incorporating a penalty factor for illiquid asset classes alongside traditional risk and return measures. Furthermore, enforcing greater portfolio diversification can be achieved by penalizing portfolio concentration.
Correlations and risk metrics for illiquid asset classes can also be derived from comparable liquid asset classes. For instance, it can be reasonably assumed that, over a suitable horizon such as one year, direct lending spreads will 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, such as equities, can then be inferred from the correlation of high-yield bonds with equities.
Liquidity stress testing should also be an integral component of ALM studies. Asset mixes must demonstrate sufficient liquidity under stressed market conditions. This is particularly pertinent for investors managing portfolios with long durations, such as those employing interest-rate or inflation derivatives, as these positions can require liquid collateral when real or nominal rates move adversely. It is best practice to pre-define a liquidity waterfall and utilize haircuts to simulate the impact of forced selling under potentially stressed market circumstances. As evidenced by the 2022 UK Gilt crisis, even highly illiquid investments like private equity can be divested rapidly, but this often necessitates accepting substantial discounts.
Strategic Implementation and Liquidity Planning
Given that reallocations within private market asset classes cannot be executed swiftly, investors incorporating these segments into their portfolios must establish a robust plan for building, maintaining, and adjusting these allocations. The investment team and external managers should possess a clear understanding of the capital deployment schedule across different vintage years. This concept extends to comprehensive liquidity planning, ensuring the capacity to meet capital calls and other potential outflows, such as pension disbursements. Investors should position themselves to minimize the likelihood of being compelled to sell assets under duress. Liquidity can evaporate during periods of market turbulence, and redemptions may be subject to fees, penalties, and gating mechanisms.
To illustrate the potential investment quandaries posed by illiquid assets, consider a hypothetical scenario involving an investor with a substantial illiquid investment program, initially allocating 20% of a €1 billion balance sheet. At the close of 2025, outstanding commitments necessitate future capital calls, while simultaneous, albeit uncertain, distributions are anticipated from the illiquid asset portfolio. The initial expectations at the end of 2025 suggested that expected distributions would outweigh capital calls, leading to a projected portfolio runoff to a 17% allocation by the end of 2027. Subsequently, at the commencement of 2026, a decision is made to commit €40 million in capital to new illiquid investments, with these funds anticipated to be called over the eight quarters following the end of 2026.
If these plans materialize as projected, with realizations aligning with the end-of-2025 expectations, the portfolio’s allocation to illiquid assets is expected to reach the target of 20% by the end of 2027. However, a deviation from these expectations can significantly alter the outcome. If, for instance, after committing the €40 million, the anticipated distributions over 2026 and 2027 are delayed by an additional year, the portfolio’s allocation to illiquid assets at the end of 2027 could exceed the target by 3%, rather than addressing a projected 3% shortfall (moving from 17% to 20%).
The inherent opacity of private markets makes precise forecasting of capital deployment and repayment challenging. As investors in private equity are currently experiencing, changing market circumstances can impede private equity firms’ ability to return capital to their investors. While investors can rely on estimates provided by external asset managers or internal teams regarding deployment and repayments, supplementing these with stress testing and scenario analysis on projected cash flows is crucial. A second strategy for managing these implementation complexities involves acknowledging in ALM studies that exposure to illiquid asset classes will naturally deviate from targets. This necessitates stress testing the asset mix under scenarios where both portfolio ramp-up and distributions significantly exceed or fall below expectations.
While there is no single, foolproof solution, as investors are ultimately subject to external market developments when committing capital, careful planning and the maintenance of adequate buffers through stress testing can effectively manage illiquidity risk.
Optimizing the Operational Framework
The complexities of investing in illiquid alternative assets extend beyond their modeling to encompass day-to-day operational management. The staffing of both the investment team and the back-office functions must be commensurate with the intricacy of the investor’s portfolio. This may involve augmenting internal resources with external partners, such as specialized investment consultants and investment reporting services. An organization must possess appropriate systems and adequate personnel to manage impending capital calls. A larger asset base or substantial internal resources can facilitate the management of more complex portfolios. As a general guideline, organizations should identify an asset allocation strategy that aligns with their size and available team resources, and progressively build additional capacity as needed.
It is widely recognized that the dispersion of manager performance in illiquid asset classes can be substantial. Consequently, manager selection in alternative assets assumes even greater importance than in traditional asset classes. Organizations must therefore invest considerable time in developing a rigorous manager selection process. Investors may also consider diversification within asset classes by incorporating dimensions such as manager, sector, and vintage year.
Concluding Remarks
The past decade has witnessed a significant augmentation in the proportion of alternative assets within institutional and private wealth portfolios, leading to increased portfolio complexity and illiquidity. Asset owners are strongly advised to cultivate a profound understanding of their liquidity requirements. This understanding will, in turn, enable them to establish appropriate quotas for illiquid asset classes within their strategic asset allocation framework. When implementing allocations to illiquid assets, liquidity planning and investment planning emerge as pivotal elements for building asset classes and effectively managing cash flows. Within illiquid asset classes themselves, diligent manager selection and diversification across multiple dimensions are crucial 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. Andreas is the Chapter Head of the CAIA Zurich Chapter and a member of the CFA Swiss Pensions Conference Committee. His prior experience includes roles at a German family office and at UBS and Credit Suisse.
Richard Sanders, CFA, is an accomplished asset allocator with a focus on fixed-income portfolios for institutional investors. He has advised sovereign wealth funds, pension funds, and insurance companies on manager selection and asset allocation, and managed the liquid investments of insurance firm NN Group. He currently leads asset allocation and external manager selection activities at Coöperatie VGZ, a Dutch healthcare insurance organization.
To learn more about the CAIA Association and its role in shaping the future of investing, visit https://caia.org/.
