Managing Private Market Asset Allocations
Private market assets provide investors with additional sources of potential return, but how the journey is managed from commitment of capital to the implementation of the allocation is crucial.
Among institutional investors, the appetite for private assets has grown considerably amid a strong demand for alternative return drivers to build diversified portfolios of assets that can help investors achieve their long-term goals. A key challenge is how to build a portfolio that includes private asset exposure while ensuring that liquidity issues do not arise.
Because there can a long lead time between making the decision to commit capital to private assets and when that cash is called, institutional investors should adopt a clear strategy on how those earmarked funds are invested in the interim, a scenario that was outlined in our earlier article, How Indexed High Yield Can Complement Private Market Allocations. The other papers in this series cover how publicly-listed real assets can be used in conjunction with private real assets funds to achieve desired exposure and also how the role of bank loan ETFs can complement private credit allocations.
As detailed in the previous articles of this series, there are liquidity considerations to be taken when making such allocations. As volatility in the public markets has increased, investors are focused on 1) how they will fund the commitments they have made in prior years; 2) how to benchmark the alternatives allocation while waiting for the capital to be called; and 3) how to manage the allocation in a period of volatile public markets.
High Demand for Private Assets
Apart from the potential upside return and diversification benefits, a key attraction of private market assets for many investors is the greater stability in pricing it offers relative to public markets. During a period in which public markets have been beset by volatility the demand for private assets has continued to grow. This is amply illustrated by the amount of potential cash available to private assets firms for investment; this ‘dry powder’ awaiting deployment stood at a record high of almost US$3.7 trillion at the end of 2022, up from $1.1 trillion a decade earlier1 . Private equity accounts for the bulk of the committed cash, although fundraising has been strong through the end of 2022 across key asset classes, as reflected in Figure 1.
Managing the Buildout of a Private Asset Allocation
One significant challenge that institutional investors regularly encounter, when investing in private asset classes, centers on managing the current asset allocation towards the long-term target. An institutional investor typically reviews their Strategic Asset Allocation (SAA) every one-to-three years, and once the decision is made to invest in private assets, their Investment Policy Statement (IPS) might look something like the example below:
| Asset Class Group | Current Target (%) | Long-Term Target (%) | Difference (%) |
|---|---|---|---|
| Liquid Growth | 70 | 60 | -10 |
| Private Growt | - | 10 | +10 |
| Real Assets | 10 | 10 | - |
| Fixed Income | 20 | 20 | - |
Source: State Street Global Advisors. For illustrative purposes only.
Building an allocation of 10% to private growth assets can take years to achieve while managing diversification within the private asset allocations. The question then becomes one of how to measure portfolio performance relative to a benchmark that is actually investible. There are several ways to manage this:
Interim Benchmarks
We start by carrying out a cash flow pacing analysis for the private assets. We estimate the required commitments and corresponding net cash flows (expected capital called minus distributions) to build up an allocation of 10% of the total plan’s assets. There are a lot of assumptions that go into the model and we typically revisit the cash flow pacing analysis annually. Figure 3 illustrates what such an allocation to private credit might resemble over time.
The table below shows the investible benchmark that we would adopt for the first year while the allocation to private assets is being built up.
| Asset Class Group | Current Target (%) | Year 1 Target | Long-Term Target (%) |
|---|---|---|---|
| Liquid Growth | 70 | 65 | 50 |
| Private Growth | - | 5 | 10 |
| Real Assets | 10 | 10 | 10 |
| Fixed Income | 20 | 20 | 20 |
| Total Assets | 100 | 100 | 100 |
Source: State Street Global Advisors. For illustrative purposes only.
Split Management of Public and Private Assets
Another approach would be to create a benchmark where we manage the publicly-traded assets to a public-only benchmark that sums to 100% and we let the private asset weight float as the allocation is gradually built up over time.
| Asset Class Group | Current Target (%) | Actual Year 1 Allocation | Public Scaled to 100% | Long-Term Target (%) |
|---|---|---|---|---|
| Liquid Growth | 70 | 65 | 68.4 | 60 |
| Real Assets | 10 | 10 | 10.5 | 10 |
| Fixed Income | 20 | 20 | 21.1 | 20 |
| Total Public Assets | 100 | 95 | 100 | 90 |
| Private Growth | - | 5 | - | 10 |
| Total Private Assets | - | 5 | - | 10 |
| Total Assets | 100 | 100 | - | 100 |
Source: State Street Global Advisors. For illustrative purposes only.
As in the previous instance, we would revisit the cash flow pacing analysis annually to ensure the private market allocation is being built up as expected.
Funding Private Asset Allocations
An additional consideration relates to how the private asset allocation is to be funded once the investment decision has been made. The most common private market allocation is to private equity. We typically benchmark private equity against MSCI World + 2% p.a., as this is the long-term aspiration for private equity over public equity. Clearly, this benchmark can change depending on the characteristics of each individual client’s private equity allocations.
Funding private equity from public equity is a natural choice given the abundance of liquidity. Similarly, we could use combinations of bank loans and high yield for private and opportunistic credit. The split of bank loans and high yield can vary depending on the nature of the private investment, in particular in terms of the risk and return profile.
Private real assets can be proxied with combinations of liquid real assets, whether that is a combination of “real assets” or a specific allocation. Private infrastructure is a good example of this, with listed infrastructure having a similar long-term return but with almost double the volatility. However, the correlation between private and listed infrastructure is around 90% if the holding period for listed infrastructure is over two years.
Other Considerations
There are other considerations investors should be aware of:
- Denominator effect: In an investor’s strategic asset allocation, the public assets tend to be more volatile than private assets. In addition, private market valuations tend to lag public assets so when markets are volatile the percentage allocation to private assets moves around a lot. We would urge clients not to be too hasty in changing their commitment plans in reaction to market volatility that could temporarily leave them overweighted to illiquid holdings.
- Currency Hedging: Typically most of the opportunities to private investments are in the US, but not all. Therefore, for US-based investors may want to consider currency hedging any non-USD exposure. For non-US-based investors, investments in private assets will carry a significant amount of currency risk so currency hedging is a much bigger consideration.
The Bottom Line
Private asset allocations, whether to real assets, equity, or credit, provide investors with additional sources of potential return, increased diversification, and lower volatility given the valuation approach. The illiquid nature of such assets and the lag time between the commitment and drawdown of capital for these investments makes managing the implementation of the allocation particularly important. This includes how to fund the capital calls, how to benchmark the allocation before it is fully implemented, how to manage volatility, and deciding whether currency hedging is needed. Each client will have different governance and structural considerations to balance when determining how best to implement an illiquid allocation.
State Street has assisted many different types of clients, in different regions, in successfully implementing illiquid asset allocations that have added value and helped them achieve their objectives. Please contact your Relationship Manager for additional information on how we can help with your portfolio liquidity and exposure needs.