Webinar recap: Determining your optimum private markets asset allocation

Executive summary:

• Alternative assets include private equity, private credit, private infrastructure, and hedge funds. These assets can provide better returns and lower volatility compared to liquid investments, making them an important consideration for portfolio diversification. 
• A private pacing model can help assess whether organizations with private asset allocations will be able to meet their cashflow needs.
• We believe it’s a good idea to have the liquid portion of the portfolio cover at least three years of spending needs, ensuring stability during market stress. This approach helps in balancing the portfolio's overall risk and managing uncertainties related to cashflows and market conditions.

On June 4, Samantha Foster, managing director of private markets at Russell Investments, led a discussion on liquidity and determining your optimal asset allocation to alternative investments. She was joined by Mary Beth Lato and Amneet Singh, both directors of strategic asset allocation at Russell Investments.

Following are highlights of their 52-minute conversation. Periodic timestamps are provided.

Foster started off by sharing the results of a poll posed for the online audience.

What is your asset allocation target to illiquids (defined as six months)? <1:35>

Most participants (40%) said 10% to 30% in illiquids.

Can you provide us with an overview of alternative assets and why they're worth discussing today in the context of liquidity? <2:16>

Singh explained that alternative assets are an asset class that is not traded in public exchanges, so a traditional investor used to investing in ETFs (exchange-traded funds) or mutual funds might not have access to them.

“You can think of them in two broad buckets: private assets—which could be private equity, private credit, private infrastructure—or hedge funds, which do trade in liquid assets but then they deploy strategies like short selling or have leverage in them, which make them unique in the kind of exposures that can get to a portfolio,” Singh said.

Historically, illiquid asset classes and alternatives have had better returns and lower volatility compared to some liquid investments that they compete with, he said.

Why do investors not include privates and alts? If they do, why is it sometimes at a relatively low level? <7:07>

Lato said it’s critical to first explore underlying illiquidity. While these investments have different liquidity profiles, their main similarity is that you're unable to guarantee when you actually get liquidity from them.

“By liquidity, we simply mean the ability to easily convert the investments to cash,” she said. That cash has two uses: first is the primary use of it—the objective of the organization. For instance, for an endowment or foundation that may be doing annual spending for a pension plan that's paying benefits. “You can't necessarily convert those investments to cash for that,” she added. 

The other use of that cash is rebalancing. “If you look to rebalance on a monthly or quarterly basis, you’re essentially looking to sell the asset classes you're overweight in—and use that cash to buy the asset classes you're underweight in—so with the inability to guarantee liquidity, you could also have rebalancing concerns,” Lato said.

Other than liquidity, are there other reasons why investors might not feel comfortable with a high allocation to alternatives? <10:37>

Lato explained that although liquidity is often the first consideration, another concern is that, in traditional assets, your return is primarily driven by market exposures, with your choice of investment manager not leading to significant dispersion in results.

“In private and less liquid investments, we do see more significant dispersion depending on manager selection, and that reliance on being able to select a top-tier manager can be a concern for many investors.” Another concern are manager fees, since fees are higher in the less liquid asset space, she added.

Foster shared the results of another poll posed to the online audience: What concerns you most about illiquid investments? <11:54>

Most participants (60%) said, “the ability to meet the organization's cashflow needs.”

Foster gave a brief explanation of managing tail risk while discussing private pacing. Private pacing is one way that helps to analyze that tail risk for the cashflow modeling and the probability of defaulting on a liability, she explained.

Analysis like this is never perfect and, like all investing, there is a component of judgement when interpreting this type of pacing model, she said. With that, “this model gives a good amount of guidance on whether there's going to be enough cash under normal and market-stressed conditions,” Foster remarked.

How many years of spending should the liquid part of your portfolio be able to cover for in the event of a cashflow shortage or shock? <18:15>

Singh said three years is a reasonable time frame. “The liquid part of the portfolio should cover multiple years of spending but there is no hard and fast tool to project this. We find that most of our clients typically have a three-year planning horizon, so it lines up well with the horizon they use in their planning and projecting purposes,” he said.

Foster added: “Having been a practitioner, three years is kind of that Goldilocks period where it's not too short, it's not too long. You tend to have a decent view of what your needed cashflows will be from either a spending payout or making benefit payments or the underlying commitments that are going to be called from your private markets—and it does sort of take that consideration of the ability for the market to recover if there has been a drawdown. Even if it doesn't fully recover, you'll tend to get some denominator effect back into your portfolio. Planning for an extreme shock is also really important.”

Do you believe a fully funded DB plan should have exposure to illiquid investments? <27:42>

Lato said it’s situational dependent and provided an example. “A fully funded open or newly-closed DB plan could still have a rather meaningful allocation to less liquid investments. A frozen fully funded plan, which is more mature but is still looking to just hibernate, might have a small allocation to private credit. It might not be zero (percent) but it wouldn't be 30% or 40% either, but a 5 % allocation to private credit could still be very appropriate,” she said.

“On the other hand, if it’s a fully funded frozen plan that is thinking they might want to terminate in the next few years, we would not recommend it.”

Singh said he takes a total portfolio approach where the amount and kind of private assets that you hold will impact the kind of liquid assets that you have. “It’s a question to be looked at from a total portfolio lens and the interaction of the public and the private both need to be taken into account,” he said.

We've discussed a bunch of the factors that impact the ability to have liquidity and the outflow coverage in these stressed market conditions. Are there any other factors that tend to impact these allocations or the desired allocation? <41:42>

“I think it's important to acknowledge the behavioral considerations because, as we've discussed, pretty much by definition, if you have an allocation to illiquids, you cannot rebalance to policy targets,” Lato said. “Yes, you can do things with your liquid portfolio to adjust factor exposures, but you will not be rebalancing to asset class policy targets on a monthly or quarterly basis. And different investors will have different levels of comfort with this.”

Singh added: “I think most research that's published on this topic doesn't really take into account, for example, the choices that you would make in constructing your private assets portfolio.” He explained that ways in which evergreen funds—or certain private asset classes that return capital more quickly than others—where the deviation or how long that persists can be squeezed.

“Most research I've read is more high level and doesn’t get into the details of actually modeling cashflows and saying, what choices can I make even if there's a drag to reduce that drag and still end up doing better with private assets in my portfolio than not having them,” he said.

Foster highlighted the main points of the discussion, including cashflow modeling, legal fund structure, total risk exposures, organizational comfort with uncertainty and planned and unknown cashflows. <50:39>

“Those are all things to think about when it comes to how much risk you want to take and how that determines your illiquidity bucket in terms of your overall portfolio,” she said.

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