Institutional investors globally are increasingly turning to private markets encompassing private equity, private credit, real estate, and infrastructure in their strategic asset allocations (SAA). This shift is driven by the pursuit of enhanced returns, diversification, and access to unique investment opportunities not readily available in public markets, particularly as traditional assets face a complex macroeconomic environment. The growth in private markets AUM has been substantial, signaling a structural evolution in institutional portfolios. However, integrating these illiquid assets presents considerable challenges. Capturing the often-cited illiquidity premium requires a long-term commitment and the ability to navigate extended lock-up periods and unpredictable cash flow patterns.
A critical aspect of incorporating private markets is understanding and adjusting for the “smoothing effect” inherent in their reported valuations. Infrequent, appraisal-based valuations can understate true economic volatility and correlation with public markets, potentially leading to misjudgments of risk and an overestimation of diversification benefits. Sophisticated modelling techniques are necessary to derive more realistic risk-return inputs for SAA.
Determining the optimal allocation involves a nuanced assessment of an institution’s capacity to bear illiquidity and complexity, its specific need for excess returns, and, crucially, its ability to consistently source, select, and manage high-performing private market investments. Frameworks that move beyond traditional mean-variance optimisation are often more suitable, considering these unique characteristics.
Robust governance and oversight are paramount for successful private market programmes. This includes establishing clear investment policies, diligent manager selection, proactive monitoring, and the effective management of conflicts of interest. Key operational practices such as disciplined commitment pacing plans and thorough vintage year diversification are essential for mitigating risk, managing liquidity, and building resilient, self-sustaining private market portfolios over time.
Different institutional investor types; endowments, sovereign wealth funds, and pension funds will approach private market SAA with varying objectives, liability profiles, and risk tolerances, leading to tailored allocation strategies. Scenario analysis and stress testing are vital tools for understanding the potential impact of private market allocations under diverse market conditions.
This whitepaper examines these critical facets of private market integration. It provides a framework for institutional allocators to prudently incorporate private equity, private credit, real estate, and infrastructure into their SAA, aiming to harness their return potential while diligently managing the associated risks. Ultimately, long-term success in private markets hinges on a sophisticated, well-governed, analytically rigorous, and adaptable approach. Advanced analytical tools, such as Acclimetry’s asset allocation platform, can play a crucial role in facilitating the complex modelling, scenario planning, and decision support required to navigate this evolving landscape and achieve optimal long-term outcomes.
The investment landscape has undergone a significant transformation over the past decade, compelling institutional investors to re-evaluate traditional allocation strategies. The persistent search for alpha, initially in a prolonged low-yield environment pre-2022 and now within a new, more volatile macroeconomic regime, has increasingly led allocators towards private markets. This strategic shift reflects a fundamental recognition of the potential for private assets to contribute to long-term return objectives and enhance portfolio resilience, particularly as public markets contend with challenges such as heightened inflation, interest rate volatility, and complex geopolitical risks.
The growth in assets under management (AUM) within private markets has been remarkable. For instance, assets in private credit markets alone nearly tripled over the decade leading up to 2025, reaching an estimated $2 trillion, primarily in direct lending. More broadly, total private markets AUM reached $11.7 trillion by 2022 and is projected for continued substantial expansion, with some estimates suggesting growth to almost $30 trillion by 2033. This sustained expansion indicates a structural shift in institutional asset allocation rather than a mere cyclical trend. A key contributing factor is the phenomenon of companies choosing to remain private for longer periods. The average age of a company at its initial public offering (IPO) increased from 4.5 years in 1999 to over 12 years in 2020. Consequently, a significant portion of economic growth, innovation, and value creation is now captured outside of public exchanges, compelling allocators to look towards private markets for comprehensive exposure to the real economy.
This trend is further amplified by what some term the “democratisation” of private markets. There is growing interest from high-net-worth individuals and, increasingly, the potential for broader retail investor participation through evolving fund structures and regulatory landscapes.
This expanding investor base could further fuel AUM growth. However, it may also introduce new layers of regulatory scrutiny and challenges related to product suitability and investor education. The influx of capital from these new segments might also lead to a bifurcation in product offerings: sophisticated, institutional-grade funds designed for experienced allocators, and more accessible vehicles tailored to the needs and understanding of newer entrants, which may come with different fee structures or liquidity provisions.
The sustained and significant growth in private markets AUM also carries implications for investment dynamics. With more capital chasing opportunities, competition for high-quality deals is intensifying. This heightened competition may compress expected returns from broad market exposure (beta) to private assets. As a result, the premium on manager skill encompassing sourcing differentiated opportunities, driving operational value-add within portfolio companies, and executing successful exits becomes increasingly critical for achieving outperformance. Investors are recognising this, with a noted preference for managers who can demonstrate an ability to produce excess and repeatable alpha.
Private markets comprise a diverse range of asset classes, each with distinct characteristics, risk-return profiles, and roles within an institutional portfolio. Understanding this spectrum is fundamental to effective allocation.
It is increasingly evident that the traditional delineations between these private asset classes are becoming less distinct. Hybrid strategies are emerging, such as infrastructure debt (financing for infrastructure projects, considered a type of private credit) and real estate credit. This convergence is also observable more broadly, with a blurring of lines between conventional and alternative assets, and even between public and private securities. This evolution necessitates that allocators develop more nuanced classification systems for their portfolios and more sophisticated due diligence processes that look beyond traditional asset class silos. Relying on rigid, historical definitions may lead to mischaracterisation of these hybrid strategies or a failure to fully appreciate their unique risk, return, and correlation drivers.
Asset Class | Key Characteristics | Primary Return Drivers | Key Risk Factors | Typical Role in Portfolio |
Private Equity (PE) | Equity in non-public companies; active GP management; LBOs, VC, Growth, Distressed; 5-12 year fund life. | Operational improvements, revenue growth, multiple expansion, financial leverage. | Market risk, illiquidity, operational risk, valuation uncertainty, manager selection | Growth, return enhancement, access to innovation |
Private Credit (PC) | Privately negotiated loans; customised terms; direct lending, mezzanine, distressed, ABF; 3-7 year typical duration | Interest income (often floating rate), fees, illiquidity/complexity premium | Credit/default risk, illiquidity, interest rate risk (for fixed), manager selection | Income, higher yield, diversification, downside protection |
Private Real Estate (PRE) | Direct/indirect property ownership; Core, Core-Plus, Value-Add, Opportunistic strategies; variable holding periods | Rental income, capital appreciation, value creation through development/repositioning | Market cycle risk, illiquidity, property-specific risks, leverage, interest rates | Income, inflation hedge, diversification, capital growth |
Private Infrastructure (PI) | Essential physical assets; long-life, stable cash flows; often regulated or contracted revenues; 10-15+ year horizons | Stable yield from user fees/contracts, inflation linkage, capital appreciation | Regulatory risk, political risk, operational risk, illiquidity, development risk | Stable income, inflation hedge, diversification, resilience |
The increasing allocation to private markets by institutional investors is fundamentally driven by the pursuit of superior risk-adjusted returns and enhanced portfolio diversification. These assets are perceived to offer unique characteristics that can contribute meaningfully to long-term investment objectives.
A central tenet of investing in private markets is the concept of the illiquidity premium. This is defined as the potential excess return that investors can expect to earn for committing capital to assets that cannot be easily or quickly bought or sold without incurring a substantial price discount, compared to otherwise similar liquid assets. This premium is compensation for forgoing liquidity and bearing the associated risks.
Several factors determine the existence and magnitude of the illiquidity premium. Primarily, higher transaction costs in private markets, which can range from brokerage fees to extensive due diligence expenses, contribute to this premium. The complexity of many private assets and their investment structures also plays a role; these assets often require specialised analytical skills and resources, thereby limiting the pool of potential buyers and reducing liquidity. This can give rise to a distinct “complexity premium.”
Furthermore, information asymmetry between buyers and sellers in less transparent private markets can command a premium for those with superior information or analytical capabilities. Academic models, such as those by Amihud and Mendelson (emphasising investor patience and holding horizons) and Acharya and Pedersen (focusing on an asset’s sensitivity to market-wide liquidity), provide theoretical underpinnings for the illiquidity premium.
Successfully capturing the illiquidity premium is not automatic. It generally requires investors to possess patience, a willingness to commit capital for extended periods, often aligning with the long-term investment horizons of private market funds. Additionally, scale can be crucial, particularly for accessing and analysing complex deals where due diligence costs are substantial. Investors must be prepared to align their longer investment horizons with the inherent illiquidity of these assets.
It is important to recognise that the illiquidity premium is not a uniform or guaranteed reward. Its magnitude can vary significantly across different private asset sub-classes (e.g., private equity may command a different premium than private credit), prevailing market conditions, and even individual transactions.
Indeed, the substantial inflow of capital into private markets, as discussed earlier, may lead to increased competition for deals and potentially compress the ex-ante illiquidity premium available in some segments. Investors, therefore, must be discerning, conducting thorough due diligence to assess whether the expected excess return from a specific investment adequately compensates for its unique illiquidity profile, rather than relying on a generic asset class label.
Moreover, the “complexity premium” is an often-intertwined component that warrants specific attention. Capturing this premium demands specialised expertise and significant resources for due diligence and structuring. Investors lacking these in-house capabilities or access to highly skilled managers might find themselves paying for a premium they cannot fully realise. In such cases, they may be taking on uncompensated complexity risk or overpaying for assets, thereby eroding any potential premium.
Beyond the potential for an illiquidity premium, private markets offer institutional investors access to a broader and often distinct set of investment opportunities compared to public markets. This includes exposure to companies at earlier stages of their lifecycle, particularly through venture capital and growth equity strategies, where public market comparables may be scarce or non-existent. These early-stage companies are often at the forefront of innovation and technological disruption.
Private markets also provide access to different industry sectors or market segments that may be underrepresented in public indices. For example, private equity portfolios often exhibit a higher concentration in technology companies compared to traditional small-cap public equity benchmarks. This allows investors to tap into specific secular growth themes more directly.
The structural trend of companies staying private longer means that a greater share of value creation from initial growth and scaling to significant operational improvements is occurring before these companies consider an IPO. By investing in private markets, institutions can participate in this value creation process, often benefiting from the active management and operational expertise of skilled General Partners (GPs) who work closely with portfolio companies to drive growth and efficiency.
The “uniqueness” of these opportunities can vary by strategy. For venture capital and growth equity, the access to nascent companies and disruptive technologies is clearly distinct. In the case of leveraged buyouts (LBOs) of more mature companies, the uniqueness may lie less in the inherent nature of the underlying businesses (which might have public market peers) and more in the control premium and the ability of PE firms to implement significant operational, strategic, and financial changes that might be more challenging to execute under public ownership structures. This active management and governance overlay is a key differentiator.
Historically, private assets have been sought after for their potential diversification benefits, stemming from reported lower correlations with traditional public market asset classes like equities and bonds. This lower correlation can, in theory, help reduce overall portfolio volatility and improve risk-adjusted returns over the long term.
However, the reported correlation figures for private assets warrant careful interpretation. The valuation methodologies typically employed for private assets—often appraisal-based and conducted quarterly rather than daily mark-to-market—can lead to a “smoothing” of reported returns. This smoothing effect can artificially dampen reported volatility and understate the true economic correlation of private assets with public markets, particularly over shorter time horizons. Consequently, the diversification benefits suggested by raw reported data may be overstated.
Various “unsmoothing” techniques have been developed to adjust reported private asset returns to better reflect their underlying economic volatility and correlations. These methods often involve analysing returns over longer rolling periods or using statistical models to account for lagged responses to public market movements. When such adjustments are applied, the calculated volatility of private assets tends to increase, and their correlation with public markets often appears higher than initially reported. For example, after unsmoothing, private equity volatility has been shown to be comparable to that of U.S. large-cap equities.
Despite these adjustments, some diversification benefits from including private assets in a portfolio may still persist. Unlisted infrastructure, for instance, has been found to have the potential to improve portfolio Sharpe ratios, even after accounting for unsmoothed returns, particularly for investors with defensive or balanced risk profiles.
The true diversification benefit of private markets is not a static property; it can fluctuate significantly with prevailing market regimes and the increasing interconnectedness of global capital. During periods of acute market stress or systemic crises, such as the Global Financial Crisis of 2008, correlations across nearly all asset classes, including private ones (once their valuations eventually reflect market realities), tend to increase sharply. This means that diversification benefits can diminish precisely when they are most needed. Therefore, relying solely on long-term average correlations for SAA purposes can be misleading and potentially hazardous. The potential for “buyer strikes” or “liquidity black holes” during crises, where markets for even typically liquid assets can dry up, further underscores this point.
Furthermore, the diversification argument needs to be nuanced by the specific private market strategy employed. A global buyout fund heavily exposed to macroeconomic cycles and investing in large, established companies may offer less genuine diversification from public equities than, for example, a niche private credit strategy focused on uncorrelated risk factors or a venture capital fund investing in truly disruptive technologies with unique idiosyncratic risks. Allocators should therefore look beyond broad “private markets” labels and analyse the underlying economic exposures and drivers of return for each specific strategy to understand its true diversification potential.
(Note: Specific figures below are illustrative and would require sourcing from the latest comprehensive reports from Cambridge Associates, Preqin, Burgiss for the whitepaper. The table structure demonstrates the concept.)
Asset Class | Avg. Ann. Return (Net of Fees) | Reported Volatility | Indicative Unsmoothed Volatility | Sharpe Ratio (Reported Vol.) | Sharpe Ratio (Unsmoothed Vol.) | Data Period Example | Key Data Source Examples |
Global Private Equity | ~12-15% | ~10-14% | ~16-22% | ~0.6-0.9 | ~0.4-0.6 | 20-Year to 2023 | Cambridge Associates |
U.S. Private Equity | ~13-16% | ~11-15% | ~17-23% | ~0.7-1.0 | ~0.45-0.65 | 20-Year to 2023 | Cambridge Associates |
Global Private Credit (Direct Lending) | ~7-9% | ~4-6% | ~7-10% | ~0.8-1.2 | ~0.5-0.8 | 10-Year to 2023 | Preqin, Cliffwater |
U.S. Public Equities (S&P 500) | ~9-10% | ~15-17% | N/A | ~0.4-0.5 | N/A | 20-Year to 2023 | S&P Dow Jones Indices |
Global Public Equities (MSCI World) | ~7-8% | ~14-16% | N/A | ~0.3-0.4 | N/A | 20-Year to 2023 | MSCI |
Global Aggregate Bonds | ~3-4% | ~3-5% | N/A | ~0.3-0.6 | N/A | 20-Year to 2023 | Bloomberg Barclays |
Notes: Returns are illustrative net-of-fee estimates based on historical data; actual returns vary significantly. Volatility for private assets is often smoothed; unsmoothed estimates attempt to reflect economic volatility. Sharpe Ratios are calculated assuming a risk-free rate (e.g., 1-2%). Data periods and sources should be explicitly stated in a final report. The primary purpose here is to illustrate the concept of comparing reported vs. unsmoothed data and their impact on risk-adjusted return metrics.
While private markets offer compelling return and diversification prospects, their integration into institutional portfolios is fraught with complexities. Chief among these are the challenges posed by illiquidity, the nuances of valuation, and the effective management of associated risks.
A defining characteristic of private market investments is their inherent illiquidity. Unlike publicly traded securities, private assets cannot be readily bought or sold. This illiquidity manifests primarily through lock-up periods imposed by fund structures, during which investors’ capital is committed and cannot typically be withdrawn. The duration of these lock-ups varies by asset class and strategy:
These extended lock-up periods contribute to cash flow mismatches. The timing of capital calls (when GPs request committed capital from LPs to fund investments) and distributions (when proceeds from realised investments are returned to LPs) is largely at the discretion of the GP and can be unpredictable. This uncertainty can create significant challenges for LPs in managing their overall portfolio liquidity and meeting other financial obligations. Even mature private market programmes, which may be “self-funding” on an aggregate basis (distributions from older funds covering calls for newer funds), can experience temporary cash flow mismatches.
Consequently, a rigorous liquidity needs assessment is a critical prerequisite for any institution considering or expanding private market allocations. Investors must meticulously evaluate their own liquidity requirements, which are dictated by factors such as liability profiles (e.g., pension payments, endowment spending rules), operational cash needs, and regulatory capital constraints, against the illiquid nature and uncertain cash flow timing of private investments. Recent surveys indicate that managing liquidity has become an increasing priority for asset owners, with six out of ten reporting it as a bigger concern over the past year, and many holding higher cash reserves as a mitigation strategy.
The rise of evergreen fund structures in private markets is, in part, a direct response to LP demands for improved liquidity and more predictable cash flow profiles compared to traditional finite-life drawdown funds. These funds, which continually raise capital and reinvest proceeds, often offer periodic redemption options (subject to gates and notice periods). While enhancing liquidity, evergreen funds introduce their own complexities. For instance, they may maintain “liquidity sleeves” – portions of the fund held in cash or liquid securities to meet redemptions which can create a drag on overall returns if these liquid assets underperform the core private market investments. Redemption gates, limiting the amount of capital that can be withdrawn in any given period, are also common features designed to protect remaining investors from forced asset sales in unfavourable market conditions. Thus, while offering a solution to some liquidity challenges, evergreen funds are not a panacea and require careful due diligence.
A common practice among LPs, particularly those building up their private market programmes, is the use of “overcommitment strategies.” This involves committing more capital to funds than the long-term target allocation, with the expectation that distributions from earlier investments will fund capital calls for later commitments, thereby accelerating the deployment towards the target. However, this approach carries significant risk. If exit markets slow down unexpectedly and distributions dry up, a scenario observed in recent years, LPs can find their unfunded commitments ballooning relative to their available liquid capital. This can lead to a liquidity squeeze, forcing LPs to become unintentional net borrowers, sell other portfolio assets at inopportune times to meet capital calls, or even default on commitments, which carries severe penalties.
Private Asset Class Example | Metric | Value Based on Reported (Smoothed) Returns | Value Based on Adjusted (Unsmoothed) Returns | Implication for Portfolio Construction |
Private Equity | Annualised Volatility | 8-12% | 15-25% | Underestimation of standalone risk; potential overallocation if risk budgets are based on reported data. |
Private Equity | Correlation with Public Equity | 0.3-0.6 | 0.6-0.9+ | Overestimation of diversification benefits; portfolio may be less diversified than perceived. |
Private Real Estate | Annualised Volatility | 5-8% | 12-20% | Similar to PE, risk may be understated, affecting capital allocation decisions. |
Private Credit (Direct Lending) | Annualised Volatility | 3-5% | 6-9% | While still lower than equity, the true volatility is higher than often perceived from reported data. |
Note: Figures are illustrative and represent typical ranges discussed in academic and industry research. Specific values depend on the dataset, time period, and unsmoothing methodology. The key takeaway is the directional impact of adjustment.
The valuation process for private market assets inherently leads to a phenomenon known as the “smoothing effect,” which has significant implications for risk assessment and portfolio construction. Unlike publicly traded securities that are marked-to-market daily, private assets are typically valued on a less frequent basis, usually quarterly, and often rely on appraisal-based methodologies or internal models rather than observable transaction prices. This practice results in reported return series that appear smoother and less volatile than the true underlying economic performance of the assets. This smoothing effect can lead to several misperceptions:
Recognising these distortions, various techniques have been developed to “unsmooth” private asset return data. These methods aim to estimate the true economic volatility and correlation by, for example, analysing returns over longer rolling holding periods (which washes out some smoothing), incorporating information from secondary market transactions (which can reveal market-based prices, especially during periods of stress like the 2008 financial crisis when some private equity assets traded at substantial discounts to NAV), or using statistical models that account for lagged betas and autocorrelation in reported returns. Studies applying these techniques have shown that the unsmoothed volatility of private equity, for instance, can be comparable to that of public equities, and correlations also tend to be higher.
The perception of smoothed returns among LPs can be complex. Some investors may implicitly welcome the lower apparent volatility as it can reduce reported portfolio drawdowns and mitigate potentially negative behavioural reactions to market fluctuations. Indeed, some research even suggests that LPs may exhibit a preference for smoothed return profiles, which could subtly influence how GPs report valuations. However, sophisticated institutional investors increasingly recognise that this smoothing masks true economic risk. Moreover, conflicts of interest can arise if GP management fees or carried interest are linked to reported Net Asset Values (NAVs), potentially creating a disincentive for timely and appropriate write-downs of asset values during market downturns.
The pressure for more “robust valuations” in private markets is growing, driven by increased regulatory scrutiny (e.g., from bodies like IOSCO) and the proliferation of open-ended or evergreen fund structures. In these structures, investor subscriptions and redemptions occur at the prevailing NAV, making the accuracy and timeliness of valuations critical for ensuring fairness among entering, exiting, and ongoing investors. This trend may lead to the adoption of more frequent or more market-sensitive valuation practices over time, which could gradually reduce the traditional smoothing effect and bring reported risk metrics closer to their economic realities.
While unsmoothing techniques are valuable analytical tools for SAA, it is important to acknowledge that they provide estimations of unobservable true economic volatility and correlation. The results of these techniques can be sensitive to the specific methodology and assumptions used (e.g., the choice of lag structure in a statistical model or the comparability of secondary market transactions). This introduces a degree of model risk. Therefore, this residual uncertainty should be recognised in risk management processes and capital allocation decisions, perhaps by using a range of unsmoothed estimates or by incorporating qualitative overlays based on market conditions and expert judgment.
Effectively managing the illiquidity inherent in private market investments is a cornerstone of a successful allocation strategy. Several tools and strategies are employed by institutional investors to navigate this challenge.
Secondary Markets for private market interests have matured significantly and are playing an increasingly vital role in providing liquidity solutions for both LPs and GPs. For LPs, the secondary market offers a mechanism to sell existing fund commitments before the end of a fund’s life, thereby addressing unforeseen liquidity needs, rebalancing portfolio allocations, or crystallising returns. For GPs, “GP-led secondaries,” often structured as continuation vehicles, allow them to move specific assets from an older fund into a new vehicle, providing liquidity to existing LPs who wish to exit while allowing the GP (and potentially new LPs) to continue managing promising assets for a longer period. Transaction volumes in the secondary market have grown substantially, reaching an estimated $160 billion in 2024. The benefits of participating in secondary transactions can include J-curve mitigation (as assets are typically more mature), reduced blind pool risk (as the underlying assets are known), and potentially attractive pricing, although sales often occur at a discount to the latest reported NAV, particularly in stressed market conditions or for less desirable assets.
The rise of GP-led secondaries, particularly continuation funds, represents a major structural evolution in private markets. While these transactions offer a valuable liquidity option and a way for GPs to extend their management of successful investments, they also introduce new layers of complexity. Valuing assets in a GP-led transaction can be challenging, as the GP is effectively on both sides of the deal (selling from the old fund and managing the new vehicle). This necessitates robust governance and independent valuation oversight to ensure fairness. LPs in the original fund face a decision to either “roll over” their interest into the new continuation vehicle or “cash out,” requiring a careful analysis of the terms of the new vehicle, the asset’s future prospects, and the pricing offered for exit. This can lead to a bifurcation of interests among LPs and requires careful management of potential conflicts.
Commitment Pacing Plans are strategic frameworks used by institutional investors to manage the timing and magnitude of their capital commitments to private market funds over a multi-year period. The objectives of a pacing plan are to gradually build up to and then maintain a target allocation to private markets, manage overall portfolio cash flows by balancing capital calls and distributions, and achieve diversification across different vintage years (the year a fund makes its first investments). A well-designed pacing plan can help mitigate the risk of over-concentrating capital in potentially unfavourable market environments and can smooth out the J-curve effect (the tendency for private equity funds to show negative returns in early years due to fees and investment deployment before value accretion) at the portfolio level over time.
Cash Flow Forecasting is an essential component of both pacing plan development and ongoing liquidity management. Given the uncertainty in the timing and size of capital calls and distributions, robust forecasting models are crucial for anticipating future liquidity needs, managing unfunded commitments, and avoiding situations of overallocation or forced selling of other assets. These models, which can range from modified versions of academic frameworks like the Takahashi-Alexander model to proprietary systems, typically use historical cash flow patterns, GP projections, and market conditions to estimate future cash flows. As institutional allocations to private markets grow, the absolute dollar amounts of these unpredictable capital calls and distributions become larger and more impactful on total portfolio liquidity. This makes ad-hoc liquidity management increasingly risky and inefficient, driving the need for more sophisticated forecasting capabilities and, often, dedicated internal resources or external expertise.
Other liquidity management tools employed by institutions include maintaining higher cash reserves or allocations to highly liquid short-term instruments to meet potential capital calls, and strategically using liquid alternatives (such as certain hedge fund strategies or liquid real asset ETFs) to manage uncalled capital, aiming to generate some return while maintaining accessibility. As previously discussed, evergreen fund structures with built-in redemption mechanisms also offer an alternative approach to managing liquidity within a private markets allocation.
Asset Class | Typical Initial Lock-Up Range (Years) | Common Extension Provisions (e.g.) | Typical Fund Life (Years) | Key Liquidity Mechanisms |
Private Equity (PE) | 5-7 (Investment Period) | 2-3 x 1 year | 10-12+ | Distributions (Exits: IPO, M&A, Sale to another PE firm); LP Secondary Sales; GP-Led Secondaries |
Private Credit (PC) | 2-4 (Investment Period) | 1-2 x 1 year | 5-8+ | Loan Repayments/Refinancing; Distributions; LP Secondary Sales (less common/deep than PE) |
Private Real Estate (PRE) (Closed-End) | 3-5+ | 1-2 x 1 year | 7-10+ | Property Sales; Distributions; LP Secondary Sales; GP-Led Secondaries |
Private Real Estate (PRE) (Open-End/Evergreen) | 1-5 (Initial Lock-up) | N/A (Ongoing Fund) | Indefinite | Periodic Redemptions (subject to gates, notice periods); Distributions |
Private Infrastructure (PI) | 5-7+ (Investment Period) | 2-3 x 1 year | 12-15+ (or longer) | Asset Sales/Refinancing (long-term holds common); Distributions; LP Secondary Sales |
The unique characteristics of private market investments—particularly their illiquidity, valuation methodologies, and return profiles—pose significant challenges for traditional Strategic Asset Allocation (SAA) models. Consequently, institutional investors often require modified or alternative frameworks to determine appropriate long-term allocations.
Standard Mean-Variance Optimisation (MVO), the cornerstone of much traditional SAA, struggles to effectively incorporate private assets for several fundamental reasons:
If smoothed data for private assets are naively incorporated into traditional MVO models, these models will often recommend an overallocation to private assets because their artificially low reported volatility and low correlation make them appear overly attractive on a risk-adjusted basis.
The core challenge extends beyond merely adjusting the inputs (e.g., by unsmoothing returns); it also involves the MVO framework’s fundamental assumption of continuous rebalancing feasibility, which is structurally incompatible with the nature of private market investments. This suggests that while MVO might offer some initial insights, it should, at best, serve as a starting point, necessarily supplemented by other analytical frameworks, qualitative judgment, and explicit constraints that reflect the realities of illiquidity.
Given the limitations of directly incorporating private assets into traditional SAA models, many practitioners and advisory firms advocate for a multi-stage approach. This often involves first determining the long-term target liquid beta exposures of the portfolio using traditional SAA techniques, and then, in a subsequent step, considering the sizing of private asset allocations as an overlay or substitute within broader asset class categories (e.g., total equity, total credit).
One such comprehensive framework, exemplified by Wellington Management’s opportunity-cost approach, focuses on three core components to guide the sizing of private asset allocations:
Other frameworks can complement this approach. Factor-Based Allocation deconstructs asset classes into underlying risk factor exposures (e.g., equity beta, credit spread, duration, inflation sensitivity), which can provide a more nuanced understanding of how private assets contribute to total portfolio risk.
Liability-Driven Investing (LDI) is particularly relevant for pension funds, where private asset allocations must be considered in the context of hedging long-term liabilities. For these investors, private assets with stable, predictable cash flow characteristics, such as certain types of infrastructure or private credit, might be preferred over more volatile, growth-oriented private equity, even if the latter offers a nominally higher total return premium. The predictability of cash flows to meet benefit payments can be a more critical objective.
Stochastic Modelling and Scenario Analysis use simulations to assess portfolio performance and risk under a wide range of potential future economic conditions, providing a more probabilistic view of potential outcomes.
To integrate private assets more effectively into any SAA framework, even if as a follow-on step, it is crucial to adjust their reported risk and return characteristics to account for the smoothing effect caused by stale, appraisal-based pricing and the resulting autocorrelation in return series. The objective is to derive “true” or economic risk parameters that are more comparable to those of liquid, mark-to-market assets.
Commonly employed methods include:
These adjustments typically result in higher estimated volatilities and correlations for private assets compared to their reported figures. While the practical implementation of these unsmoothing techniques requires robust data sets and careful methodological choices (e.g., determining the appropriate lag structure for beta calculations or selecting comparable secondary market transactions), the process is vital. The results can be sensitive to these choices, introducing a degree of model risk. This is an area where specialised analytical platforms and expertise can add significant value by providing standardised, defensible methodologies and robust data management, thereby reducing idiosyncratic errors that might arise from less sophisticated or manual approaches.
More advanced dynamic portfolio choice models are also being developed in academic research to explicitly incorporate the stochastic nature of illiquidity (e.g., modelling liquidity events as Poisson shocks or random arrival times) and its impact on optimal consumption (withdrawal) rates and strategic asset weights. These models generally find that illiquidity risk, by constraining rebalancing and creating uncertainty about access to capital, can significantly temper the otherwise attractive characteristics (higher expected returns, diversification) of private assets.
A key insight from these models is that the presence of illiquid assets optimally leads investors to preemptively reduce their portfolio consumption/withdrawal rates and to tilt their strategic asset weights away from the illiquid investments in anticipation of prolonged lock-up periods. While these dynamic models are theoretically superior in capturing the nuances of illiquidity, their practical implementation can be complex for many institutions due to data and computational requirements. Nevertheless, their qualitative conclusions that illiquidity imposes a real economic cost beyond just smoothed reported volatility and that this cost should influence allocation decisions provide crucial context for all allocators.
Dimension | Key Questions & Considerations for Institutional Allocators |
1. Capacity for Illiquidity & Complexity (Upper Bound) | Net Cash Flow Needs: What are the institution’s projected net outflows (e.g., benefit payments, spending rates, operational costs)? How stable and predictable are these? Can these be met comfortably if a significant portion of assets is illiquid? Regulatory/Policy Limits: Are there explicit regulatory or internal policy constraints on holdings of illiquid assets? Time Horizon: What is the institution’s effective investment time horizon? Does it align with the long-term nature of private markets? Operational Bandwidth & Complexity: Does the institution possess the internal expertise, systems, and resources to manage the complexities of private market investments (due diligence, capital calls, distributions, valuations, reporting)? Or is there a budget for external expertise? Stress Testing: How would the portfolio and the institution’s ability to meet obligations be impacted under adverse scenarios (e.g., prolonged market downturn, simultaneous liquidity calls, denominator effect)? |
2. Need for Excess Return (Lower Bound) | Return Objectives: Can the institution’s long-term return targets be realistically achieved with an all-liquid asset portfolio, given current capital market assumptions? Illiquidity Premium Expectation: What level of excess return (illiquidity premium + potential alpha) is expected from private markets to compensate for their illiquidity, complexity, and risks? Is this expectation realistic and consistently achievable? Trade-offs vs. Liquid Risk: If higher returns are needed, what are the comparative merits and risks of increasing allocation to higher-risk liquid assets (e.g., public equity) versus allocating to illiquid private markets? Sufficiency of Premium: Is the anticipated premium large enough to justify the costs (fees, operational resources) and constraints associated with private market investing? |
3. Ability to Source, Select & Allocate (Determines Position within Bounds) | Access to Top Managers: Does the institution have, or can it develop, access to high-quality, consistently performing private market fund managers? Is the institution of a size/profile that is attractive to these managers? Due Diligence Capabilities: What is the depth and rigor of the institution’s manager research and due diligence process? Can it effectively assess strategies, teams, track records, and alignment of interests? Governance for Long-Term Programme: Is there a robust governance structure in place to oversee the private markets programme, make disciplined commitment decisions, manage GP relationships, and ensure consistency through market cycles? Portfolio Construction Skills: Does the institution have the skills to construct a well-diversified private markets portfolio across strategies, geographies, and vintage years, and to manage pacing effectively? Track Record/Experience: What is the institution’s past experience with private markets? What lessons have been learned? |
The long-term, illiquid, and complex nature of private market investments necessitates exceptionally robust governance and oversight frameworks. Unlike public markets where liquidity and transparency are greater, success in private markets hinges critically on the quality of decision-making, the alignment of interests between Limited Partners (LPs) and General Partners (GPs), and disciplined programme management over many years.
Effective governance begins with the establishment of clear, well-documented investment policies specifically tailored to private market allocations. These policies should articulate the objectives of the private markets programme, define the roles and responsibilities of the investment committee, board of trustees, and internal investment staff, and establish clear lines of accountability. The governance framework must also explicitly define the institution’s risk appetite for private markets, including tolerance for illiquidity, valuation uncertainty, and potential concentration risks.
A critical function of governance is the proactive identification and management of conflicts of interest. These can arise in various forms, such as those related to the valuation of assets (especially if fees are tied to Net Asset Value), fee structures, transactions with affiliated parties, or GP-led secondary transactions where the GP may have interests on both sides of a deal. The Institutional Limited Partners Association (ILPA) Principles, which emphasise alignment of interest, robust governance, and transparency, provide a valuable framework for LPs in structuring their relationships with GPs and addressing potential conflicts.
Effective governance for private markets extends well beyond the initial due diligence and commitment to a fund. It requires ongoing monitoring of not only fund performance against benchmarks and expectations but also the organisational stability and strategic consistency of the GP. Given the long-term nature of these partnerships, which can span a decade or more, changes at the GP—such as key person departures, shifts in investment strategy, or changes in ownership—can significantly impact the outcomes for LPs. Therefore, governance structures must incorporate mechanisms for continuous oversight and engagement with GPs throughout the life of the investment.
Furthermore, as larger institutions increasingly pursue direct investments and co-investments alongside their fund commitments, their governance frameworks must evolve accordingly. Direct and co-investing demand a different set of skills and processes for deal-level due diligence, execution, monitoring, and risk management compared to passive fund investing. Governance structures originally designed for overseeing fund commitments may be inadequate for the increased responsibilities and more active role LPs play in these types of transactions.
A commitment pacing plan is a cornerstone of disciplined private market investing. It is a multi-year strategic plan that guides the timing and amount of capital commitments made to private market funds. The primary objectives of a pacing plan are to:
A well-executed pacing plan can help smooth out the J-curve effect at the portfolio level and reduce the volatility of returns over time. Developing a pacing plan involves sophisticated cash flow forecasting, NAV evolution modelling, and commitment scheduling, often supported by specialised software or analytical models. These plans should not be static; they must be flexible enough to adapt to changes in market conditions, such as shifts in GP deployment rates, variations in distribution patterns, or evolving investment opportunities.
For example, if GPs are calling capital more slowly than anticipated, a rigid pacing plan might leave an LP underinvested. Conversely, if capital calls accelerate unexpectedly or distributions slow, a static plan could lead to overcommitment and liquidity strains. Regular review and adjustment of the pacing plan, typically on an annual or semi-annual basis, are therefore essential.
Vintage year diversification is a critical risk management strategy in private markets, achieved by spreading capital commitments across funds launched in different years (i.e., different “vintages”). Market conditions, valuation levels, and investment opportunities can vary significantly from one year to the next, and these factors heavily influence the ultimate performance of funds launched in a particular vintage. For instance, funds that invested heavily at the peak of a market cycle may underperform those that had capital to deploy during a subsequent downturn when asset prices were lower.
The benefits of vintage year diversification are manifold:
Achieving effective vintage year diversification requires a disciplined and consistent approach to making commitments annually, as outlined in the pacing plan. It also implies diversification of the underlying investment periods of the companies within those funds. A commitment to a 2023 vintage fund, for example, does not mean all its capital is deployed in 2023; the fund will typically invest that capital over the subsequent 3-5 years. This staggering of the actual investment deployment further smooths market cycle risk. Interestingly, periods of weaker fundraising in the overall market can present strategic opportunities for disciplined, long-term investors to gain access to highly sought-after or “hard-to-access” fund managers who might have excess capacity or be more flexible on terms.
Robust governance also encompasses rigorous initial and ongoing due diligence, comprehensive monitoring, and the proactive management of conflicts of interest. The initial due diligence on potential GPs and fund strategies must be thorough, covering not just past performance but also the stability and experience of the investment team, the coherence of the strategy, the robustness of the investment process, alignment of interests (e.g., GP commitment to the fund, fee structures, carried interest provisions), and the quality of operational infrastructure.
Once an investment is made, ongoing monitoring is critical. This involves tracking not only financial performance relative to benchmarks and expectations but also adherence to the stated investment strategy, any significant changes within the GP organisation (e.g., key person departures, changes in ownership), and compliance with fund terms and regulatory requirements.
As previously noted, identifying and managing conflicts of interest is a paramount responsibility for LPs. The increasing complexity of fund structures and market practices such as the rise of GP-led continuation funds, the use of NAV-based credit facilities by funds, and the proliferation of co-investment vehicles necessitates more sophisticated monitoring by LPs and a deeper understanding of potential embedded conflicts. Standard due diligence checklists and traditional monitoring approaches may no longer be sufficient to navigate these evolving complexities. LPs need to ensure their governance frameworks and monitoring capabilities keep pace with market innovations to adequately protect their interests.
Setting appropriate Strategic Asset Allocation (SAA) targets for private markets is a complex, institution-specific exercise that requires careful consideration of long-term objectives, risk tolerance, liquidity needs, and organisational capabilities. It is not a one-time decision but an ongoing process of evaluation and refinement.
SAA targets for private markets should inherently be long-term, reflecting the illiquid and extended investment cycle of these asset classes. While the overarching principles of private market investing apply broadly, the specific SAA will vary significantly depending on the type of institution:
When setting targets, many institutions find it practical to define allocation ranges (e.g., 10-15% of total assets) rather than precise point targets. This approach provides flexibility to navigate market fluctuations, manage commitment pacing, and respond to investment opportunities without triggering frequent, potentially disruptive, rebalancing.
Given the uncertainties inherent in private markets, illiquidity, valuation lags, unpredictable cash flows, and sensitivity to macroeconomic conditions, scenario analysis and stress testing are indispensable tools in the SAA process. These techniques help institutional investors understand the potential impact of their private market allocations on the total portfolio under a variety of plausible, and even extreme, market conditions.
Stochastic modelling, such as Monte Carlo simulations, can be used to generate thousands of potential future paths for the portfolio, incorporating different assumptions about returns, volatilities, correlations, and the timing of private market cash flows. This allows for a more probabilistic assessment of risks and potential outcomes, highlighting scenarios where the portfolio might underperform its objectives or face liquidity strains.
Stress tests should be designed to evaluate the portfolio’s resilience to specific adverse events, such as:
A crucial aspect of scenario analysis for private markets is the explicit modelling of the “path dependency” of cash flows. Unlike liquid assets where portfolio composition can be adjusted relatively quickly, the timing of capital calls and distributions in private markets is not fully controllable by the LP and can significantly impact realised returns, NAV evolution, and overall portfolio liquidity. Simple, single-period shock analyses are often insufficient to capture these dynamic effects. Multi-period simulations that model the J-curve, commitment pacing, and the interplay between calls and distributions are necessary for a more realistic assessment.
The effective integration of private assets into SAA, encompassing the complexities of illiquidity modelling, return unsmoothing, cash flow forecasting, pacing plan management, and robust scenario analysis, demands advanced analytical capabilities. Traditional spreadsheet-based tools may prove inadequate for handling the scale and intricacy of these tasks, particularly as private market allocations grow in size and sophistication.
Specialised asset allocation platforms and analytical software are increasingly being adopted by institutional investors to support these complex decision-making processes. Tools like Acclimetry’s asset allocation platform, for example, are designed to model illiquid assets with greater fidelity, help decision-makers evaluate the trade-offs between capturing the illiquidity premium and managing liquidity risk, and facilitate the comprehensive scenario planning necessary to find an optimal balance for long-term success. Such platforms can provide functionalities for:
The value of these sophisticated analytical tools extends beyond mere complex calculations. They play a vital role in enhancing governance and communication within the institution. By providing clear, data-driven insights into complex trade-offs (such as the impact of illiquidity on potential returns, or the difference between reported and economic risk), these tools can help investment committees, boards, and other stakeholders make more informed, consistent, and defensible decisions regarding private market strategy and allocations.
Achieving long-term success in private market investing is not merely a function of securing access or hitting an allocation target. It is an endeavor that demands a combination of prudence, patience, and adaptability, consistently applied over many market cycles.
The integration of private markets into institutional Strategic Asset Allocations has become a strategic imperative for investors seeking to navigate an evolving financial landscape and achieve long-term return objectives. Private equity, private credit, real estate, and infrastructure offer compelling opportunities for return enhancement, diversification, and access to unique segments of the economy. However, the allure of these assets is accompanied by significant complexities, most notably their inherent illiquidity, the nuances of their valuation, and the challenges of managing unpredictable cash flows.
Successfully harnessing the potential of private markets requires a sophisticated and deliberate approach. This begins with a clear understanding of the distinct characteristics of each private asset class and a realistic assessment of the potential illiquidity premium, which is neither guaranteed nor uniform. Investors must critically evaluate reported return and risk metrics, recognising the “smoothing effect” of infrequent, appraisal-based valuations, and employ techniques to derive more economically meaningful inputs for their SAA process.
Determining the optimal long-term allocation to private markets is not a simple optimisation exercise. It demands a holistic framework that considers an institution’s specific capacity to bear illiquidity and complexity, its genuine need for the excess returns that private markets may offer, and, crucially, its organisational ability to source, select, and manage these investments effectively over extended periods. This often means moving beyond the limitations of traditional SAA models and incorporating qualitative judgment, robust scenario analysis, and tailored constraints.
Robust governance and diligent oversight are the bedrock of any successful private market programme. This includes establishing clear investment policies, implementing disciplined commitment pacing plans to manage deployment and achieve vintage year diversification, conducting thorough initial and ongoing due diligence on managers and strategies, and proactively managing conflicts of interest. The increasing complexity of fund structures and market practices necessitates a continuous evolution of LP capabilities in these areas.
Different types of institutional investors endowments with perpetual horizons, sovereign wealth funds with diverse national objectives, and pension funds with defined liability streams will naturally approach private market SAA with tailored strategies that reflect their unique circumstances. However, the common threads of prudence, patience, and adaptability are universal requirements for long-term success.
As private markets continue to grow in scale and importance, the ability to analyse, integrate, and manage these complex assets effectively will be a key differentiator for institutional investors. Advanced analytical tools and platforms, such as Acclimetry, can provide invaluable support in modelling illiquid assets, conducting sophisticated scenario planning, and empowering decision-makers to strike the optimal balance between capturing returns and managing risks, thereby contributing to the achievement of their long-term financial goals. The journey into private markets is a long-term commitment, and those institutions that navigate it with diligence, strategic foresight, and analytical rigor are best positioned to reap its potential rewards.