The search for higher returns and better diversification has led many institutional investors to allocate more capital to illiquid private assets. This has come at the cost of decreasing portfolio liquidity, as private assets are not easily sold in a short period of time and may be unable to meet immediate portfolio liquidity demands. At the same time, private asset investors may encounter additional and often hard to predict liquidity demands when GPs make capital calls stemming from prior commitments. Investors need to have a strong understanding of how the liquidity characteristics of private assets impact their portfolios.
Investors are increasingly faced with the difficult choice between potentially higher returns and greater liquidity. Given market uncertainty, the risk of failing to meet liability obligations or failing to capture attractive opportunities during market dislocations further complicates the decision. What is the right amount of private assets in one’s portfolio?
Leveraging the cross-asset research capability and experience of GIC EIS and PGIM IAS, we have enhanced and expanded PGIM’s asset allocation framework (OASISTM – Optimal Asset Allocation with Illiquid Assets) to formally integrate liquidity measurement and cash flow management into a multi-asset, multi-period portfolio construction process.
Investors can use this framework to analyze how allocations to illiquid private assets (a topdown decision), in combination with their private asset commitment strategy (a bottom-up decision), affect their portfolio’s ability to respond to liquidity demands (Figure 1).
Specifically, this framework can help investors address the following key asset allocation questions:
- How to formulate a private asset commitment strategy to manage private asset exposure and the uncertainty in timing and magnitude of cash flows over time?
- What should be the desired allocations (public vs. private, public passive vs. public active) given the investor’s liquidity risk tolerance?
- How would various market scenarios impact the portfolio’s liquidity and performance?