Harnessing the Potential of Private Assets: A Framework for Institutional Portfolio Construction

Abstract

Institutional portfolios are increasing allocations to illiquid private assets seeking better returns and diversification. However, as allocations increase, a portfolio’s liquidity structure changes, sometimes abruptly. How can a CIO increase their confidence with private asset allocations and unlock their potential? Using a corporate defined benefit pension plan as our example, we present and illustrate a practical framework (OASIS TM) that can help CIOs analyze how their top-down asset allocation and their bottom-up private investing activity interact to affect their portfolio’s ability to respond to liquidity demands in a multi-asset, multi-period setting. This is exactly what a CIO needs to know. Besides scheduled benefit payments, corporate pension plans have many unexpected liquidity demands which should be accounted for when evaluating liquidity risk. For example, a plan should be able to rebalance when market movements cause allocations to exceed risk limits. A plan also needs liquidity to meet unexpected capital calls and be prepared for exogenous cash flow events driven by corporate actions (e.g., pension risk transfers, corporate contributions, and merger and acquisition activities). Many plans also have asset allocation glide paths, conditional on the plan’s funding ratio, that present additional liquidity strains as it may be difficult to sell illiquid assets to satisfy new allocation targets. The CIO’s challenge is to maximize expected portfolio performance while keeping liquidity risk under control. By measuring the potential tradeoff between asset allocation, portfolio performance and multiple dimensions of liquidity risk, the OASIS framework can help CIOs make more informed portfolio management decisions.