With their potential to enhance returns, diversify portfolios and capture an illiquidity premium, private assets have become increasingly attractive to institutional investors. Yet integrating private equity and private debt into open-ended funds available to retail clients remains far from straightforward. Even though a fund may offer investors periodic subscriptions and redemptions, the underlying private assets generate cash only gradually and with uncertain frequency. They also require liquidity to meet unpredictable capital calls.
By Raul Leote de Carvalho, Deputy Head of Quantitative Research Group; Xiao Lu, Head of Machine Learning Research, Quantitative Research Group; Thomas Heckel, Co-Head of Quantitative Research Group; Gilles David, Manager Consultant, Deputy Chief Investment Officer, BNP Paribas Asset Management
This is the central issue addressed in our recent paper, “Managing Illiquidity in Open-Ended Funds with Private Asset Allocations: Challenges and Solutions” just published in The Journal of Private Markets Investing. The paper presents a practical framework for incorporating modest allocations to private assets into open-ended funds while preserving liquidity. It shows that the real question is not only how much to allocate to private assets, but how to design a vehicle that can credibly deliver liquidity while holding illiquid investments.
Why is this difficult?
In practice, committed capital is not fully invested from day one. Some of it remains idle while waiting for calls, and distributions may later sit in cash or low-yielding liquid assets. As a result, effective returns on committed capital can be materially lower than the private fund’s reported IRR. At the same time, open-ended funds must still meet subscriptions and redemptions, which means liquidity requirements must be managed explicitly.
Three key points
Allocating to private assets in an open-ended fund creates a structural tension. Private asset funds typically lock up capital for many years, draw on it only gradually, and return it unevenly over time. This means that the internal rate of return (IRR) reported by a private asset fund is not the same thing as the realised return captured by an investor on all the capital initially committed.
- Small allocations to private equity and private debt can be integrated into open-ended funds without sacrificing liquidity, provided the structure includes sufficiently large liquid sleeves in public equities and public fixed income
- A dynamic recommitment strategy can reduce cash drag by investing capital across vintages, which improves the translation of fund-level IRRs into effective realised portfolio returns
- Stress testing is essential: After-market dislocations or large redemptions – the main means of rebalancing private asset exposures – are not about selling private holdings but, rather, reducing or suspending commitments to future vintages.
A practical framework
A key contribution of our paper is that it treats liquidity management as an integral part of portfolio construction. The proposed framework combines private asset funds with liquid public-market sleeves that can absorb capital calls, reinvest distributions and meet investor redemptions. In other words, the liquid sleeve is not a residual cash bucket: It is a core component of the design that is invested in liquid assets.
The recommitment strategy then acts as a capital-efficiency engine. Instead of allowing private allocations to drift down as older vintages distribute capital, the framework calibrates the size of commitments to new vintages so that the aggregate capital at work remains close to its strategic target over time. This helps to synthetically replicate a more fully invested private allocation even though each individual fund is only partially invested at any point in time.
Examples from the paper
IRR versus realised return
The paper illustrates the gap between reported IRR and realised return with stylised private equity and private debt cash-flow examples.
In the private equity illustration, the IRR reaches 11.5%, but the effective annual return on total committed capital is only 4.0%.
In the private debt example, the IRR is 5.3%, while the effective return on committed capital is only 1.9%.
This dilution arises when cash sits around waiting for capital calls and is not immediately re-invested after capital distributions.
These examples make the point clearly: if capital is not continuously at work, investors capture significantly less than the reported IRR.
Exhibit 1: Cash flows from a private equity and a private debt fund over their lifecycle
Exhibit 1 shows the example of changes in the allocation between unused cash and capital put to work for a commitment of $1 million to a buyout private equity fund (right) and to a junior commercial real estate private debt fund (left) over their respective typical investment horizons. Unused cash accrues at 0.5% p.a. Management fees and carried interest payments of 1.2% p.a. were included in each case.
Source: Managing Illiquidity in Open-Ended Funds with Private Asset Allocations: Challenges and Solutions
Building the allocation from inception
The framework also addresses the ramp-up problem faced by new open-ended funds. If a fund commits only a steady-state amount from day one, it may take years before the capital at work in private assets reaches its target level. Therefore, we also studied optimised commitment paths that accelerate convergence toward target allocations while controlling the risk of overshooting them.
This is especially relevant in practice because building a diversified multi-vintage private allocation takes time. In the paper, we show that a front-loaded but disciplined commitment profile can materially shorten that ramp-up phase.
Stress tests under redemptions
Finally, we examined what happens when investors redeem from the open-ended fund. If redemptions are met only by selling public assets, the weight of private assets rises mechanically. In that setting, the most effective response is often to suspend or reduce new commitments and let existing private holdings run off through distributions.
Our analysis shows that the framework remains robust under severe but plausible shocks, while also making clear that liquidity transformation has limits. If outflows become too extreme, liquid buffers can be exhausted and additional measures may eventually be required.
Conclusions
Our paper provides a practical roadmap for investors and asset managers seeking to combine liquid and illiquid assets within open-ended structures. Its central insight is that liquidity does not come for free: It must be designed, funded and governed. Private assets can play a useful role in diversified open-ended portfolios, but only when commitment pacing, liquid sleeves and stress testing are treated as core components of the investment process.
More broadly, the framework should be particularly relevant for institutional investors looking to make modest private asset allocations without losing control of portfolio liquidity. By focusing on recommitment, ramp-up and stress testing, our paper shows how to turn a difficult implementation problem into a more robust and manageable one.
