Allocating to private assets in open-ended funds can offer investors benefits such as diversification, but there are drawbacks, too, like illiquidity. In this second article in a three-part series drawn from a recent paper, we look at how asset managers can construct portfolios for open-ended funds that include allocations to private assets, providing a way for smaller investors to gain exposure.
There are three main challenges when it comes to allocating to private assets in open-ended funds:
- The capital needs to be deployed efficiently, with calls to invest and distributions from the investments in private assets managed so as to minimise allocation to cash and avoiding the dilution of returns
- The funds’ managers need to ensure that drift in portfolio weights does not lead to undesired allocations to illiquid private assets, which are difficult to rebalance
- The investment strategy needs to be designed to offer the liquidity requirements expected from an open-ended fund, including redemptions and new investments, while committing capital to private assets that will be locked up for several years.
Below, we propose a strategy that addresses these challenges.
Why amounts and timing of cash flows can affect returns
The internal rate of return is the performance metric of choice for private assets. The IRR reflects the performance of a private equity or private debt fund by taking into account the size and timing of its cash flows (capital calls and distributions) and its net asset value at the time of the calculation.
As we shall see in the third part of this series, the IRR of private asset funds tends to be attractive and higher than the returns of their equivalent public asset benchmarks.
However, an IRR cannot be directly compared with the returns on public assets because it uses a built-in reinvestment assumption that capital distributed to investors early on will be reinvested over the life of the private asset fund at the same IRR that is generated at the initial exit.
Unfortunately, capital committed to a private asset fund is neither all put to work at the same time nor for the entire period of the investment. This may affect the effective return on the total capital committed as unused cash dilutes returns.
Investing in private assets for open-ended funds
Adequately managing private asset cash flows so as to minimise the cash not put to work is of crucial importance to avoid dilution of returns.
Because it is impossible to precisely synchronise distributions and capital calls from private asset funds, an allocation to listed equities and fixed income is needed as a buffer to manage the cash flows efficiently.
In our proposed strategy, new capital is committed each year to the newest vintages of private asset funds, while minimising the allocation to cash. Using this approach, the fund is permanently invested in several vintages of both private equity and private debt. The strategy is in effect implementing the reinvestment assumption that is behind the IRRs.
To be able to offer a level of liquidity acceptable for an open-ended fund – for example, allowing investors to buy or redeem the fund once every two weeks – the portfolio must balance private and listed holding so that a sufficiently large capital allocation to listed assets can deal with inflows and outflows over shorter-term horizons.
Dynamic recommitment strategy
A dynamic recommitment strategy uses the expected calls and distributions from different vintages of private asset funds in the portfolio as well as the expected IRR of the funds and expected returns for public asset classes.
Let’s take an example for private equity. The strategy calculates the size of the required annual commitments from a simulation of the portfolio over time using our assumptions for calls, distributions and expected returns.
This amounts to 1.92%, split between
- The allocation needed to meet the first call of the newest vintage of private equity and put to work immediately – say, 0.42%
- An allocation to a buffer invested in public equities, big enough to meet future calls, say, 1.50%.
This commitment to the new vintage is calculated with the additional assumption that the capital put to work in private equity funds remains constant at 7.5%.
The simulation takes into account
- That a new commitment to the newest vintage is repeated each year
- How the different assets in the portfolio accrue over time
- How the investments in each of the sub-portfolios committed to a given vintage accrue over time
- How the allocation to capital at work changes over time in each sub-portfolio, based on the expected calls and distributions.
At any point in time, there are 12 sub-portfolios, one for each new vintage used in the last 12 years.
Although simple, this strategy does capture the IRR of private asset funds as a contribution to the return of the overall portfolio, avoiding dilution of private asset returns.
It should be said that the strategy would be more complex in a real portfolio as it would have to adapt dynamically to the fact that neither all private equity funds nor all private debt funds have exactly the same profile of calls and distributions, nor the same realised IRRs. The realised returns of the different asset classes are also likely to differ from their expected returns.
Nevertheless, the same principles can be applied to the design and management of the strategy in a real portfolio.
Responding to stressful conditions
Managing the allocation to private assets in an open-ended fund while capital is locked up for a number of years is a challenge. Here we look at two stress scenarios.
Impact of equity market crash – If the allocation to private assets rises because of the underperformance of other asset classes in the fund, the cheapest way to bring the allocation to private assets back to the target weights is to reduce the annual commitments to new vintages – to zero, if necessary, and for as long as required.
Impact of fund redemptions – The challenge of meeting the liquidity requirements of the open-ended fund can be addressed by using public equities and public bonds to manage the immediate liquidity needs. This means that when a subscription or a redemption is made, public equities or public bonds will be bought or sold until there is the opportunity to bring the allocation to private assets funds back to the strategy’s target by changing the commitments to new private asset funds.
The need to manage the fund’s liquidity acts as a constraint on the maximum allocation to private assets and the minimum allocation to public equities and bonds.
We expect investments in private assets to continue to grow, given their potential to enhance returns and reduce risk, and the role they can play in sustainable investing.
We believe it is possible for asset managers to construct portfolios for open-ended funds that include allocations to private assets, allowing smaller investors to gain exposure to this attractive asset class.
For more on investing in private assets, go to private-assets Archives – ViewPoint English (bnpparibas-am.com)