Mastering Illiquidity: Risk management for portfolios of limited partnership funds

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Prudent Investing and Alternative Assets

“A prudent man sees danger and takes refuge; but the simple pass on, and suffer for it.”

Proverbs 27:12. World English Bible

Long-term investors in illiquid assets seek to harvest special risk premia – notably an illiquidity risk premium – and achieve portfolio diversification gains. In pursuing these goals, however, many investment managers are not entirely free in their investment decisions. For example, pension funds and insurance companies as fiduciaries are generally subject to regulation that aims to limit the risk for their beneficiaries (and in systemically important cases, the broader economy). Thus, investment decisions take place within a legal framework that attempts to achieve a balance between two objectives – the maximization of returns and the protection of capital (Möllmann, 2007). In principle, there are two broad regulatory approaches to investing: first, the qualitative description of managerial behaviour according to the “prudent investor rule” and second, the explicit setting of quantitative restrictions (Franzen, 2010).

The general perception of what constitutes prudent investing has developed over time. Initially, “prudent investments” were largely defined by legal lists. In many jurisdictions, this rather static approach was eventually replaced by the prudent man rule. While the prudent man rule focuses on individual investments, over time this rule has increasingly been seen as still too narrow. With modern portfolio ...