Mastering Illiquidity: Risk management for portfolios of limited partnership funds

Acknowledgements

Alternative investing in illiquid assets has become increasingly popular in the past few decades. For some long-term investors, especially family offices and endowments, the label “alternative” may no longer be appropriate as their exposure to private equity and real assets has risen to 20 – 30 percent, in some cases even more. While pension funds and insurance firms usually allocate a comparatively smaller share of their capital to alternative asset classes – reflecting, among other things, different liability profiles and regulatory requirements – their exposure has also increased considerably over time.

Alternative investing is expected to gain further momentum as investors chase yields in an environment where policy rates look set to remain low. Higher expected returns typically come with higher risk. But not only that. The nature of risks in alternative investing in illiquid assets is fundamentally different from risks that investors are exposed to when allocating capital to marketable assets. This is a key lesson investors have learned in the recent global financial crisis, which culminated in the collapse of Lehman Brothers in the fall of 2008. In light of this experience, a growing number of them have adopted new asset allocation models that focus on asset class-specific risk premiums.

Harvesting asset class-specific risk premiums requires asset class-specific risk management techniques. However, as far as investments in private equity funds and similar ...