How to create an effective asset allocation strategy for private markets investing

Asset allocation – how investors divide their portfolios among different asset classes – has an outsized impact on portfolio returns. Research shows asset allocation is the most important decision investors can make in terms of its ultimate impact on portfolio returns. 

Three key factors influence an investor’s portfolio returns: asset allocation, market timing, and security (or fund) selection. Of these, asset allocation accounts for the vast majority of long-term returns (the exact figure varies from research to research).^1,2

For LPs adding private markets to their portfolios, this insight can be crucial. While picking the most appropriate fund or timing an investment might seem important in the short term, over time these factors are eclipsed by the foundational role that asset allocation plays in portfolio performance. Without a well-informed allocation strategy, investors risk undermining long-term value creation.  

So what do LPs need to do when including private capital in their portfolios? 

How to determine the allocation to private capital asset classes 

1. Set long-term portfolio risk/return expectations 

The first step is for the investment committee or advisor to define their long-term portfolio risk/return expectations. 

This can be straightforward for some investors. Pension funds, for instance, have a liability they match against assets. Similarly, endowments or foundations have a constant payout obligation to their associated entities.  

For a sovereign wealth fund or a family office, it may be more complex because there is no obvious liability they are trying to match against.  

Active involvement from the board and investment team is essential to understanding the obligations, objectives, long-term liabilities, and liquidity needs, and to establishing a clear risk/return target. Setting this target is the foundation on which a portfolio should be built. 

2. Establish risk/return and correlation expectations for each asset class

Next, LPs should establish their long-term risk/return and correlation expectations for each asset class. The goal is to construct a portfolio with a combination of asset classes that achieves the desired return within the approved risk parameters. 

Correlation is an important metric and a crucial consideration in portfolio construction, especially because private capital asset classes tend to have a lower correlation with public markets. Two asset classes may have similar levels of volatility, but if their correlations are low or negative, the overall portfolio volatility can be lower than the volatility of each individual asset class. Investors should integrate uncorrelated assets into their portfolio to enhance diversification and reduce overall risk. 

When an investor includes private capital in a portfolio of public investments, it can be more challenging to build in these expectations because they differ from the constraints and assumptions of public markets.

➔ Resource tip: Use industry reports to help develop long-term risk/return expectations 

When developing long-term return assumptions, some investors may find external research from reliable institutional sources provides valuable insights. 

Many investment firms and advisors produce capital market assumptions on an annual basis. These set out their expectations for how private and public asset classes may perform over the medium to long term. Firms like BlackRock also offer portfolio construction toolkits on strategic asset allocations for specific client types, based on their needs, objectives, and constraints.  

Specialized reports that analyze private capital trends and provide forecasts on fundraising, deal activity and valuations, exit conditions, and sector outlooks can also be valuable tools in shaping an allocation strategy. For instance, Preqin’s State of the Market series examines how economic shifts may impact private markets in the near term, while its Future of Alternatives reports present performance and growth projections across asset classes.  

Once LPs have established optimized portfolio weights for each asset class based on these risk/return and correlation forecasts, they can overlay additional constraints to reflect their specific needs and limitations. These include: 

Liquidity constraints

LPs should determine an appropriate allocation to illiquid private assets based on their liquidity needs. In cases where the investor might need immediate liquidity, this may be more difficult. Liquidity in private capital funds comes from distributions, which are at the discretion of the fund manager. Selling in the secondaries market is an option, but it is typically done at a discount to net asset value and can take weeks or months to execute. 

Advances in fund structures have led to the rise of open-ended evergreen funds, which can appeal to new investors who value flexibility and liquidity in their private capital investments.  

Investors should ensure a portion of their portfolio can quickly be converted to cash if an obligation needs to be met. This portion will vary from investor to investor – a pension fund may have higher liquidity needs than a sovereign wealth fund, for instance. 

Concentration constraints 

To manage concentration risk, LPs should impose caps on asset class exposures. Asset allocation models solely based on historical risk/return profiles might recommend disproportionately large allocations to asset classes that have shown favorable past performance. However, practical and real-world constraints often limit excessive exposure to any single asset class. 

For example, an investor may find private debt highly compelling. According to Preqin data, historically, the asset class has shown an attractive risk/return profile, with a median net internal rate of return (IRR) of 10% and a standard deviation of IRR at 9.7% for funds of vintages 2009–2022.  

To mitigate overexposure to a single asset class, an investor might choose to cap private debt allocation at a certain portion of the total portfolio. This would ensure the overall portfolio impact remains controlled and diversified in the event of private debt funds underperforming. 

Investor-specific constraints 

Investors may face unique constraints based on institutional mandates, regulatory requirements, or tax considerations. For instance, pension funds may evaluate the tax implications of income-generating investments, as certain strategies can result in taxable income that affects overall returns. They may wish to impose a cap on exposure to these types of investments.  

➔ Resource tip: Access historical data for insights on asset class characteristics 

Historical performance data is a key tool for gaining a deeper understanding of the long-term characteristics of asset classes. While past performance is not a predictor of future returns, it can help investors make informed allocation decisions. 

Each asset class has its own risk/return profile, and investors allocate to them for different reasons – private equity and venture capital (VC) for high returns, private debt for a reliable income stream, and real estate and infrastructure for diversification. 

Access to this data enables investors to assess whether asset classes have historically delivered on their intended benefits. It also provides insights into periods of underperformance. 

For example, looking at the Preqin Private Capital Indices, global VC funds have historically outperformed private debt funds over the long term (Fig. 1), but in recent years – particularly post-COVID – private debt has outperformed VC due to high interest rates and declining valuations (Fig. 2). 

Fig. 1: Global VC funds outperform private debt funds in the long run 
Long-term historical index returns for VC and private debt, 2007 – 2024* 

^{*Latest data as of September 2024
Source: Preqin Pro}

Fig. 2: Global private debt funds outperform VC funds post-COVID 
Short-term historical index returns for VC and private debt, 2021 – 2024

^{Source: Preqin Pro}

By analyzing performance across time periods, strategies, and geographies, investors can better judge the true risk profile of an asset class. They can also set realistic risk parameters and adjust their allocation strategies accordingly. 

How to allocate within private capital asset classes 

Once LPs have planned out their portfolio allocation, they need to determine how to structure allocations within each asset class. There are several approaches, depending on the investor’s preferences, resources, and expertise. These include: 

Core-satellite 

This involves anchoring most of the portfolio in stable, income-generating investments (core), while allowing for opportunistic investments that can capture potentially higher returns (satellite).

For instance, an investor might decide that 60% of their real estate allocation will be in diversified, lower-risk strategies such as core or core-plus. The remaining 40% could then be allocated to higher-risk, high-conviction funds that leverage specialized expertise in a particular sector or market niche. 

Benchmark strategy breakdown 

This involves aligning the portfolio with a market index to achieve representative exposure. For example, a real estate index may have a broad strategy breakdown like this: 

An investor could replicate this distribution to mirror the broader market. They could study breakdowns of the fund indices and align portfolio allocations with index compositions based on strategy, geography, sector, or vintage. 

However, achieving similar returns to the index requires a well-diversified portfolio within each strategy because the index includes a wide range of vintages, geographies, and sectors. 

Bottom-up manager selection 

This focuses on selecting investments based purely on manager quality, rather than a predefined allocation model. 

An investor using this approach starts by assessing individual fund managers’ expertise, strategies, and track records. They allocate to managers with the strongest conviction, rather than adhering to a strict top-down allocation framework. 

➔ Resource tip: Learn about allocation trends from peer investor data 

To inform their allocation decisions, new investors can look at how their peers structure private market exposure. Analyzing peer investor data – such as average allocations, over- or under-weighting trends, and performance outcomes – can help investors gauge where they stand relative to similar institutions and provide insight into successful strategies so they can refine their portfolio strategy as appropriate. 

However, investors should be careful to identify peers who align with their objectives, rather than basing their analysis on industry averages. 

For example, when analyzing a pension plan's allocation, it is necessary to also understand the rationale behind it, otherwise the analysis might give an incomplete or inaccurate picture. Pension funds typically structure their portfolios to match their liability growth rate, often targeting returns to meet future obligations. If an investor does not have similar liability-driven constraints, using pension plan allocations as a benchmark could create a misaligned risk/return profile. 

<sub>1. https://caia.org/total-portfolio-approach-2024
2. https://blogs.cfainstitute.org/investor/2012/02/16/setting-the-record-straight-on-asset-allocation/</sub> 

Our thanks to Steve Novakovic, Managing Director, Educational Programs at CAIA Association, who provided key insights for this blog.
 

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Preqin Primers are a series of short reports on the major trends shaping the alternative investment industry.

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