Asset Allocation with Private Equity

Reprinted from Volume 17, Number 1, 2016 of The Journal of Investment Consulting by Mark J.P. Anson

Private assets such as private equity and venture capital have long been a thorn in the side of asset allocators and chief investment officers. Their lack of liquidity makes it hard to model their return streams as an input to an asset allocation model, risk budget, or optimization function. Typically, asset allocators make assumptions based more on intuition and expectation than fact.

In this paper, we attempt to correct for the misspecification of illiquid assets. More specifically, we show that estimates of the parameters of the underlying distributions are routinely underestimated. This underestimation of the true risk and return factors can lead to an allocation to private assets that is not consistent with the fundamental economic value of illiquid assets. We present a new method to unsmooth illiquid asset class returns to reveal the true distributional parameters. We then recalibrate our asset allocation process with the new parameters to determine whether private assets should be increased or decreased in a diversified portfolio.