Private markets refer to investments not traded on a public exchange or market. In the past they were often considered too hard to access, opaque or niche for traditional investors. Today, it’s accepted that investing in private markets can enhance diversification and long-term return potential.

This article aims to shed light on some of the key areas of portfolio management when building private market allocations. We’ll focus on the importance of a structured research framework, a robust valuation and risk management approach, as well as the ability to manage cashflows to optimise returns and provide liquidity when required. We hope pension scheme trustees, investment advisers, proposition managers, and consultants working with DC schemes will find this article useful. 

Part 1: Dispersion of returns

The attraction of private markets is the ability to generate excess returns. However, there is a wide dispersion of returns across the different segments within private markets.

Investing across the private markets spectrum requires a broad understanding of the investment universe and the differing risk profiles within it. For example: 

Understanding the key drivers of returns and the differences between asset classes and the various sub-strategies in each of these sectors is important when allocating capital, as they will perform differently in different market environments. 
 
From experience in investing across the private market spectrum over more than two decades, we’ve identified that this dispersion of returns is a function of several factors or attributes, which can be divided into the five categories of sensitivity listed in the table below. We’ll address how the risks associated with these attributes can be identified and mitigated through a tailored approach to each in Part 7 of this article (Risk and analytics). 

Table 1 - Key return dispersion factors in different private markets asset classes

Source: abrdn, 2024

Understanding the market dynamics and implications of access routes is a key part of generating consistent returns over the long term. Given the idiosyncratic nature of private markets, managers tasked with generating returns will have a range of skills and capabilities across sectors, geographies and risk profiles. Therefore, evaluation of the fund manager's track record is vital in order to determine the critical reasons for prior performance, including, but not limited to: 

As with any investment, past returns can be misleading if taken as a guide to future return potential. For example, a manager specialising in large / mega cap deals may have been operating in smaller / mid-market space in the past, and these changes may have implications for future expected returns. Understanding the management team's organisational depth and adequacy in professional staffing is important, as is the infrastructure and investment team dynamics. 

This information is typically established through one or more on-site visits. For CIOs, asset allocators, and trustees, access to a comprehensive view of expected returns by asset class, sector, geography and access route can be useful for supporting the allocation process. 

Ensuring sufficient time given to understanding each of these factors, and having a robust systematic process, increases the chances of achieving the returns that are required to justify an allocation to illiquid assets. Therefore, it is important that active portfolio management is considered rather than a simple allocation of capital into an asset class. 

Jargon buster:

Part 2: Cash management

In all portfolios, cash management is important to maximise returns. This includes reinvesting dividends and staying exposed to markets, and where cash is held for liquidity, ensuring it is optimised to generate returns and reduce counterparty risk.  

The importance of cash management in private markets is more acute due to the nature of how private market exposure is created depending on the access route. Primary fund investment results in committed amounts over a 3–5-year period (investment period), with periodic drawdowns over that time. Once capital is drawn, it is invested, and when assets are sold, distributions are sent back to investors. Many of these distributions are called recallable distributions, where the manager can call these payments back under certain circumstances. While not common in practice, this results in an inherent liability.

Therefore, modelling expected investment cashflows, for drawdowns and distributions, and how the cashflows are to be funded, is a key area of management to ensure any cash is ring-fenced for meeting these contractual commitments is not dragging down overall portfolio returns. Many investors deploy this allocated capital in listed equity or debt markets to generate returns.

Given that the timing of drawdowns is uncertain (as it is based on when deal flow is available for investments), investors may have to fund these commitments at times from liquid markets, which exposes the investor to the risk of selling at a time when liquid markets may be going through a correction, which in turn could lead to crystallising losses.

The private markets manager may also use different forms of fund financing (limited partnership (LP)-backed or net asset value (NAV)-based fund financing) which changes the drawdown and distribution profiles of the investment. In these circumstances, it's important to understand and track potential drawdown paths and build a systematic way to ensure exposures can be funded appropriately to ensure investor returns are not diluted.

As there is a growing availability of open-ended vehicles, the task of liquidity management (in order to fulfil liquidity terms), lies with the manager. Open-ended structures offer investors the flexibility to enter and exit investments at various points, unlike their closed-ended counterparts. This fluidity introduces a layer of complexity in ensuring that there is enough liquidity within the fund to meet redemption requests, without having to sell off assets at unfavourable prices or holding too much cash when waiting to deploy capital, which could harm remaining investors' returns. 

Fund managers must, therefore, implement robust liquidity management strategies. These could include setting limits on the proportion of the fund that can be redeemed within certain periods, maintaining a cash buffer to meet redemption requests, or arranging lines of credit to cover short-term liquidity needs.  

Not all long-term asset funds (LTAFs) will be created equal, however. There are different performance dynamics affecting closed-ended funds and open-ended funds and the net result of cash flows, both at private markets level and the overall portfolio level can drive very different outcomes. As such, how cash flows are mapped and managed within these funds is an important consideration when selecting a vehicle for achieving private markets exposure. Close attention needs to be paid to these areas to ensure the desired outcome is achieved.

Traditionally, the internal rate of return (IRR) has been the metric of choice for measuring performance in private markets, however IRRs have limitations, particularly when it comes to the assumption of reinvestment rates. A historically high IRR for a manager may be hard to replicate given the dynamics described above, therefore money-weighted NAV returns can be significantly lower over time, if this is not accounted for and managed. 

The modified IRR (MIRR) offers a more accurate reflection of performance by accounting for the differential in reinvestment rates, though it too has its challenges, particularly in aligning with the accounting NAV performance. Ultimately, translating these IRRs into a money-weighted rate of return (MWRR) will better reflect the actual client experience. 

The conservative approach of holding obligations in cash can significantly lower the MWRR, given the recent history of low-interest rates on deposits. Furthermore, the use of cash or listed securities for managing liquidity and funding commitments introduces its own set of challenges, including potential performance drag and asset volatility. In order to optimise cash management, clarity on the following aspects is required:

Once these elements are in place, managers can look to target a dynamic liquid set of investments to maximise returns above cash to reduce the cash drag in the portfolio. If implemented robustly, this can reduce reliance on holding liquid or listed assets and provide greater confidence in the ability of private markets managers’ abilities to deliver targeted returns.

In summary, as private markets evolve towards more open-ended structures, cash management becomes a critical component in protecting and enhancing returns for investors. At the fund level, strategies around liquidity limits, cash buffers, and lines of credit; coupled with rigorous asset valuation processes; are key. If these funds are being held within a DC default, understanding and managing liquidity needs at the default fund level, alongside minimising the cash drag impact in the underlying private markets funds being held, are essential.

Each investor will have different methods of managing cash flows and it is important that private market managers have a close dialogue with the default fund allocators to ensure that client tolerances for risk exposures and liquidity management are within acceptable bands, while being as fully invested as possible, to maximise the return potential.

Key points and summary recommendations:

Source: abrdn, 2024

Jargon buster:

Fund financing

Fund financing facilities are loans provided to private market funds including private equity, credit, infrastructure or real estate across various stages of their lifecycle. The market is often divided into two areas: LP-backed or subscription line financing - backed by first recourse to undrawn LP commitments. These are typically by blue-chip clients, including insurers, pension schemes and sovereign wealth funds. They also tend to be NAV-backed and secured on a diverse portfolio of underlying assets and cash flows of private market funds that are typically at a later stage of their lifecycle.

Internal rate of return (IRR)

The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments. It is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR can be used to rank several prospective projects an investor is considering. In essence, the higher a project's IRR, the more desirable it is to undertake the project.

Modified internal rate of return (MIRR)

The modified internal rate of return (MIRR) is a more accurate reflection of an investment's profitability than the traditional internal rate of return. It addresses some of the limitations of the IRR by assuming that positive cash flows are reinvested at the investors cost of capital, and that initial investment outlays are financed at the prevailing financing cost. Therefore, MIRR provides a more realistic measure of the profitability and efficiency of an investment.

Money-weighted rate of return (MWRR)

The money-weighted rate of return (MWRR) for a portfolio is a measure of the performance of an investment that takes into account the size and timing of cash flows into and out of the portfolio. It is the rate at which the present values of cash inflows and outflows equal each other. This method is particularly useful for evaluating the performance of a portfolio or investment where there have been multiple cash flows over time. It reflects the return on the actual amount of money invested, taking into account withdrawals and contributions, which can be modified for the cost of capital.

Part 3: Mitigating the J-curve

The J-curve effect in private markets is primarily driven by initial investment expenses, management fees, and the time needed to operationalise and mature investments. Early-stage investments (venture capital, private equity) often report negative returns until these entities start generating revenues. The same applies to the development of new real assets (real estate, infrastructure), and the period of planning and construction before assets are stabilised and start generating revenues. For DC propositions, where consistent performance, ensuring fairness between investors entering or exiting the default fund at different times, and liquidity are key, understanding and mitigating the J-curve effect is crucial.

Figure 1 - Typical private equity J-curve

Source: abrdn, 2024

The timing of cash flows during the life of an investment is a structural element of private markets investing. Understanding the J-curve and how to manage cash flows at multiple levels is paramount to the successful inclusion of private markets in a DC proposition.

The J-curve phenomenon, characterised by initial negative returns followed by a period of significant positive returns, is a common feature in private markets due to the upfront costs and lag in realising returns from these investments. Managing this dynamic effectively is essential to harness the long-term benefits of private market investments.

Strategies to Mitigate the J-curve.

Diversification across asset classes, stages and sectors: By investing across diverse asset classes (debt vs equity), different stages (e.g., seed, growth, late-stage) and different sectors, investors can mitigate the impact of the J-curve. Early-stage investments might take longer to mature, but later-stage or more mature investments can provide returns sooner, balancing the overall portfolio performance.

Co-investment strategies: Engaging in co-investments can allow investors to participate directly in specific opportunities alongside their primary fund investments. This can potentially lead to lower fees and quicker access to returns, as co-investments might be made in more mature assets with shorter time horizons to exit and realise investment returns.

Secondary market participation: Buying into private market funds or assets in the secondary market can offer a way to bypass the initial downward phase of the J-curve. Investments acquired in the secondary market are typically past their initial value-depreciation phase, which can lead to quicker realisation of returns. Secondary funds usually operate as closed LPs, are higher risk profile and often have embedded fees. Disclosure is therefore hard given the number of underlying holdings, which can be challenging for DC to accommodate. Utilising a third-party manager that specialises in allocating across diversified access routes incorporating secondaries is one way in which schemes can access this market.

Phased investment approach: Implementing a phased approach to capital deployment can also help mitigate the J-curve impact. By gradually investing capital over time, investors can potentially reduce the initial negative return period and better align cash outflows with the realisation of investment returns.

Actively managing the investment portfolio to optimise the timing of exits and reinvestments can also significantly mitigate the J-curve effect. This involves closely monitoring portfolio companies or real asset investments for opportunities to exit at an optimal time and reinvesting proceeds in opportunities that will generate returns more quickly.

Cash flow changes can result in more variable levels of exposure. The movement in listed assets, alongside shifting exposure in a private markets target allocation, can be likened to trying to hit a moving target. It is therefore important to consider risk and portfolio management consequences of potential implementation choices.

Mitigating the J-curve and reducing cash drag in private market investments requires a comprehensive approach that incorporates strategic diversification, efficient cash flow management, and active portfolio management. By employing these strategies, investors in DC schemes can better navigate the inherent challenges of private markets investing. Given the impact of the J-curve, careful consideration needs to be given by schemes to ensure inter-generational fairness is maintained avoiding unfair sharing of costs and returns for members that join and leave at different times. This is addressed further in Part 5 (DC member experience).

Part 4: Pacing of deployment 

As discussed earlier, cash management and J-curves will all have a material impact on return streams.

Private markets transactions are originated over a prolonged period from months to, in some cases, years. The deployment of capital can be clustered in a single period and/or there may be spells where no mergers and acquisitions (M&A) transactions are concluded.

Depending on the access route if assets are in funds with defined fund lives, or co-investments with expected liquidity, this may result in future liquidity being sought at a time where pricing may not to be attractive. Therefore, future expected returns should be spread out to mitigate the potential risk of large parts of the portfolio seeking exit at the same time. Depending on the sector or the market, if there is little market depth or availability of financing, this will affect pricing. Navigating such factors will help to determine the outcomes of an allocation to private markets for DC members.

Pacing plans for capital deployment

A pacing plan builds on the concept of J-curve management and acknowledges that market timing is inherently challenging, underscoring the importance of vintage year diversification in the pacing plan.

A pacing plan is a systematic approach for deploying capital, with a view to mitigating the clustering of market dynamics, thus avoiding a situation where a significant portion of the portfolio might be exposed to adverse conditions both in making investments (i.e. when assets are expensive) or when divesting assets (when pricing is unfavourable). This has been evidenced over time where portfolios have been exposed to multiple market shocks in the same period, for example, a recession, a credit crisis, a liquidity or default cycle or a pandemic.

Market conditions, investment opportunity availability, and fund lifecycle stages are primary drivers of capital deployment speed. While rapid deployment can be helpful for seizing market opportunities in a timely manner, it also risks increased exposure to the initial negative phase of the J-curve. On the other hand, a slower deployment pace might mitigate early losses but could lead to cash drag, where uninvested capital yields minimal returns, thus impacting overall portfolio performance negatively.

The difficulty of precise market timing necessitates a diversified approach to the timing of investments, specifically through vintage year diversification. This strategy involves spreading capital commitments across different vintage years via the different access routes, with a view to mitigating the risk associated with any single market cycle. By diversifying investments across multiple asset classes and vintages, investors can seek to smooth out the volatility associated with market timing and economic cycles, leading to more stable and potentially enhanced returns over time.

Incorporating vintage year diversification into the pacing plan allows for a more strategic deployment of capital, balancing the need to invest with caution against the inefficiencies of holding too much cash. This approach can help in managing liquidity and other risks. It can also help to better align the investment horizon and risk profile of private market allocations, with the long-term growth objectives of DC members.

Part 5: DC member experience and inter-generational fairness

As value creation in private markets may be generated towards the end of an investment, tools to deliver a smoother return journey should be carefully considered. This is essential to enable the broadest group of investors to benefit from an allocation to private markets. The allocation of performance fees can also be a contentious issue – is there a way to get exposure to high-performing managers with a ‘2 and 20’ model (a fee structure with an annual charge of 2% of the fund value, and that charges 20% of any gains the fund makes), within a framework that fairly allocates both the benefits of higher return, performance fees and ongoing fund expenses (which are often charged at the end of a fund life), more fairly?

Value creation processes in private markets can take several years to complete. There are some common features of private markets, such as the time it takes to develop a wind farm, or deliver a business from growth to profitability. Therefore, as described earlier, the J-curve can be a useful tool, especially with respect to valuation and timing of costs.

As a result of DC investors entering and exiting the scheme over time, it is important to acknowledge that if not managed carefully, investors may indirectly be exposed to different strategies of investment maturity and cost, particularly if transaction costs and performance fees are being paid at the completion of projects or exiting from companies.

Ensuring allocative fairness for investors

Therefore, a framework that understands these issues and fairly allocates both the benefits of higher returns and the performance fees (often charged at the end of a fund life) should be put in place. These could include:

If effectively deployed, the above measures can also reduce the sequencing risk, which is a prominent risk in post-retirement periods, stemming from the need to make withdrawals during periods of falling asset values. In this regard, a portfolio with a blend of J-curves, and a well-structured pacing plan, can reduce the risk of assets being exposed to periods of multiple market or macro shocks.

In summary, a combination of strong operational and portfolio management oversight is required, and appropriate processes need to be put in place that provide confidence, including to governance bodies, that fairness will be achieved across different cohorts of investors over long time periods, potentially spanning decades.

Reducing costs

Investing across private markets can be rewarding but also comes with higher costs and complexities. Here are some strategies to keep costs under control in a portfolio of private markets assets:

Part 6: ESG and Net Zero

Private markets can allocate capital directly to innovative projects. This includes the financing of sustainable initiatives, such as renewable energy, clean technologies and next generation real-estate developments, to support decarbonisation.

Private markets can play a pivotal role in supporting responsible investing and supporting global decarbonisation efforts, particularly in the context of environmental, social, and governance (ESG) criteria and Net Zero initiatives. Private markets offer investors more direct control over their capital allocations, allowing for targeted investments in innovative projects and companies that are at the forefront of sustainable development. This direct investment capability is essential for supporting the transition to a low-carbon economy and achieving Net Zero carbon emissions.

The direct control afforded by private market investments enables investors to exert greater influence on portfolio companies' strategic directions, encouraging them to adopt more sustainable practices. This influence is critical in sectors where technological advancements and operational shifts can significantly impact carbon emissions. Through active engagement, private investors can push for the adoption of cleaner energy sources, efficiency improvements, and better waste management practices, thus directly contributing to global Net Zero goals.

Data issues in ESG-orientated private markets investing

One of the biggest challenges in understanding ESG risks and opportunities in private markets is the relative paucity of relevant data. While this is an evolving area of disclosure, best practice involves seeking out policies and procedures that managers are putting in place to mitigate material ESG risks associated with the business.

Some approaches to look for in this regard include whether managers are utilising frameworks such as Sustainable Accountant Standards Board (SASB), and whether management is linking material ESG risks factors to key performance indicators (KPIs), and then monitoring these KPIs relative to established baselines. Often a complex task here is seeking to aggregate available ESG indicators across the portfolio to paint a bigger picture of risk that in isolation may be inconsequential, but in aggregate may be quite different.

An example of an important risk area is data security, where there is often operational dependency on digital processes to conduct businesses. Another example is ‘physical asset risk’, where geolocations of each asset can be tagged to understand localised issues, such as flood risk, water scarcity, or geopolitical tensions that might put pressure on supply chains.

Collecting, systematising and reporting on ESG areas across the portfolio requires managers to allocate dedicated resources and take a long-term mindset to establishing data baselines. Tracking improvements or deterioration in this data can be used to drive engagement priorities. However, progress in this space will require asset owners to work with and encourage their managers to support the collection and reporting of relevant ESG data, which would also improve transparency. You can read more about our approach to ESG data in this article.   

If a systematic approach is followed, it can help ensure private capital allocations are driven towards sectors and projects with significant potential for positive environmental impacts. For example, this could be for projects that promote renewable energy sources and clean technologies that reduce emissions and improve energy efficiency, or next-generation real estate projects that are focused on more sustainable construction and green buildings. By investing in these areas, private markets not only contribute to reducing global carbon footprints but also drive innovation in technologies and practices that are crucial for a sustainable future.

Beyond immediate environmental impacts, investments in sustainable projects and companies through private markets can support long-term economic growth by fostering innovation and creating jobs in emerging industries. This approach aligns investors' financial objectives with broader societal goals, demonstrating that responsible investing can generate competitive returns, while also promoting positive real-world changes.

In some ways, private markets may be uniquely positioned to support decarbonisation and advance ESG goals through more direct control over investments. By strategically allocating capital to sustainable initiatives and engaging with portfolio companies on ESG-related issues, private investors can play a crucial role in driving real world progress.

Part 7: Risk and Analytics – improving member outcomes

Different types of tools and methodologies are available to understand key portfolio risks as well as running forward-looking scenarios. The use of these tools can support private markets decision-making over the long term in order to generate consistent returns.

Detailed risk analytics in private markets is a developing field. While there are several similarities between embedded risks in private markets and listed assets, there is generally greater idiosyncrasy in private markets. Combined with generally less disclosure, this increases the need for a nuanced and enhanced risk management approach to ensure that appropriate governance and oversight mechanisms are in place for scaled private markets portfolios.

Risk management necessarily requires a multifaceted approach that encompasses idiosyncratic, market, and macro factors. As such, a comprehensive strategy is crucial for navigating the inherent complexities and uncertainties of private market investments. By effectively understanding these three critical risk areas, investors can flex the enterprise valuation model to better manage and mitigate potential risk events, thereby enhancing the overall resilience and performance of their portfolios.

Idiosyncratic factors involve deep dives into the specifics of management quality and governance structures, the intricacies of the capital structure, operational platforms, and the nuances of a firm's competitive edge or corporate strategy. Consideration of such factors can be indispensable for assessing the unique risks and opportunities presented by each investment, while also facilitating more tailored risk mitigation plans.

Market factors consider the broader industry and economic environment in which firms operate. This includes evaluating sector growth prospects, discount rates, valuation multiples, market liquidity, and transparency. Additionally, it involves considering secular changes and trends, as well as country-specific risks, such as political stability and tax regimes. These elements can be pivotal in understanding how external forces could impact investment performance.

Macro factors encompass broader economic indicators, such as business and financial cycle indicators, monetary policy, and expectations around interest rates and inflation. These factors are critical in gauging the overall economic climate, and its potential effect on private market investments.

Risk transparency remains a challenge due to the typically more opaque nature of private markets. Improved disclosure and transparency regarding future cash flows, valuation drivers, and other critical asset-specific information are increasingly being asked for to enhance investors' understanding and confidence in private assets.

Decomposition of value drivers at the asset level enables a more precise allocation of capital, by identifying and testing key return drivers under various market conditions. This is particularly challenging in private markets, but is essential for understanding the effectiveness of management decisions and the sensitivity of assets to external factors.

This risk management approach underscores the dynamic nature of private investments, where the optimisation of value through various levers can be both an opportunity and a challenge. By leveraging a systematic framework that integrates idiosyncratic, market, and macro risk factors with detailed scenario analysis, investors can better navigate the complexities of private markets, thus supporting their ability to achieve robust, resilient investment outcomes.

Summary

As DC schemes begin to focus more on the scope for increased exposure to private markets, we hope that this article can serve as a useful summary of the analytical and risk management processes for managing private markets portfolios within a semi-liquid vehicle.

In summary, it is advisable for DC pension schemes look to implement private markets exposure in a robust and risk-controlled manner, whereby the differences to listed assets, and idiosyncrasies of each private markets allocation, are duly accounted for. More specifically, some key recommendations are summarised below:

The information in this article was first published by the Pensions and Lifetime Savings Association in a Private Markets Portfolio Construction Made Simple Guide authored by abrdn Investments. You can view the guide, and others, on the PLSA website.