Asset Allocation and Private Markets

A Guide to Investing with Private Equity, Private Debt, and Private Real Assets

Cyril Demaria, Maurice Pedergnana, Remy He, Roger Rissi, Sarah Debrand

• Publisher: Wiley
• Year: 2021
• Print ISBN:
  9781119381006
• eBook ISBN:
  9781119380993
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Finanzwesen

The comprehensive guide to private market asset allocation

Asset Allocation and Private Markets provides institutional investors, such as pension funds, insurance groups and family offices, with a single-volume authoritative resource on including private markets in strategic asset allocation. Written by four academic and practitioner specialists, this book provides the background knowledge investors need, coupled with practical advice from experts in the field.

The discussion focuses on private equity, private debt and private real assets, and their correlation with other asset classes to establish optimized investment portfolios. Armed with the grounded and critical perspectives provided in this book, investors can tailor their portfolio and effectively allocate assets to traditional and private markets in their best interest.

In-depth discussion of return, risks, liquidity and other factors of asset allocation takes a more practical turn with guidance on allocation construction and capital deployment, the "endowment model," and hedging — or lack thereof.  Unique in the depth and breadth of information on this increasingly attractive asset class, this book is an invaluable resource for investors seeking new strategies.

• Discover alternative solutions to traditional asset allocation strategies
• Consider attractive returns of private markets
• Delve into private equity, private debt and private real assets

• Gain expert perspectives on correlation, risk, liquidity, and portfolio construction

Private markets represent a substantial proportion of global wealth. Amidst disappointing returns from stocks and bonds, investors are increasingly looking to revitalise traditional asset allocation strategies by weighting private market structures more heavily in their portfolios. Pension fund and other long-term asset managers need deeper information than is typically provided in tangential reference in broader asset allocation literature; Asset Allocation and Private Markets fills the gap, with comprehensive information and practical guidance.

CHAPTER 1
Sources of Capital: Nature, Constraints, and Objectives

In a Nutshell

This chapter will guide readers with background on investors and their asset allocation. Allocating assets can be challenging due to behavioral biases and an ever-changing macroeconomic and financial environment. Moreover, each investor is different. Taking into account their specific constraints is crucial for building a successful asset allocation, although those constraints are evolving over time.

Investors try to optimize the use of their capital to generate the highest financial performance possible within a set of identified constraints. Investors operate trade-offs to make the most of what is possible within these constraints. This task is called asset allocation (Chapter 2).

Setting up an asset allocation is challenging in multiple ways. First, investors are subject to behavioral biases (Section 1.1). Second, investors have to allocate their capital in an ever-changing environment: macroeconomic conditions, the performance and risks associated with specific investments, as well as demographic, regulatory, socioeconomic, and even psychological (investor's preferences) dimensions generate uncertainties about the outcome of an asset allocation.

Moreover, each investor is different and therefore has to carefully assess his own constraints to build an asset allocation (Section 1.2). These constraints evolve over time as well. Investors have to then revise their approach and their asset allocation. This can prove to be difficult, as investors tend to rely on the observation of the past to project themselves into the future.

1.1 BEHAVIORAL BIASES AND THEIR CONSEQUENCES

Behavioral biases affect every investor. This has been widely documented when investors look at listed markets. Behavioral biases apply also when investors plan to deploy capital in private markets (Section 1.1), although the consequences might differ. It is possible to address these behavioral biases (Section 1.2) thanks to specific actions.

1.1.1 Behavioral Biases in the Context of Private Markets Investing

Demaria (2015, Introduction), quoting Allen (2001), describes investors as agents of final capital providers, making decisions in the name and/or the account of the latter in private market funds. Fund investors are heterogeneous in their expectations and behaviors as well as irrational and subject to biases.

Demaria¹ explains that “in a context of low, asymmetrical, and incomplete information, noise can have significant consequences” on the behavior of private market fund investors. This noise can be rumors, outdated information, or partial information that fills the void. Demaria notably explains that the reputation of fund managers plays a significant role in private markets. Sorting information from noise can be challenging for fund investors.

Prospect theory applies to private market investors. As explained by Demaria (2015), an investor's expected outcome from an asset selection is determined by the gains or losses registered since the asset was acquired. Demaria mentions that private market fund investors do not fall into the usual trap of over-weighting recent information and under-weighting long-term trends. The conclusion of Demaria is that fund investors might, in fact, “under-react to information while they over-react on the stock exchange.” Focusing specifically on losses, he explains that they are booked first as provisional (through the evolution of net asset values of funds) and then as effective losses. Fund investors tend to underreact to provisional losses, as they are judged only as an estimate. They also underreact to actual losses, as they have already integrated the information. Demaria also notes that losses booked by private market funds are the result of a process over which they have no control. Their potential actions are also limited.

Information on private markets is also subject to a significant time lag. Demaria mentions that as this information, notably about fund performance, is acknowledged, waves of investments are triggered and are fed by “belated knowledge and understanding of past performances.” They are the result of fashions, fads, the representativeness bias (fund investors base their judgements on stereotypes), aversion to ambiguity (fund investors prefer the familiar to the unfamiliar), and fear of the unknown. As an illustration, investors have avoided strategies that recorded a loss, such as Western European venture capital after 2001. They missed the particularly high performance of these funds during the following years. Investors also tend to pile up on strategies that enjoyed significant and unexpectedly high returns, such as US venture capital in 1990–1997. A wave of capital inflow created an oversupply in the following years, resulting in a bubble and a crash in 2000–2001. Moreover, investors tend to over-weight their own experience and a limited number of recent events. They revise their beliefs with a certain time lag in front of new evidence, and with a relative lack of magnitude.

Demaria states that home investing bias affects fund investors, as they are a way to address the recurring lack of information mentioned above. U...

Table of contents

• Cover
• Table of Contents
• Title Page
• Copyright
• Dedication
• Foreword
• Acknowledgments
• About the Authors
• Data Sources
• Abbreviations and Acronyms
• CHAPTER 1: Sources of Capital: Nature, Constraints, and Objectives
• CHAPTER 2: Asset Allocation: Models, Limits, and Adaptations
• CHAPTER 3: Private Markets Investing1
• CHAPTER 4: The Three Dimensions of Investment
• CHAPTER 5: Portfolio Construction and Management
• General Conclusion
• Glossary
• Bibliography
• Index
• End User License Agreement