Private Equity Allocation Decisions: Integrating Liquidity, Active Risk, and Investor Circumstances

Abstract

Private equity can offer return-enhancement potential through liquidity risk premia and manager alpha, but these benefits come with meaningful liquidity and active risk that are not fully incorporated into certain portfolio construction frameworks. In addition, adjusting appraisal-based valuations reduces the apparent diversification benefits of private equity to levels more consistent with what would be expected for an asset that represents a subset of the equity market. We extend an existing framework which integrates these considerations in the context of traditional drawdown funds to the case of semiliquid (evergreen) fund structures. We find that, similar to the case of drawdown funds, the optimal allocation to semiliquid private equity exposures varies across investors and depends on assumptions regarding manager skill, the level of active risk, and investor tolerance for active risk and liquidity constraints. For fully specified non-naive investors, it ranges from 0% to 40% of a portfolio’s total equity exposure. These considerations also have important governance implications for advisors, investment committees, and other decision-makers.