Yin and yang: how private assets and derivatives can work together
Many studies indicate that private assets offer a significant risk premium above public market comparators, even allowing for higher asset management costs.
The volatility of private assets is also no worse, or sometimes even better, than the volatility of their public market equivalents. This implies that unconstrained portfolio optimisation would result in very high allocations to private assets.
So why are private assets not more widely used?
Concern over portfolio liquidity tends to explain why private asset allocations are generally well below the theoretical optimum. Indeed, the risk premium on private assets is often explained as an “illiquidity premium”, available only to those who can tolerate illiquidity.
The important point to note here is that liquidity constraints are usually met simply by ensuring that the investor has sufficient liquid assets in stressed downside scenarios to fund their liquidity requirement. In other words, we are not usually stressing the liquidity requirement itself – or the illiquid asset - but instead stressing the residual liquid assets.
However, a stressed event in liquid assets is really just a significant fall in their market value. Thus, the capacity to hold illiquid assets can potentially be increased by managing the downside risk of the liquid assets (i.e. the risk of a significant fall in a liquid asset’s value) and one of the most effective ways of doing this is through the use of derivative instruments.
Derivatives can improve downside risk characteristics of liquid assets
We modelled three different approaches to allocating to private assets subject to a liquidity constraint. The base strategy allocated the maximum amount to private assets that can be achieved without breaching the liquidity constraint in the 99th percentile modelled outcome for liquidity.
We found that a strategy which allocated an additional 10% to private equity combined with put protection meets the liquidity constraint and still captures two thirds of the improvement in portfolio internal rate of return (IRR) seen in the base strategy, after basically spending the remaining one third of the IRR improvement on the put option protection.
It is worth remembering that the use of protection serves a dual purpose: not only can it facilitate higher investment in illiquid assets to improve overall expected return, it also reduces the downside risk of the overall portfolio. Indeed, the solution could equally be thought of as subsidising the cost of risk management using the illiquidity premium.
An investor concerned about developed market equity valuations could potentially implement the above put strategy to address downside risk and use an allocation to illiquid assets to mitigate the cost impact on expected return.
Derivatives can also improve the liquidity characteristics of private assets
Furthermore, the put protection doesn’t have to be notionally paired with the public assets; it can also be paired with the private assets. This strategy can then be viewed as improving its liquidity by providing a targeted “liquidity shot” during periods of public market distress rather than managing downside risk of the private asset per se.
So, we can view derivative based risk management solutions as either improving downside risk characteristics of liquid assets or improving the liquidity characteristics of private assets.
Derivatives can help increase returns, lower risk and enhance liquidity
In conclusion, there has been significant interest recently in the idea of combining various forms of private assets to provide blended solutions. We would suggest that derivative based risk management strategies should be considered alongside illiquid assets as part of these blended solutions, potentially creating overall strategies with higher return, lower risk and enhanced liquidity.
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