Total Portfolio Approach: Integrating Private Assets

In markets with liquid secondary assets, price discovery is straightforward, allowing for quick transactions at market values. However, private assets present unique challenges:

• Illiquidity is a defining, permanent feature - not a temporary anomaly 
• Valuations are subjective; prices often emerge from lengthy negotiation processes
• During crises, secondary market transactions may only occur at significant discounts, if at all 

This reality demands a robust risk framework that differentiates four distinct risk types:

• Capital risk: The long-term risk of capital loss
• Funding liquidity risk: The risk of failing to meet capital calls
• Market risk: The risk of accounting losses typically assessed by Value-at-Risk (VaR)
• Market liquidity risk: The potential loss when liquidating positions   

Many institutional investors and regulators often treat private assets as if they were liquid, emphasizing market risk while applying conservative shocks that assume some liquidity. This approach distorts the real risk landscape. In practice, funding liquidity risks are significantly more pertinent for investors in closed-ended funds than traditional market risk metrics.

When attempting to integrate private assets into a holistic portfolio view, conventional market risk models create a paradox. They may recommend a near-total portfolio concentration in private assets (when using buy-and-hold return assumptions) or completely dismiss private asset allocations due to steep secondary market discounts. This inconsistency reveals the inadequacy of conventional approaches.

The resolution lies in recognizing that cash flows—not theoretical market transaction opportunities—constitute the primary constraint affecting illiquid private asset allocations. The critical insight is that the costs associated with illiquidity depend on the specific composition and time horizon of the portfolio, rather than solely on the characteristics of the assets themselves. It is vital to assess whether liquidity is genuinely needed within the investment timeframe.

To turn this insight into a practical strategy, investment managers require capabilities that most traditional systems lack: on-demand cash flow forecasting powered by practitioner-tested and academically validated models, available precisely when decisions must be made.

To fully leverage the potential of TPA with private assets, investment managers must utilize continuously generated cash flow forecasts. Unlike traditional annual planning cycles, asset allocation within the TPA framework requires:

• Automated, consistent, and frequent cashflow forecasting and pacing processes
• Probabilistic models that reflect underlying uncertainty
• The capability to generate "cash flow-consistent net asset value" measurements 

Private market data often suffers from poor quality and limited granularity compared to publicly traded assets. Advanced forecasting algorithms need to aggregate data from disparate sources, standardize it, identify the best matches for specific assets, and apply appropriate proxies when necessary.

The mantra for forecasting practitioners remains; it's better to run a simple model frequently than a complex model rarely. Transitioning from manual, labor-intensive forecasting to automated approaches that can be applied as needed is a crucial step in integrating private assets into TPA. This establishes a unified framework where risks are measured more accurately, and the illiquidity of private assets is not unduly penalized when liquidity is not a portfolio necessity.

With reliable cash flow forecasts, organizations can adopt a practical methodology for achieving balanced exposure between liquid and illiquid investments.

The effective integration of private assets into TPA involves a pragmatic two-step process:

1. Calculating overall asset allocations based on risk factors without factoring in cash flow constraints
2. Applying cash flow probability distributions along with appropriate stress testing

This methodology aids in determining the optimal allocation for private capital investments characterized by uncertain cash flows. By emphasizing a buy-and-hold strategy throughout the investment's lifespan, this approach maximizes investor wealth without considering premature exits in secondary markets. 

Additionally, effective implementation requires a robust technology infrastructure that provides real-time visibility across the entire multi-asset portfolio, which is essential for superior risk management and accurate cash flow forecasting.

In today's fast-paced markets, having a total portfolio view in real time is no longer a luxury - it's a necessity. This holistic approach requires:

• A comprehensive, singular Investment Book of Record (IBOR) supporting the complete business lifecycle
• The elimination of batch processes that introduce latency and fragmentation
• A system that's always on, always ready, processing all actions using the same data   

Most investment organizations still rely on disparate systems—a fragmented landscape developed over time in response to growth and market demands. This situation is further complicated by outdated outsourcing models with their own delayed, disconnected data.

The result is that every integration and reconciliation point in the investment lifecycle adds complexity, making it challenging to achieve a complete, accurate, and timely overview of the entire portfolio. For investment managers, this necessitates a fundamental rethinking of how systems integrate, how data flows, and how risk is assessed across both liquid and illiquid asset classes.