Sizing private-market allocations: part one

Interest in private-market allocations appears to be continuing its steady ascent in 2025. Historical returns and diversification potential are attracting a wide variety of asset owners, who are accessing everything from early-stage venture capital to investment-grade private placements through an expanding set of vehicles.

But critically, asset owners are often less familiar with how to properly size these private-market allocations to meet their portfolios’ distinct objectives. In this four-part series, we provide an actionable framework to help asset owners evaluate three core components of this decision: the capacity to take on illiquidity, the need for excess return and the ability to consistently allocate to “good” investments.

Here, in part one, we briefly highlight the main reasons we think asset owners allocate to private assets, introduce our approach to sizing private investments and outline the three remaining parts of the series.

Why allocate to private assets?

In our view, private investing can offer asset owners a range of attractive characteristics, including the potential for return premia and greater diversification and breadth of opportunity set.

Return premia
Private assets are characterised by illiquidity and have historically commanded a premium (excess return) that asset owners can capture if their portfolios can tolerate that illiquidity. Moreover, premia from factor risk, idiosyncratic risk and manager skill¹ can also be outsized due to the complexity, concentration and dispersion of private-investment vehicles or underlying investments. As we outline below, private-market investors should confirm and quantify their need for excess return to reach their goals, as well as their ability to align the longer investment horizons with their own portfolio needs.

Diversification and breadth
Notably, illiquidity risk can also diversify market beta risk (i.e., asset owners can potentially take less market risk and more illiquidity risk to get to the same return target). In addition, even if a public-market strategic asset allocation (SAA) provides sufficient return, an allocation to privates may offer diversification and breadth. This is because private investments can provide access to earlier-stage companies, different sectors or other market segments that may be hard to access in a public-market portfolio. With companies staying private longer and the number of public companies shrinking, part of the opportunity set previously available in the small-cap listed market is now likely to be found in the pre-IPO or late-stage VC market. Importantly, some asset owners have been attracted by the additional perceived volatility benefit of private investing’s “smoother ride” given infrequent pricing. We would caution that this benefit only exists on paper in that it can’t be realised by rebalancing or selling.

How to size private assets: our approach

For most asset owners, we believe in an opportunity-cost approach to sizing private assets. Crucially, this means we do not incorporate private assets directly into our SAA process. Instead, we consider sizing them in a follow-on step. First, we use the SAA process to determine the long-term target liquid beta exposure of a portfolio. Subsequently, when considering portfolio construction and implementation, we evaluate and structure private allocations according to the criteria we outline below. We frame the source of funding for each private investment as its “opportunity cost.”

Why do we have a separate process for determining the sizing of private assets outside of SAA to begin with? Private assets have several qualities we believe make them poor fits for inclusion in a mean-variance-based asset allocation process:

• Illiquidity: As noted above, private assets typically cannot be quickly bought or sold in a unitised fashion. This is especially important because it means asset owners are often unable to rebalance and therefore may not achieve the correlation benefits implied by historical private asset returns.
• Lack of internal homogeneity: Even after we categorise private assets into areas like private equity or private debt, or even a step further (e.g., within private debt — mezzanine, distressed, IG private placements, etc.), generalised assumptions are difficult. This is because there is often a high level of concentration within an implemented allocation and/or significant dispersion among managers and strategies. Given these issues, forecasts of attributes such as return and correlation often require meaningful simplifying assumptions, which can limit their applicability when making real-world decisions.
• Lack of an accessible liquid alternative/requirement for skill: Lastly, because asset owners cannot passively access private “exposure”, there is an explicit additional cost (in terms of fees, operations and research) that must be considered against the expected benefit. These variables can also vary by fund and investor, making incorporation into SAA difficult.

With these factors in mind, and because private assets are such a wide-ranging category, we prefer to decompose their return and risk profiles into what we can measure as beta and “other” (with “other” including illiquidity premia and idiosyncratic risk). This gives us a framework to align public- and private-market exposures within broad asset class types (e.g., thinking about private equity holistically within a total equity allocation). We then decide within each of those asset class exposures what the best implementation blend is (i.e., private versus public) as well as the choice of managers. We believe this approach has significant benefits for investment governance because it takes into account the specific characteristics of private assets, which often require a more tailored approach.

Below, we introduce each component in turn. The subsequent parts of this series will devote a full article to each.

1. Capacity to take on illiquidity and complexity

We believe the upper bound of the private asset allocation weight should be based on a practical limitation — how much illiquidity can an asset owner reasonably take on? Given illiquidity is a core characteristic and a key return driver for private assets, it is critical to confirm that a portfolio has the capacity to handle this risk. There are three main types of liquidity constraints that can impact sizing:

• Cash flow (return versus net liabilities/spending): We believe in taking a holistic approach to incorporating portfolio objectives (with particular attention to net outflows) when determining an asset owner’s maximum capacity for illiquidity. Generally speaking, and all else equal, an asset owner whose only goal is capital appreciation (no spending or liability considerations) may have a higher capacity for illiquidity than one whose primary goal is to ensure their ability to pay out liabilities over time. Of course, there is a lot of nuance in between and we believe in using a cash-flow-focused modelling approach and stress testing to parse that nuance. Where applicable, we believe asset owners should incorporate pacing model projections and denominator effect² implications into this exercise.
• Regulatory: Some asset owners have limits or guidelines on the amount of capital that can be illiquid. Two examples are the liquidity coverage ratio for banks and Solvency II capital charges for insurers.
• Complexity: The inherent complexity in allocating to these assets is a lesser but still-notable issue. This includes decisions about how to fund commitments, how to measure and monitor performance, how to manage allocations over time as well as the resources required for each of these steps. These challenges also contribute to the expectation of a return premium for private investments.

In part two of this series, we will focus largely on considerations related to cash flows and complexity, as they are more easily generalised across types of asset owners. In addition, we will explore private-market assets’ liquidity characteristics (and how they relate to asset owners’ liquidity needs) in greater detail. The goal of this step is to evaluate the potential negative impacts related to illiquidity — largely through stress testing — and thereby set the upper bound for the allocation weight to private assets.

2. Need for excess return

We believe the lower bound of a private asset allocation should be based on a portfolio’s distinct need for excess return (combined with the size of the premium available). This part of the sizing exercise seeks to analyse whether the asset owner can achieve their objectives without taking on the illiquidity and complexity of private assets. The answer to this question helps identify a minimum allocation because if the portfolio does, in fact, need more return, it will likely be necessary to increase risk, either through higher risk (e.g., in equities) or illiquidity.

To rationalise an investment in private assets, the asset owner should believe the risk-adjusted return premia noted above exists, is durable and is capturable. One key question is how large of a premium one can expect. Estimates of return premia from private assets have generally ranged from as low as 2% to as high as 6+%, depending on the time period, the specific subasset class and the methodology used. We believe in taking a conservative approach and assume 2% premia for broad private debt and 3% premia for broad private equity. However, we view these as general starting points, and it may be reasonable for individual asset owners to make different assumptions based on their experience and/or the asset category in question.

The goal of this step is threefold: 1) to provide guidance on a reasonable starting point for assumed premia, 2) to evaluate how different premia assumptions imply different allocation weights to private assets and 3) to evaluate trade-offs between market and illiquidity risk when seeking alternative sources of return. Weighing these factors together can help identify the minimum private-market allocation necessary to achieve the asset owner’s goals.

3. Ability to source, select and allocate consistently to “good” funds/investments

Finally, private investing’s breadth, heterogeneity and skill requirements have a crucial consequence: returns have exhibited significant dispersion due to manager and strategy selection historically. This has meant that asset owners with the ability to source, select and allocate consistently to the “best” managers have often earned outsized excess returns.

• Source: The ability to invest effectively is influenced by the number of investment options available, access to outperforming managers and the resource and time intensity of the associated research.
• Select: The selection process presents many challenges, including identifying optimal investment timing and selecting managers and strategies based on incomplete information. The evaluation of historical success in manager selection also involves subjectivity and is often carried out by those making the selections, which can create an additional challenge.
• Allocate consistently: Consistent allocation strategies are crucial for managing liquidity, vintage-year diversification and governance. We believe it is essential to maintain investment discipline over the long term despite potential short-term shifts in market conditions and liquidity concerns.

The goal of this step is to provide data to contextualise the importance of manager selection and vintage-year diversification. After all, once an asset owner has determined the maximum percentage that can be allocated to privates (the upper bound) and the amount of additional return needed (and thereby the lower bound), the focus can turn to implementation. Where one sits within that range will depend on the capability not just to source and select “good” managers but also to run a long-term program at the appropriate size.

Bottom line on sizing private-market allocations

In parts two through four of this series, we’ll dive further into how to evaluate the capacity to take on illiquidity (the upper bound), the need for return premia (the lower bound) and the ability to source, select and allocate consistently to “good” managers (where one lands within that range). In our view, combining these criteria can help asset owners better size their private-market allocations to align with their long-term portfolio goals.

In the meantime, our key takeaways for asset owners from this introduction are:

• Sizing target private asset exposure is a critical decision but is inherently different from determining target weights to stocks, bonds and other measurable asset classes.
• Asset owners should first decide what mix of broad market exposures is best aligned with their return objectives and risk constraints and then size public and private allocations within classifications such as equities, credit and real assets.
• In strategic asset allocation, the key inputs — expected return, risk and correlation of broad asset classes — are often integrated with an asset owner’s return objective and risk tolerance to set target market exposures.
• In portfolio construction, the key inputs — expected premia and liquidity limitations offered by private investments — can be integrated with an asset owner’s tolerance for illiquidity risk, need for incremental return and ability to source compelling strategies to set target weights of public and private assets.

¹Some premia may be linked to specific attributes of how value is added to private assets, which are not available in the listed space. For example, in venture capital, this may be the value added by a long-term capital partner to prepare the company to go public. Additionally, some portion of the private debt premium may be linked to the fact that borrowers are willing to pay a higher yield for flexibility on covenants and deal structure. | ²The denominator effect in this case refers to when public assets decrease in value to a greater degree or faster rate than the private assets in a portfolio — thus causing private assets to represent a larger percentage of overall asset allocation than may have originally been intended.