Understanding and managing risks in private market portfolios

In the public markets with liquid assets, it’s easy to call up a broker for a trade. “But in the private market space you’ve got to pay lawyers and accountants and tax advisors and — particularly if you’re going down the direct route — all that implementation risk is held with you as the owner.”

There are many other considerations for asset owners, ranging from operational due diligence to looking at a portfolio to determine its economic correlations, he added.

Further, a big dispersion exists between managers’ private market returns. And accessing co-investment opportunities with the best mid-market managers, that are capacity constrained, can be difficult unless there’s a longstanding prior relationship, noted De Silva. “I think it’s a noble cause to try and get cheap deals out of the best managers, but the practicalities of doing that — particularly if you’re on the smaller end of the spectrum — is quite challenging and the cost of it is quite expensive as well because now it’s a buyers’ market.”

Plan sponsors should be thinking about their overall program and asking what they’re trying to accomplish with their private market allocations. “You’ve got to be able to say, over the next 15 [or] 20 years of the life of this program — matched to your liabilities, matched to your liquidity stress — where do we want to take our exposures to, in theory, and then look at the practical application of that.”

In addition to access, transparency can also be challenging, said De Silva, noting the industry still has to step up on this front.

Yet, private markets also present advantages compared to public markets where it’s more difficult to sit down with a large company’s management and ask for information outside of the regular reporting cycle. “The irony is, in private markets you can go to your manager and ask them to go and see the [chief financial officer] and send you a statement of accounts.”

That said, he noted it isn’t a particularly time-efficient process and can also be an expensive exercise.

Some top-tier managers are putting technology in place to increase transparency and information availability. However, accessing the data, in general, still requires close relationships.

It’s also challenging for pension plans to incorporate private assets through asset-liability modelling studies. “The path of least resistance is to jam a private asset into a public market risk model,” De Silva said. “Don’t do that.”

Instead, he suggested that pension funds try to decompose factors that are relevant within their private markets portfolios, which he acknowledges does require data. “In terms of optimizing, you need to have that transparency first before you optimize. And then, I think, we need to break down these boundaries between asset classes because, actually, the asset classes don’t matter. It’s the implementation method and the economic exposure that you’re taking on.”

Another consideration when owning private assets is environmental, social and governance risk.

De Silva pointed to a number of frameworks that can be used in the real assets space. “We use one that’s broadly linked to the Sustainable Accounting Standards Board, which [details] ESG materiality within sectors. And then, when you try and look at each of those sectors, try and map that to your investment and say, ‘Actually, what are we genuinely exposed to from an ESG standpoint?’”

This approach allows investors to pose questions to managers about what they’re doing in certain areas related to ESG.

Overall, everything in private markets is currently expensive, De Silva said. “Anything that’s got a reliable stream of cash flows associated with it and reliable risk management tends to be priced, so I think what you really want to be doing is getting rewarded for complexity and execution risk.”