The $1 trillion shortfall if private equity bets turn sour

Institutional allocations to private markets have surged in recent years. Large US endowment funds lifted their allocation to private equity and venture capital from 19% to 30% between 2018 and 2021, eclipsing their holdings of public equities. There is no sign that this growth is about to tail off. Quite the opposite in fact.

This large allocation has worked well. Private equity and venture capital outperformed the S&P 500 by nearly 3.5% per annum from 2007 to the end of March last year. It is hardly surprising, therefore, that Preqin, a data compiler, forecasts that investors will speed up their allocations to private equity and venture capital over the next five years (see figure 1).

This powerful trend raises an important question for investors. What happens if the market changes direction after they have committed to give private equity managers an ever-greater share of their assets? Investors would have no choice but to keep sending the money even as the returns from their existing investments in private equity tumbled. Every time they up their allocations to private equity, investors also increase the liquidity risk in their portfolios. The liquidity needs of these allocations could become acute if a mismatch appears between the size of distributions from mature, cash-generative private funds and capital calls from their general partners.

Liquidity risk is not a minor problem. If asset prices fall, mature funds will probably delay exits via initial public offerings, secondary buyouts and strategic deals, curtailing their distributions to investors. A falling market will simultaneously produce more attractive valuations, prompting a wave of capital calls, especially if prospective deals consist of a higher-than-usual participation from equity investors because of credit tightening.

It has happened before. Our analysis of flows into private assets since 2000 identifies liquidity shortfalls during the market downturns of 2002 and 2008. The 2001 to 2003 drawdown, during which the S&P 500 fell 48% peak to trough, created a need for dollars equivalent to 25% of global private equity assets at that time (see figure 2).

How big a concern could a future liquidity shortfall be? The biggest to date – $235 billion – occurred during the financial crisis of 2008–09. It amounted to 14% of total private equity and venture capital assets. Private market allocations have grown dramatically since then and are forecast to reach $7.1 trillion by the end of this year. A liquidity shortfall of 14% on today’s enlarged asset base would require investors to find $1 trillion.

Where would they look? Investors do not keep $1 trillion parked in cash on the offchance that there is a repeat of the financial crisis. The opportunity cost would be excessive. In the absence of cash or other highly liquid holdings, investors facing a liquidity shortfall on their private asset portfolios would be forced to sell liquid public market assets, such as equities, at the worst possible moment. Worse still, public market liquidity, as measured by the depth of the order book, is at historic lows, potentially exacerbating any sustained market drawdown. Put these two facts together and it becomes clear that asset allocators have never had a greater exposure to liquidity risk.

There is a way to mitigate the potential damage. Investors could set up an equity tail-risk hedging programme designed to pay out enough money in a market downturn to cover the sums they have committed to private equity managers. The cost of such a tail hedge is half that of the traditional approaches of holding excess liquidity or selling public assets, according to modelling by Capstone.

Excess liquidity would provide investors with the cash they need. But the sums involved are huge. Capstone’s modelling suggests that investors would need highly liquid assets equivalent to 20% of their holdings in private assets. We assume that equity markets suffer a 40% peak-to-trough decline. The equity risk premium – the extra return generated by investing in equities rather than holding cash – is 5%. That means the opportunity cost of holding excess liquidity as a percentage of private assets is 1% per year – 20% multiplied by 5%.

Selling public market assets to plug the gap is just as expensive. An investor who sold US equities to meet a 20% liquidity shortfall during the financial crisis would have ended 2008 with an underweight position in the S&P 500 equivalent to 10% of their private asset portfolio. The underweight would have doubled to 20% by the end of 2009. We then assume it takes three years to unwind each of these underweights. Over these two three-year periods (2008–11 and 2009–12), the S&P 500 rallied 36% and 48%, a performance that we believe is not untypical of risk assets following a major drawdown. If we annualise the cost of this 20% underweight in the S&P 500 over a typical eight-year business cycle, we find that the opportunity cost of this approach as a percentage of a private asset portfolio is 1%.

Investors that don’t plan for a downturn in private equity’s fortunes could be forced into liquidations that crystallise mark-to-market losses

Using a tail hedge is much cheaper. We calculate that the expected annual cost of a tail-risk programme is 7.5% of the hedge’s size. That sum was derived from geometrically weighted returns – a measure of the compound growth rate of a portfolio that strips out inflows and outflows of money. Let’s assume that a 40% equity market drawdown produces a 20% liquidity shortfall on the investor’s private asset portfolio. Assume that the investor will get a payout of 300% the size of their tail hedging programme because of the downturn. The investor will need to allocate a sum equivalent to 6.7% of their private assets to cover the liquidity shortfall – 20% divided by 300%. If the expected cost of the tail programme over a business cycle is 7.5%, the cost of the hedge, as a percentage of the private assets, will be 0.5% – which is 6.7% multiplied by 7.5%.

Tail hedge programmes should be customised to match each investor’s portfolio and risk preferences. The geographic exposure of the private market investments and the type of market downturn an investor is most concerned about should be the key considerations. Short market drawdowns with rapid recoveries, such as the crash in March 2020, create limited liquidity risk as the market price of assets is depressed too briefly to change the behaviour of private equity managers. The real concern is a long recession creating a very large private asset overweight in investor portfolios. This should be the focus of the tail hedge.

Many private equity portfolios are overweight in technology companies, so the tail-risk hedge should also be overweight that sector. Recent drawdowns such as the fourth quarter of 2018 and the first quarter of 2022 were tech-centric events. A technology-focused hedge referencing the Nasdaq outperformed a broad volatility-based hedge referencing the Vix during both those downturns. The volatility spike in February 2018 – known as Volmageddon to excitable financial commentators – produced the opposite outcome. The Vix-based hedge outperformed. The same also happened in the March 2020 downturn (see figure 3).

Asset allocators can plan for liquidity shortfalls caused by their private asset portfolios. And recent history has shown that these events occur episodically. Investors that don’t plan for a downturn in private equity’s fortunes could be forced into liquidations that crystallise mark-to-market losses. Spending part of the future expected outperformance from private assets in a tail hedge can provide a cost-effective way to mitigate the risks of a liquidity shortfall in investors’ private market portfolios. The future returns from a portfolio combining private assets with a tail hedge are more attractive, on a risk-adjusted basis, than handing over money to the private equity giants and hoping for the best.

Tom Leake is head of solutions at Capstone Investment Advisors, a hedge fund that focuses on volatility and derivatives.