Investors continue to pour money into private market assets, drawn by higher returns and diversification. Yet as these investments grow, so are liquidity challenges — particularly for underfunded public pensions with high private equity and credit allocations.
Pensions with a big slice of their portfolios in investments that can’t be easily sold need to closely manage other sources of cash and securities such as listed stocks, particularly amid increasing geopolitical and fiscal uncertainty. For public pensions, the risk of having to sell off assets at inopportune times looms large.
Paul O’Brien, trustee and investment committee member at the $10 billion Wyoming Retirement System, warned these macro pressures can’t be ignored. “The U.S. can no longer be a global shock absorber. We might even become a source of volatility rather than stability,” he said.
“It’s inevitable that something will happen — somebody will get in trouble — it’s just a question of when and during what kind of market downturn,” O’Brien said. “This is why very good liquidity management and a solid understanding of what could go wrong are crucial.”
While O’Brien is optimistic about private credit and described the investments as “the gift that keeps on giving,” he sees some red flags down the road. “I think it’s a great asset class, but when too much money piles into credit, bad things are going to happen,” he said.
The IMF and Brookings Institute have outlined several bad things that could happen if too much capital flows into the sector. For starters, defaults among highly leveraged borrowers could ripple through the financial system, tightening credit and disrupting markets. Plus, the sector’s lack of transparency and interconnections with insurers and other investors make it harder for regulators to monitor risks or respond quickly during downturns, heightening the chance of systemic instability. Both the IMF and Brookings argue for stronger safeguards to mitigate those risks.
For allocators, the challenge will be capitalizing on the right opportunities within private markets while ensuring they have the cash to weather the next bear market or full-blown global financial crisis.
“Private equity can’t stay private anymore,” O’Brien said. “If something bad happens in the public pension world, it will wake everyone up — regulators included.”
Wyoming’s portfolio currently allocates 17.5 percent to private markets.
Navigating Saturated Markets
The dispersion of returns in private debt are significantly tighter than those of private equity. So, discerning which private debt strategies are the best out there comes down to other factors beyond returns, such as sourcing, underwriting, and being able to offer different vehicles for different investor types. Investors should also look into whether private debt fund managers have properly staffed their portfolio monitoring team and mid and back-office resources, since private debt funds can often have up to five times the number of investments that a private equity vehicle would have.
But Scopelliti believes private credit and private equity differ. While private credit strategies are distinguinshed from one another by losses during downturns, private equity presents a different dynamic, with a much wider dispersion of returns, making it easier to separate winners from losers.
Even so, Scopelliti argues institutional investors understand illiquidity and its relationship to the long-term nature of private markets, even when allocations appear stretched in the short term. “Most sophisticated investors and asset owners in particular, who have been in the private markets for a long time, understand that despite perhaps being overallocated at a point in time, allocations self-correct over a period of time,” Scopelliti said.
Stress Testing for Downturns
Recognizing the risks inherent in illiquid assets, OCIOs like NEPC and Commonfund OCIO regularly employ robust stress-testing measures to ensure clients can withstand periods of market stress. NEPC’s head of investment manager research Sarah Samuels emphasized the importance of careful pacing and guardrails. “If this guardrail framework were in place prior to the GFC, I believe a lot of heartburn would have been avoided in private market programs,” Samuels said.
Commonfund OCIO, which focuses exclusively on endowments and foundations, conducts rigorous liquidity assessments for its clients. Anthony Peretore, a senior leader on Commonfund’s OCIO investment team, explained how they stress test their clients’ E&F portfolios to determine if they can handle a specific amount of illiquidity.
Peretore said that typically, “whatever your target is, you can go 50 percent higher.” So, portfolios with a 20 percent target should handily be able to go up to 30 percent, if not a little more.
In a crisis, cash distributions can slow and markdowns of private assets can take place a quarter or more after the declines in public securities — both of which drive up the proportion of a portfolio allocated to private markets. So, a portfolio that was 20 percent allocated to private assets may now be up to 35 percent. Communfund would then test if the client could still handle their liquidity needs.
“We stress test their portfolios to ensure they can not only reach their target but, in some cases, surpass that meaningfully,” he said.
Peretore highlighted that most foundations and endowments enjoy greater flexibility than cashflow-negative pensions. “With normal distributions at roughly 5 percent, E&Fs have plenty of liquidity in their portfolios regardless of their allocation to private investments,” he said.
Still, Commonfund models worst-case scenarios to prepare clients for potential downturns. (During the global financial crisis, many endowments and foundations were overcommitted to illiquid strategies like private equity and were forced to sell assets at depressed prices to meet distributions.)
“It starts with a pretty draconian set of inputs. We look back at the worst moments for public markets and pair that with a stress scenario at the institution,” Peretore said. The analysis is intended to ensure clients can meet spending needs even if private allocations balloon during a downturn.
While a myriad of factors — geopolitical, fiscal, and monetary — could disrupt market conditions, or even trigger another global financial crisis, Mercer’s outlook for private markets remains positive, pointing to improving conditions for distributions as rates stabilize and M&A activity picks up.
“The election is behind us, the economy is doing pretty decent, and we’re still seeing economic growth,” Scopelliti said, adding that while “there are still challenges,” he expects to see “an uptick in liquidity and distributions across private markets.”
