An alternatives allocation framework with a liquidity budget and a due-diligence checklist

What you will learn

• How a liquidity budget sets the maximum illiquid share.
• How to stress-test that share for a market fall plus capital calls (the denominator effect).
• How to pace commitments without overcommitting.
• A due-diligence checklist that pulls the course together.

Explanation

An allocation framework is a written set of rules that decides, before any product is in front of you, how much of your portfolio may be illiquid, in which categories, and when you add or stop. Without it, alternatives are bought one sales pitch at a time. It has four parts.

1. The liquidity budget

Start from needs, not products. List every cash need over the next three to five years: living costs not met by income, planned purchases, taxes, an emergency reserve, and uncalled commitments (money promised to private funds but not yet called). Then list what can pay: cash and short bonds within days, listed assets within a week at an uncertain price, illiquid funds never on demand. The rule: liquid assets after a severe market fall must still cover all needs with a margin. What is left is the maximum that may be illiquid.

2. The stress test and the denominator effect

When public markets fall 40%, slowly valued illiquid funds may still show the old value, so their share of the portfolio jumps (the denominator effect: the denominator shrank, the numerator did not). You cannot rebalance by selling the illiquid part, and capital calls continue; this forced institutions to sell liquid assets at the bottom in 2008–2009. Test your target under a combined scenario: public assets down 30–40%, illiquid NAV down 10–20% with a delay, all uncalled commitments called within a year, no distributions.

3. Commitment pacing

Closed-end private funds call capital over three to five years and return it later, so invested NAV peaks at roughly 50–70% of the commitment. To hold a steady target NAV you must commit more than the target, every year: annual commitment ≈ target NAV ÷ (peak NAV ratio × vintage years in the cycle), reviewed yearly. Committing everything at once concentrates in one market cycle.

4. Category limits

Diversify across categories, managers and vintage years. A practical rule: no single fund above one third of the alternatives bucket, no category above half, and collectibles only with money whose total loss would not change your plans.

Rules of thumb for the illiquid share

These are planning guides; your own liquidity test decides.

Worked example

Hypothetical example: a €600,000 portfolio. The owner needs €24,000 per year from it for three years (€72,000) and has €60,000 in uncalled commitments. Target illiquid share: 25%. Taxes and fees are excluded.

1. Split: illiquid €150,000, liquid €450,000. Stress: public assets fall 40%: €450,000 × 0.6 = €270,000.
2. Needs: €72,000 + €60,000 capital calls = €132,000.
3. Coverage: €132,000 ÷ €270,000 ≈ 49% of stressed liquid assets. Covered with a margin; the 25% target passes.
4. Denominator effect: illiquid NAV is marked down only 10% to €135,000. Illiquid share = €135,000 ÷ (€135,000 + €270,000) ≈ 33%, up from 25% with no new investment. If the cap is 35%, no new commitments until the share falls back.
5. Pacing: to maintain €150,000 of private-fund NAV with a 60% peak ratio over a three-year cycle, commit about €150,000 ÷ (0.6 × 3) ≈ €83,000 per year during build-up, then recalculate yearly.

Common mistake

Practice activity

A €300,000 portfolio has €60,000 in illiquid funds, €240,000 in listed assets, €30,000 uncalled commitments and a required spending reserve of €40,000. Stress: public assets down 35%, illiquid NAV unchanged. (a) Stressed liquid assets? (b) Coverage ratio? (c) Illiquid share after stress? (d) Should the owner make a new €30,000 commitment if the cap is 25%?

Due-diligence checklist

Before any alternative investment, write down:

1. Role: Which return source does this add? Could a liquid ETF deliver most of it?
2. Liquidity: Lock-up, redemption frequency, gate, notice period, suspension and side-pocket rules, secondary-market discount.
3. Costs: All layers, annualised performance fees, fund expenses, entry mark-ups; KID total cost over the holding period.
4. Track record: IRR with and without credit line, MOIC, DPI, PME, same team, key person clause.
5. Valuation: Who values, how often, how independently.
6. Structure: Legal form, regulator, depositary, title separation, what happens if the platform or manager fails.
7. Fit: Passes the stress test and category limits; taxes checked with a Steuerberater.

Key takeaways

• Set the illiquid share from a liquidity budget and a stress test, not a brochure.
• The denominator effect raises the illiquid share in a crash; cap it and stop committing when the cap is hit.
• Pace commitments across vintage years; uncalled commitments are a liability.
• Run the checklist every time; if an answer is missing, the answer is no.

Next step

This completes the course; to manage risk and generate income in liquid markets with defined structures, continue with "Options Strategies in Practice: Spreads, Income and Position Management".