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FRM Part II · FRM Exam Part II · Private Markets Investing

During a sharp market downturn, an LP with a large private equity allocation finds that public asset values have fallen, so its private equity share exceeds policy limits (the denominator effect), while capital calls keep arriving and distributions slow. Which risk management response best addresses the resulting liquidity squeeze?

The best response is to stress test cash flows with higher calls and lower distributions, then hold a liquidity buffer or credit facility sized to the stressed net outflow. Calls and distributions are correlated with markets, so ignoring this or adding commitments would worsen the squeeze.

  1. AStress test cash flows assuming higher calls and lower distributions, and hold a liquidity buffer or credit line sized to the stressed net outflowCorrect
  2. BAssume calls and distributions are uncorrelated with public market returns, so no adjustment is needed
  3. CIncrease new commitments to restore the target allocation immediately
  4. DValue the private holdings at cost to remove the denominator effect

Explanation

In stress, calls tend to persist while distributions fall, so net outflows rise just as liquid assets lose value. Stress testing and a sized buffer address this directly. Assuming independence ignores the observed correlation, new commitments add to future calls, and valuing at cost hides the problem rather than managing cash.

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