Twenty-five years of allocation decisions traded exits for yield. A new Davidson Kempner white paper asks what that bargain costs when markets turn. DK Research writes that "liquidity has proven to be increasingly scarce, valuable, and, in some cases, illusory," and sets out to quantify it.
The Drift Into Illiquidity
Alternatives grew from roughly $1 trillion in 2000 to $24 trillion, surpassing 10% of the investable universe. Private strategies grew nearly twice as fast as hedge funds, so "a growing share of their capital has become less liquid." Even hedge funds drifted: DK estimates "only 52% of hedge fund assets can now be fully redeemed within a year," down from 70% in 2000. The cause was leverage. Multi-strategy gross leverage doubled to 12x after 2020, and DK warns that "the increased use of leverage signals heightened risk from crowded positioning." A 5% drawdown on 10x gross assets translated to a 50% loss at the fund level. By mid-2026, 88% of alternatives sat in illiquid or semi-liquid strategies, up from 74%.
The Distributions Drought
PE distributions averaged 12% of NAV after 2022 versus 20% since 1990, "the lowest historic levels for the asset class absent a recession." DK projects that NAV held seven years or more will grow 74% by 2030, and PE returned just 2.9% over T-bills across three years versus a 9.7% historical average. Semi-liquid BDCs expanded from roughly $10 billion to over $300 billion, yet the research DK cites finds they offered "far less liquidity than advertised," which is why DK labels anything unsellable within three years illiquid. Software made up 34% of PE deals against 8% of public equity, and with cheaper AI coding tools arriving, DK observes that "AI losers are concentrated in private market portfolios" already strained by higher rates.
A Tab Nobody Budgeted For
DK models a foundation spending 5.2% of NAV. In the ZIRP era it ran a 0.8% surplus. Over the prior three years it faced a 2.2% gap, because "absolute return is picking up the tab for PE." In the Fed's 2026 stress scenario, equities fell 58%, cash needs peaked at 16% of NAV against 3% of inflows, and "the portfolio must sell assets to close the gap." Uncalled commitments lifted PE exposure from 29.6% to 35.2%.
The Crisis Quarters
DK frames it simply: "the cost of illiquidity is concentrated in a handful of crisis quarters." Four portfolios, each 54% public and 46% alternatives, were measured from the trough. Portfolio B, holding 15% liquid hedge funds, beat the limited-liquidity portfolio by 12% and the direct lending portfolio by 19%. Portfolio A, with 25% liquid hedge funds and 10 fewer points of PE, gained 24%, with liquidity supplying 17 of those points.
That result needed context, since hedge funds won over the full crisis period. DK's answer is "buy low, sell high." Liquid portfolios redeemed hedge funds and rebalanced into equities at the bottom, holding their 41% target and "playing offense," while the others sold equities and drifted up to 13 points underweight. To be clear, the model was hypothetical, and DK manages hedge funds.
Bonds Are Not Enough
Only partly. The stock-bond correlation turned positive in 2022 and reached +0.68 in December 2024, and DK suggests the 2001 to 2022 negative era may prove "the exception rather than the rule." Bonds still cushioned growth shocks, but not inflation shocks like 2022, and sovereign debt stood far heavier than before the GFC. DK argues that "hedge funds can serve as a superior alternative to fixed income": since 2000, credit hedge funds earned 260 basis points more at equal volatility, or 170 after bias adjustments.
BDCs fared worse. DK finds that "despite alpha-like fees, BDCs deliver credit beta-like returns," as a 3.4x levered public proxy matched the index at 9.4% versus 9.3% with 74% correlation. The hedge fund index kept a 2.2% edge over its best replica.
The Reallocation Ahead
DK concedes that longer lockups served purposes, but "there is a specific and vital role for absolute return strategies with liquidity." It expects institutions to "gradually increase their allocations to hedge funds in place of PE and direct lending."
Five Key Takeaways
- Judge liquidity by exit terms, not marketing labels.
- Model funding needs, calls, and distributions together.
- Track uncalled PE commitments, which swell as portfolios shrink.
- Check hedge fund leverage: large multi-managers ran near 10x versus under 3x for traditional funds.
- Do not assume bonds diversify; pair them with liquid absolute return.
Footnote:
1 Davidson Kempner Capital Management. When the Tide Turns: Absolute Return's Liquidity Advantage. Nov. 2026, saprdeus90c0a106.b-cdn.net/2c2afb15-02b6-4e91-81c0-e45ebdc9b6c3/WhentheTideTurnsWhitePaper_Final1.pdf.
