Illiquidity: a booster engine, not concrete boots

October 9, 2014 Categories: Investment Strategy

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Travelling across different countries reveals very different institutional attitudes to illiquidity. Some institutions embrace it, considering it the true advantage of long term investors; others seem to consider it akin to donning concrete boots ahead of a swimming lesson.

How should pension trustees consider illiquidity?

As ever, it depends on their current needs and objectives. Many trustees need to generate returns rather than simply “sell equities” on a predetermined de-risking timetable. Also, these returns have to be achieved without increasing the potential losses. The only way to do this is by broadening their sources of returns to better manage downside risks and volatility.

Given the higher expected returns and a wide array of strategies, the potential benefits of both returns and diversification from illiquid assets are clear. However, the “concrete boots” analogy may result from concerns on whether trustees can access these benefits and more particularly whether they will be stuck in investments and unable to change.

Well, how long should trustees’ investment horizons be? For those funds close to insurance buyout, new illiquid investments may not be appropriate. But given that the majority of funds are likely to remain in existence for some time, this is not the answer for most.

If the pension fund will continue for some time, then how much liquidity is actually needed?

Even funds that are closed to new members are likely to be at least 70% of their current value in 10 years time. This suggests there is quite some scope for long-term holdings of assets. As such, I think “concrete boots” is the wrong analogy; illiquid assets can actually be considered as a booster engine. Certainly once lit it’s hard to turn off, but most schemes would find a 10% or 20% increase in “power” a very helpful funding enhancement.

Illiquidity can take on many guises and durations.

It doesn’t have to mean holding an asset for twenty or more years. It also doesn’t have to be based on asset based definitions such as real estate or private equity. It should, however, be considered in terms of its broader return and duration profiles. These profiles fit into 3 broad groups:

  • Liability Surrogates: These offer long term secure cashflows, but offer enhanced returns over gilts due to their illiquidity. These can be suitable for long term pension funds looking for a secure basis for their funding levels, but at a higher return than the gilt market.
  • Credit Opportunities and Direct Lending: Following the financial crisis, the strain on the financial sector has created a broad array of credit and lending opportunities. The underlying illiquidity can range from a few months to several years, but typically is much shorter than traditional private equity. The shorter holding period means that these investments can be particularly attractive for funds with a medium term outlook before they buyout.
  • Return Seeking: Traditional closed-ended Private Equity, Infrastructure & Real Estate funds typically have terms of 10 or more years. However, they offer higher and diversifying returns. A recent paper by Harris, Jenkinson and Kaplan** estimated a premium of c.3% per annum to public equity markets, with skilled investors achieving a c.6% premium. These investments can be suitable for Trustees with long term investment horizons who are looking to boost returns.

The final challenge trustees face is governance.

Clearly these investments are more complex. That said, there is an array of solutions that can help mitigate this difficulty, ranging from advisory support, fund of fund and bespoke programs, to inclusion within fiduciary management programs.

So is it worth it?

The case for long term investors seems quite obvious; who wouldn’t want a boost to their returns? What is then required is the right approach to access the opportunity, considering not only the illiquid portfolio’s governance and investment challenges, but how it fits within the broader portfolio.

In summary, if your fund is approaching insurance buyout with a liquid strategy that takes little risk, then you don’t need to consider illiquid assets. But if not, I would encourage you to see illiquid assets as booster engines to help meet your long term goals and not concrete boots that you are expected to swim with!

** Private Equity Performance: What Do We Know? Harris, Jenkinson and Kaplan

Nick Spencer, Director, Client Portfolio Manager

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