The past decade has seen illiquid assets increasingly celebrated as an important diversifier in pension funds looking for alternative sources of growth and income.
While this was an easy argument to make during benign economic conditions, the outbreak of the coronavirus pandemic has seen investors and consultants question the role that illiquids should play in a defined contribution portfolio.
Until the arrival of Covid-19, illiquids were praised for their potential to enhance returns, to offer predictable cashflows and for their characteristics as a lower source of valuation volatility. But some assets within the illiquids classification have behaved differently during the recent market sell off.
As an umbrella term, illiquids cover investments in private equity, venture capital, private credit, hedge strategies and real estate. It is the latter, in particular, that has made headlines in recent weeks for all the wrong reasons.
At the end of March, a sell off of property assets, led to around a dozen real estate funds suspending dealing. While this isn’t necessarily a problem for long-term investors in DC pension funds, it has had a knock on effect on the confidence of valuation of assets within their portfolios.
In a statement at the end of March, Schroder confirmed it was adding a “market uncertainty clause” to valuations in its real estate investment trust, because t wanted to caution on valuations due to ongoing “uncertainty” on how coronavirus may affect asset prices.
Can we trust valuations?
So, should corporate advisers be worried that the value of assets within illiquid allocations may not be as high as previously valued? Not necessarily.
“The last few weeks should make everyone q estion what a ‘price’ means, when it can be 10 per cent different from one day to the next,” explains Trevor Castledine, senior director on the Private Markets team at bfinance.
“Just because there’s a market in something on which a price is quoted, doesn’t mean that the price is right, or th t the price can in fact be achieved, if you even wanted to trade.”
Castledine say illiquid assets do still hold appeal, however, and that advisers should not worry about the price estimate after the initial purchase. Or at least, not until they come to cash it in, that is.
“People saving for 40+ years for their pensions should not be bombarded with daily pricing or tempted into making unfortunate decisions by the myth of daily pricing,” he says.
This point is echoed by numerous industry experts with whom Corporate Adviser spoke for this article. There was broad consensus among interviewees that the biggest risk to the pricing of illiquid assets in a daily-priced environment like a DC plan is not the accuracy of pricing itself, but the lag in that price coming through.
“Pricing for private funds is on a quarterly basis, with a one quarter lag,” explains Hayden Gallary, a managing director at Cambridge Associates’ pension practice. “Funds mark their investments to market based on both public market comparable as well as details on the private company.”
There is also an audit process that helps to ensure a fair valuation of the portfolio, according to Gallary. “This is a significant change in the past 10-15 years, where previously many investments were just held at cost until they are sold.”
There are two primary approaches currently in use for adjusting for this timing mismatch, all of which have their advantages and drawbacks.
The first is to take the latest quarterly value, and update it based on recent cash flows, but this does not allow for interim market movements, which can of significant volatility, such as this.
The second approach is to use some estimate of public market returns to forecast the value of the portfolio, and then adjust this when quarterly data becomes available. While this does consider interim market movements, it can be difficult to correctly identify which sector or market is the best indicator.
Are illiquids still attractive?
Are illiquids still worth exploring? Cambridge Associates’ Hayden Gallary thinks so. “Illiquid investments can be additive as part of a multi-asset structure, both in terms of
increasing potential return, as well as managing risk,” he says.
“This can be seen looking at the broader institutional investment landscape – the best performing institutions over the last 10-20 years have been those that have taken advantage of illiquidity.”
Many fund houses agree. Keen to sell their strategies, there is no shortage of asset managers stressing that illiquid products in private markets offer a broader range of opportunities for DC schemes right now. Among them is BlackRock, the world’s largest fund manager.
Alex Cave, head of unit-linked and platforms, says he believes the “most relevant” illiquid opportunities are in private markets.
“This includes more familiar strategies such as infrastructure equity, but also debt investments in railways, utility providers and data centres, to name a few,” he says.
“Many illiquid private equity and credit investments are also attractive, as they can focus on really interesting companies operating in sectors such as healthcare, media and technology, while also delivering potentially attractive returns.”
But there is also some academic evidence that supports these claims. An October 2019 report from the Defined Contribution Alternatives Association, entitled Why Defined Contribution Plans Need Private Investments, concluded that investing in private equity and venture capital “always increases average portfolio returns” and “reliably increases” return per unit of risk taken.
Understand the difference
Of course, discussing the appeal of ‘illiquids’ as one, individual asset type, is a misnomer. The term is used to cover such a broad range of assets that the risk attributes of each are actually vastly different.
Take real estate, for example. As previously highlighted, it has rarely been out of the headlines of late, thanks to several asset managers gating redemptions. However, DC plans have typically used open ended real estate funds with some success, as they had previously offered lower volatility than real estate investment trusts, with a relatively stable return.
Private Credit strategies, meanwhile, are typically employed to generate higher levels of income within a portfolio but can have a vast spectrum of risk profiles. Direct lending funds can be thought of akin to bank lending to private companies and typically have yield as a priority, but these differ from special situations or distressed funds that aim for equity-like returns and can dabble in higher risk credit scenarios.
Another potential exposure to illiquids is through private equity and venture capital, which invest in privately held companies. But these exposures can range from companies in their infancy to established businesses that have been taken private through a management buyout. As seen from the DCAA research, the return
profile does tend to be higher than equities, but investors must be willing to accept a degree of opacity compared to listed investments. Advisers should also acknowledge that quarterly pricing may affect how quickly volatility comes through a client portfolio during choppy markets, compared to listed assets.
With such a vast arrange of choices, some DC schemes may prefer to opt for owning assets directly, but this throws up its own complications.
“Owning assets directly is possible as long as you have access to the right custody and accounting mechanisms,” explains bfinance’s Castledine. “The question will still arise as to who chooses the assets, executes the transactions and does ongoing monitoring and reporting. The cost of a ‘fund’ style wrapper to hold illiquid assets is fairly minor when taken in context of the other costs involved.”
