DC schemes are desperate to find a way to offer members access to illiquid asset classes, but they face a number of hurdles along the way. So just how much effort is required to bring illiquids into DC, and is the due diligence, effort, time and energy worth it?
It is clear that DC does need illiquids, and for all the right reasons; illiquidity and complexity premium, impact, diversification and correlation benefits. When you consider the amount of work that goes into the sourcing, the due diligence, and extra checks involved in deploying to these deals, you realise why these markets are sought after and attractive, and why in some cases can be expensive too.
But as it stands its nigh on impossible to think of how we might invest directly in some of these asset classes, particularly in equity, and not fudge the issue with a cheaper listed version that is a pale synthetic imitation, and too correlated with equities as a whole. A further complexity is the fact that the legal structure adopted – NURS or Investment Trust – may be hiding layered fees from the underlying investments.
The fees issue is a huge problem. Clients are struggling with an investment budget that is at the opposite end of the spectrum when compared to a private equity fund costing 2+20, where the master trust has in some cases, somewhere below 10 bps to play with. So as it stands, its only really possible to consider a modest allocation, which to be fair, may not be worth it.
New legal structures have been touted as the panacea, and in the case of the LTAF for example, may help the platform overcome permitted links rules, but there is no silver bullet here. We still need a joined up group of stakeholders that are happy to understand and take on the risk of an illiquid asset, that may be locked-up for a period of time, may have a deployment phase – meaning there could be a “J” curve to contend with – performance fees, monthly or quarterly valuations, and higher fees overall.
And the fetish for liquidity is still at the very forefront of the issue. You can’t create liquidity easily from an illiquid asset, so let’s not try. It’s about what can you do with the rest of the assets within a blend to ensure we can trade happily, and daily, for people as they retire, or move on.
Life company platforms still control the majority of UK-based scheme assets, and that won’t change for the foreseeable future. These gatekeepers will still need to be comfortable that they have mitigated the risks associated with these asset classes. However, we have seen a shift in how flexible they can be, and how they can be more pragmatic about the existence of a private illiquid asset in a broader portfolio mainly of listed equity and debt.
This represents an excellent start, so let’s not look for daily liquidity from an illiquid asset. Let’s play to our strengths and use cash-flows and listed liquid assets to provide for the daily activities and transactions on the fund.
Having discussed a way forward and how we might be able to make this work, we must consider the asset classes themselves, as they are all very different and represent very different profiles and problems when trying to solve this conundrum. So from debt to equity let’s look at return and risk targets, correlation to other asset classes, position in the capital structure and liquidity profile.
For example in the private credit asset space, whether the loan is senior, mezzanine or subordinated dictates the fee, risk, and liquidity profile. At the top of the structure are senior loans, and these have a secondary market that provides a degree of short term liquidity, even though categorised as an illiquid asset.
At the extreme of the asset class spectrum we have private equity and interesting ESG-focused natural capital strategies covering areas such as sustainable oceans, land degradation projects, re-forestation, and bio-diversity. They all tick the boxes for UK DC schemes that want to jump on the “impact” bandwagon, but unfortunately are broadly inaccessible. They can be expensive, locked-up for many years, closed-ended, a zero liquidity profile, have a significant “J” curve and a significant risk profile, but they do have high averaged net returns (IRR).
As lovely as they sound, we are some way off DC schemes being able to take a direct position in these asset classes.
And not all schemes have the luxury of huge regular contribution flows, high AUM, and can deal with the “J” curve and liquidity in the round, but many smaller schemes do have the ambition and desire to make these asset classes available for their members.
But, we do want to find a way for these interesting asset classes to benefit our DC members. We fully appreciate the pitfalls, and complexity of their inclusion, and need a collective effort, focusing more on the net risk adjusted returns profile and what that can do to future outcomes.
As it stands there are currently less than a handful of solutions available for DC schemes that can work on these fund platforms, and have sufficient liquidity and daily transaction capability. These are mainly at the credit end of the spectrum, so that the fees are manageable, but do bring access to the precious illiquidity and diversification benefits the UK DC market desires.
