SPONSORED COMMENT
Many DC schemes are searching for ways to offer their members access to illiquid asset classes, but they face a number of hurdles to get there. So just how much effort is required to bring illiquids into DC, and is the due diligence, effort, time and energy worth it?
Illquids add value, but are beset by challenges
It is clear that DC does need illiquids: they offer an illiquidity and complexity premium, impact, diversification and correlation benefits. When you consider the amount of work that goes into the sourcing, due diligence, and extra checks involved in deploying to private market deals, you realise why these investments are sought after and attractive (and why, in some cases, they can be expensive).
As it stands, DC schemes find it impossible to invest directly in private markets, particularly private equity. Exposure to private markets can only be obtained by investing in cheaper, listed versions that are often correlated with broader equity exposure and may be hiding layered fees.
The fees issue is a huge problem to direct investment. DC schemes are struggling with a fees cap while private equity fees stand at 2+20. A DC master trust has, in some cases, below 10bps to play with. So, as it stands, it would only be possible to consider a modest allocation, which may not be worth the requisite time and resources.
Let’s play to our strengths
What is needed is a joined-up group of stakeholders that are happy to take on the risk of an illiquid asset, that may be locked-up for a period of time, have a “J” curve, higher fees and more complex reporting constraints.
Life company platforms control the majority of UK-based scheme assets, and that won’t change for the foreseeable future. These gatekeepers will need to be comfortable that they have mitigated the risks associated with private market assets. We have already seen a shift in how flexible they can be, and how they can be more pragmatic about incorporating private illiquid assets into a broader portfolio.
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 cashflows and listed liquid assets to facilitate illiquid transactions in DC funds.
Some asset classes are simply not viable
To transition DC schemes from totally liquid to blended portfolios containing illiquid assets, we must have sound understanding of illiquid asset classes. They are all very different and represent different profiles and problems that must be solved, including return and risk targets, correlation to other asset classes, position in the capital structure and liquidity profile.
For example, in the private credit 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 can be traded in a secondary market that provides a degree of short-term liquidity, even though they are categorised as an illiquid asset.
At the other of the asset class, we have private equity and innovative ESG-focused natural capital strategies covering areas such as sustainable oceans, land degradation projects, re-forestation and bio-diversity. Unfortunately, we are some way off DC schemes being able to take a direct position in these “impact” asset classes. As lovely as they sound, they can be expensive, lock up capital for many years, are closed-ended, have a zero-liquidity profile, and have a significant “J” curve, even if they do enjoy high average net returns.
Moving forward through collective effort
Not all schemes have the luxury of sizeable and regular contributions, and high AUM, to be able to generate liquidity. Nevertheless, many smaller schemes have the ambition to make illiquid asset classes available to their members and provide access to the precious illiquidity and diversification benefits the UK DC market desires.
So we do want to find a way for these interesting asset classes to benefit DC members. We believe getting over the difficulties requires a collective effort – a combined effort – based on the understanding that better risk-adjusted returns can be achieved by DC schemes if the will is there.
