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Impact Investing

IPE special report May 2018

Sections

Illiquid approaches

Some of the world’s largest institutional investors have had great success in illiquid investments such as private equity, infrastructure and lending. Charlotte Moore explores how smaller investors can enjoy the fruits of such exposure  

At a glance

• The long-term investment horizons of pension schemes make them ideally suited to harvest the illiquidity premium of certain alternative assets.
• Most pension funds opt to invest in specific illiquid funds rather than directly to achieve diversification.
• Allocations illiquid alternatives are usually highly bespoke with a similar approach to the fund of hedge fund model.
• Some managers are developing pooled funds aimed at smaller institutional investors.

A closer focus on risk and diversification has encouraged many pension funds to diversify away from traditional bond and equity investments and into alternatives. While liquid alternatives, such as some hedge fund strategies, may offer a good source of returns with lower levels of correlation to other assets, many recognise the benefits of illiquidity in terms of exploiting the risk premium that longer-horizon investors can exploit and also the fact that many investment opportunities currently lie in illiquid areas. 

“Pension schemes have a competitive advantage compared to other market participants, such as banks. They do not have to sell their assets any time soon so can harvest the illiquidity premium,” says Iain Brown, EY’s European pensions advisory leader. But investing in illiquid alternatives is far from straightforward and these assets span a diverse universe: the principal categories are private equity, infrastructure, real estate and private debt. Shipping, forestry, fishing and farming investments are others.

Most investors prefer to invest across a broad range of illiquid assets to ensure diversified exposure. For larger investors, it may be possible to take advantage of co-investor opportunities or have customised accounts. However, to achieve this level of diversity, direct investment is not usually the best option. 

“If, for example, a pension scheme with assets of €500m invests only 10% in illiquid alternatives, then direct investment becomes almost impossible,” says Brown. The huge scale of individual investments, such as infrastructure projects, would swallow all of this investment so the fund would not be able to diversify across multiple illiquid asset classes. To achieve the right level of diversification both within the asset class and across the illiquid alternatives universe, it is necessary for most pension funds to choose a fund rather than the direct route. 

Choosing and managing fund selection can also be also outsourced. “Pension schemes have governance constraints which impose a limit on the number of managers they can directly manage,” notes Bill Muysken, global chief investment officer for alternatives at Mercer, which is one such provider. In effect, this creates multi-asset illiquid alternative portfolios. But unlike diversified growth funds where one manager invests in a range of different assets, the investor or adviser selects the best managers for each asset class.

Ian Brown

As the complexity of the task means the management of the managers also needs to be outsourced, a multi-asset illiquid alternatives can be compared to the fund of hedge fund model. Investing across multiple illiquid alternatives is usually a highly bespoke process with a customised mix of illiquid assets. There is no standard mix of assets, says Muysken.

Each investor’s preferences and aversions are taken into account to ascertain the optimum allocation. “If the client already has an existing exposure to an illiquid asset class, such as real estate, this is taken into account,” Muysken adds.

Joe McDonnell, EMEA head of Morgan Stanley Alternative Investment Partners’ solutions group, adds: “We will try to determine whether clients’ legacy positions are still desired and should be built out further or whether it’s something that should be reviewed and diluted on a forward looking basis.”

But illiquid assets should not be viewed in isolation and should also be considered in the context of the overall asset allocation. “We construct an alternatives portfolio which will take all of these factors into account,” notes McDonnell.

An allocation to illiquid alternatives can only provide true diversification benefits if a sizeable proportion of the total portfolio is invested. Mercer asks investors to think carefully about how much liquidity they really need and a typical allocation to illiquid assets is in the 5–30% range.

Once this has been determined, this overall allocation is divided between different assets. Specific tilts can be included, for instance towards inflation generating assets such as infrastructure or real estate. “One of the key considerations is how much inflation protection the scheme requires,” says Muysken. “But if the scheme wants to focus more on return enhancement, then that tilts it more towards private equity.” Accordingly, if the focus is on greater diversification away from equity markets then the tilt will be towards private debt.

Joe McDonnell

Risk appetites also have to be considered: private equity is higher risk and higher return while private debt is lower risk and lower return, as Muysken points out, while infrastructure and real estate lie in between.

Determining the right asset allocation to each illiquid asset class is not the end of the process – it can take several years to build the right portfolio and achieve full diversification. McDonnell says: “While clients who have been with us for many years have a mature, well-diversified portfolio, it can take time for a new client to achieve this goal across illiquid strategies.”

While it makes sense to determine an asset allocation strategy, this should be more of an approximate plan than a rigid guide. The fluid and unpredictable nature of the illiquid market means it is impossible to predict when the best opportunity will arise. In addition, each asset class will be at a different point of its market cycle. “Rather than focus on the precise allocation of each asset class, we instead look at which are the best opportunities currently available,” says McDonnell.

While almost all alternative illiquid strategies are invested in highly personalised and bespoke manner, some fund managers are considering how to make this asset class more accessible.

A pooled fund investing across a range of different illiquid alternatives this would make it much easier to access these assets and could be thought of as an illiquid version of a diversified growth fund. “The bespoke approach makes it hard for smaller schemes to access this asset class as they lack the size, sophistication and governance,” says Andrew Stephens, head of intermediated institutional clients at BlackRock. “Such an approach would not have the same manager diversification as the bespoke approach but it would at least allow schemes to access an asset class which would otherwise be unavailable to them.”

Andrew Stephens

However, there are challenges with building a pooled fund with illiquid assets – the liquidity of the fund needs to be set to a similar level to that of the underlying assets. A mismatch between the liquidity terms of pooled commercial real estate funds and those of underlying assets created significant problems in the aftermath of the financial crisis, so any pooled would have to have a minimum investment period. 

“The fundamental reason for choosing these assets is that investors want to make the most of the illiquidity premium,” says Stephens. “We would not have an investment period of less than three years and it might be longer.” Even though the maturity of most of those assets will be longer than three years, the income thrown off may enable the fund manager to offer investors periodic windows of liquidity.

In addition, greater flexibility could be achieved by using assets with different maturities. “For example, direct lending can mature after only two to four years.” However, this should never be considered a ‘liquid’ portfolio, Stephens warns.

While there is probably no substitute for a well-governed illiquid asset strategy managed internally by a pension fund with sufficient scale and expertise, intermediated solutions like these can offer smaller investors a useful means to gain exposure to asset classes hitherto inaccessible to them. 

But investors must be prepared to explore and understand the significant downsides before they commit.

 

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