Illiquid assets have played a small but significant role in defined benefit (DB) pension scheme investment for many decades. A modest allocation to property or infrastructure funds has often been seen by trustees as a diversifier with potential both for growth and liability matching, while an allocation to private equity has provided leveraged exposure to firms not represented on listed equity indices.
But are illiquid investments universally appropriate to DB schemes? We’ve explored five key factors to think about here. The most important question to address is whether illiquids are right for your scheme’s long-term goals and governance structure.
Private equity, private debt, direct real estate, and infrastructure are often collectively called illiquid alternatives, as investing in these assets involves a long-term commitment and they exhibit characteristics that differ from “mainstream” assets. Their unique attributes provide diversification for pension scheme portfolios that are typically dominated by liquid assets such as listed (or public) equities and bonds. There are three main sources of diversification:
- Illiquidity premium: i.e., the reward or additional return that an investor might expect to earn in exchange for locking up their capital for a long time. The size (or even the existence) of illiquidity premia vary, depending on how you measure them and the investment strategy involved. Estimates of the value of the illiquidity premium range from zero to around 3% per annum as a rough benchmark.
- Access to different sectors and markets: the range of sectors represented on public market indices such as the FTSE 100 is quite limited. Investing in illiquid private markets can give access to lucrative sectors such as new software applications and biotechnology that are not well represented in public markets and enables investors to benefit from the performance that they offer.
- Liability matching: certain illiquid assets, such as infrastructure, can provide a stable cash flow that matches the profile of pension fund liabilities. They can also act as a good inflation hedge, helping schemes to match real as well as nominal cash flows. Other forms of illiquid assets, such as high lease-to-value real estate, are also sometimes used for liability matching.
Asset classes such as equities are described as liquid because they trade and are priced on a daily (or in the case of some funds, weekly). In contrast, trustees need to commit to investing in illiquid assets over a long time period, both to achieve returns and because of the way that illiquid funds operate.
Illiquid assets typically operate on a basis where capital commitments are “called” over time, and capital is subsequently returned to investors (in the case of a maturing fund) or generates dividends (in the case of so-called “evergreen” funds). Pension schemes need to designate assets to meet capital calls and reinvest the capital that is distributed. This creates a return mismatch in the capital call phase and poses reinvestment questions when distributions arise.
Once money is committed to these structures, it is very difficult to exit (or sell a scheme’s commitment) without incurring a severe discount on the amount committed. This is an important consideration for pension funds preparing for buyout, as few if any, insurers will accept illiquid investments as part of a transaction. Chances to buy out can appear quickly as markets change and having a large allocation to illiquids can prevent schemes from seizing these opportunities.
Barnett Waddingham’s End Gauge Index for May 2022 showed that on average DB schemes targeting buyout now expect to take just 8.3 years to reach that goal, so the time frames associated with many illiquid assets may no longer be appropriate for their portfolios.
The way that returns and charges operate in illiquid investments are very different from liquid asset classes such as equities. The most common structure is a General Partner/ Limited Partner (GPLP) model. The general partner manages the fund and has an open interest in the assets. Investors such as pension funds are called limited partners because their exposure is restricted to the amount they have decided to invest.
The returns from illiquid funds reflect the amount of risk each type of partner takes. As such, general partners will harness a greater share of returns than limited partners. Some funds will also include a performance ‘hurdle’ rate, with limited partners only receiving returns on performance above the hurdle. Other “internal” fees, such as director remuneration, will also accrue to the general partner.
Overall, charging structures for illiquid assets are expensive when compared to liquid asset classes.
In terms of returns, illiquid fund structures are priced on a net asset value (NAV) basis. This may often diverge from the saleable value of assets in the fund, and the true return from such investments only emerges once the fund has returned all capital to investors.
As we’ve seen above, the fund management practices, investment process, costs and return structures, and exit procedures associated with illiquid investments can all be extremely complex. Trustees and their investment consultants will need to properly research appropriate funds and make sure they have sized their illiquid allocation appropriately relative to the rest of the portfolio. The contractual details will almost certainly require legal input. Managing these factors creates an additional governance burden on the trustees or their delegated representatives.
Often asset managers require a sizeable minimum allocation to gain access to a fund, which can be prohibitive for smaller pension schemes in particular.
The final factors to consider are operational, such as administration and performance reporting. Capital calls in particular (as alluded to above) can be administratively complex.
From a performance reporting perspective, it is difficult to get a clear picture of the return from illiquid assets at a specific point in time. As a result, quarterly or even annual reporting can be difficult to interpret and of limited value when assessing the contribution of these assets to a pension scheme’s overall objectives.
Illiquids offer potential diversification advantages for pension schemes. However, they are expensive and complex to manage and tie up sizeable chunks of a scheme’s assets. And the promised illiquidity premium or the benefits of leverage (which have boosted private equity returns in the past) may not materialise in the future. For DB schemes planning for buyout, perhaps the most important consideration of all is whether illiquids will make a positive contribution to achieving their ultimate goal.
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