Private assets are appealing for their attractive risk-return properties and diversification potential which is not available to investors limited to public markets. But as demand rises for private assets in the search for alpha, liquidity risk has become a growing concern for investors.
While funds that closely manage volatility risk in their portfolios can generally survive periods of short-term volatility, sustained liquid asset drawdowns are a greater concern and can cause lasting damage to portfolios, according to Michelle Teng, vice president of the Institutional Advisory and Solutions (IAS) group at PGIM – the global investment management business of Prudential Financial.
With funds facing lower inflows at the same time as there was a capital flight to safer asset classes – all the while marking to market their FX hedging positions – funds with large private asset allocations faced difficulty with liquidity management, Teng pointed to the experience of institutional investors in March 2020 during a conversation in a Market Narratives podcast interview.
CIOs need to emphasise liquidity risk measurement in order to manage liquidity during these times, which involves ensuring they have enough liquidity to meet their liquidity demands over more than just the immediate term, Teng said.
“In March 2020, some funds experienced heavy liquidity demands that they were able to meet, however, these heavy liquidity demands continued well into April,” Teng said. “At that point, CIOs started to have liquidity worries. Fortunately…government intervention came to the rescue and liquidity demands quickly tapered off after only a couple of months. But what would have happened if help didn’t arrive for six months or longer?”
Teng said the growth of private capital markets has seen a range of up-and-coming companies stay private longer without going public, making their gains unavailable to investors who don’t invest in private markets.
With general partners (GPs) of private equity funds deciding when they call the capital and make distributions back to limited partners (LPs) who are investors, this creates uncertainty around the timing and amount of cash flows of private equity investments.
Further complicating the matter, when a fund doubles its private equity allocation from, say, 15 to 30 percent, the portfolio’s liquidity risk is not simply doubled. There may be a point where liquidity risk suddenly jumps much higher, Teng said.
“So if liquidity is not managed properly, the CIO may end up in a situation that they are forced to sell illiquid assets with a big haircut to raise cash, or they may have to sell assets that are hard to reacquire later.”
Teng said a fund’s overall liquidity is a consequence of independent decisions being made by different teams, such as the asset allocation group which makes decisions at the portfolio level, and the private equity team which sources deals and makes decisions on a deal-by-deal basis.
It is the CIO’s challenge and responsibility to understand the interaction of these decisions, and how they may affect the portfolio’s overall liquidity risk over time, Teng said, but a lot of CIOs lack tools to measure liquidity risk over the entire investment horizon. Some only forecast liquidity for short periods and lack a total portfolio view on liquidity risk over a multi-year horizon, she said.
Teng said it is not always a problem of having insufficient liquidity. Some funds who were chastened by the GFC may carry too much liquidity, leading to an opportunity cost that drags down performance.
As a result, PGIM IAS has been focused on tracking cash flows from different asset classes over varying investment horizons, with an asset allocation framework that helps CIOs think through the consequences of changing asset allocations between liquid and illiquid assets.
This framework brings together various moving parts to help CIOs evaluate their portfolio’s liquidity and performance under different scenarios in a consistent way, Teng said.
