Illiquid investing – is it time to make a decision?
09 Oct 2019
Have you ever thought about how you make a decision? Do you go with your gut/instinct? Do you make a pro and cons list? Or do you simply ask someone else to make the decision for you? I personally, ask a cohort of people and then do what I want to do anyway (often based on a pro and con list – but it works for me!).
And that’s exactly what I’m doing today – discussing the pros and cons for one of the most debated topics of our industry; illiquid investing for DC.
Many DC pension schemes rely heavily on listed equities to drive long-term returns, and ultimately, member outcomes. But with aggregated assets in DC schemes projected to be over £800 billion by 2039¹, it’s no wonder that investors are looking beyond public markets.
The PLSA defines an illiquid investment as ‘any asset which must be bought and held for a long period of time and cannot be sold quickly without losing a significant portion of its value.’ Examples of this would include infrastructure, property or unlisted securities such as private debt or equity. It can also include the much discussed Patient Capital (Patient Capital is defined as Venture Capital and Growth Equity). But we’ll get to that later, first we need to establish why illiquid investments matter (the pros) and second, the restrictions for investing (the cons).
Globally, illiquid assets are not an uncommon form of investment for pension schemes, in fact some Australian superannuation funds and workplace pension schemes in North America allocate approximately 30% of their assets to illiquid strategies. ² Here the UK have lagged, but seeing illiquid assets work in other countries gives me hope.
Inclusion of illiquid investments within schemes could provide additional returns due to the illiquidity premium. Given the long time period before members crystallise their benefits, being able to access the illiquidity premium from assets such as private equity, property or infrastructure is worthwhile. In addition, investing in illiquid investments alongside more traditional asset classes, such as equities and bonds, could increase diversification and provide increased expected risk-adjusted returns.
However, within the UK, many managers find it hard to incorporate such funds into DC investment platforms as they follow strict liquidity and daily dealing requirements (unit pricing must be quoted on a daily basis and serve redemptions and purchases). The common theme to get around these strict requirements is to dilute the illiquid nature of the assets by investing in listed vehicles of these asset classes (listed property, listed infrastructure and listed private equity). Unfortunately, diluting the illiquidity also dilutes the diversification benefit and dilutes the expected return.
The other aspect is cost. These types of investment are high maintenance and specialist in nature which means that they need more intervention than even most actively managed funds. This in turn increases costs to investors and can often mean a layering of costs. This means that its addition to the default can be difficult as it pushes the strategy over the charge cap or the allocation is so small that its value is limited.
So where does this leave us? Do our hopes of a comfortable retirement depend on more traditional asset classes? Or can something be done to provide members with better expected returns?
One solution may be Patient Capital (remember I said we’d come back to this?). A consultation process led by the British Business Bank and Oliver Wyman, looked into the feasibility of DC pension schemes investing in Patient Capital.
The feasibility study aimed to establish a fund vehicle which could overcome the operational challenges we discussed above, however aside from liquidity and charges, there are additional concerns:
- The quality of assets – would fund managers be able to continually source high quality investments?
- There would be a governance challenge as Trustees of DC schemes would need to understand these products, the underlying investments and charging structures. Pension funds have not traditionally allocated AUM to these types of assets.
- Depending on charging structures, how much would DC schemes realistically allocate to Patient Capital?
- The need for seed capital - before DC flows can be accepted these funds would need to be seeded separately unless DC flows are very large.
Illiquid asset class funds typically would not continuously accept cashflows so there would be a decision to be made as to where assets should be allocated in the interim. Would they be allocated to cash or other growth assets, such as passive equities, to not miss out on strong markets?
I know, there’s a lot to think about – and the decision on whether the pros outweigh the cons…I’ll leave to you.
But to conclude, I will say this - it is evident there is a place for private markets within DC, however there are limitations at present. Yet I’m hopeful, the DC pension landscape is ever evolving, and the topic of illiquid investing is far from over.