CONTRIBUTORS
Christoph Butz
Institutional Client Director
As auto-enrolled workplace pension schemes get to grips with investing in private markets, they need to understand how liquidity can be managed in assets such as private credit and infrastructure.
These are very different investments to the passive equity funds which make up the bulk of these pension schemes portfolios. Pricing is less frequent and it is difficult to liquidate positions quickly. Target returns are dependent on assets being held to maturity.
But these characteristics should not deter DC pension schemes as they have a variety of different ways that they can manage liquidity.
Liquidity levers
Large master trusts with significant monthly contribution levels can use these to offset redemptions. For example, Nest receives around £500m a month in contributions while People’s Pension receives over £300m.
Master trusts can also create internal markets within individual asset classes. Transferring assets from members entering retirement to those who are just starting out on their pension wealth creation journey. This avoids an unnecessary capital realisation and reinvestment.
Pension schemes can also move liquidity from other asset classes to meet private market redemptions.
Fund manager tools
Just as schemes have a number of internal liquidity levers they can use, so too can a fund manager ensure redemptions have the least impact on the overall investment. Like a pension scheme, a fund can offset subscriptions and redemptions to ensure the illiquidity of these investments does not create problems.
Hierarchy of fund liquidity tools
Source: Franklin Templeton. For illustrative purposes only.
The next option is to create a 'liquidity sleeve'. This could be a portion of the portfolio allocated to publicly traded versions of the same underlying asset class as the fund. For example, an infrastructure fund could have a portion invested in publicly-listed infrastructure securities.
Public asset liquidity tools
Source: Franklin Templeton. For illustrative purposes only.
While this approach does allow a fund to quickly divest, it does bring in investment risks not associated with private assets such as equity risk.
An alternative is to invest part of the portfolio in US treasuries instead to minimise these risks, despite the reduced return. This is often preferred as US sovereign debt holds its value better in times of market turmoil – when redemptions tend to occur.
A fund will typically allocate less than 10% to this liquidity sleeve as the fund typically only allows 5% of the fund to be redeemed each quarter.
There are, however, a further two lines of liquidity defence which can be used before a fund has to gate redemptions.
Managers can use asset repayments to match fund redemptions. This involves aligning these capital flows with payments. That can be achieved if the portfolio is diversified and seasoned. Then there should be a natural ebb and flow of assets reaching maturity and releasing capital which can be used to meet redemptions and fund new investments.
A further line of defence is for the fund to use credit to fund the redemptions. An overdraft facility is agreed and used to pay redemption requests. This is refunded through future subscriptions, capital released from asset repayments or publicly traded assets. But the associated costs of this facility will detract from the investment return.
Mopping up liquidity concerns
While there are good reasons for auto-enrolled workplace schemes to take their time getting to grips with the illiquid nature of private assets, there are extensive tools for managing these risks both within the scheme and the individual fund.
The pressure on workplace schemes to divest illiquid assets during extreme market conditions will not come from scheme members. The allocations will be made within the overall default portfolio. Very few members are proactive in switching in times of market volatility.
With less pressure on them to produce instant liquidity in the way, for example, defined benefit schemes did during the LDI crisis, these tools should be sufficient to withstand market turbulence.
WHAT ARE THE RISKS?
All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested.