Five factors to consider before investing in illiquid alternatives

A modest allocation has often been seen by trustees as a diversifier with potential for both growth and liability matching. But are illiquid investments universally appropriate to DB schemes? We have explored five key factors to think about.

For DB schemes planning for buyout, the most important consideration of all is whether illiquids will make a positive contribution to achieving their ultimate goal

Assets provide diversification

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. There are three main sources of diversification:

• Illiquidity premium: ie, the reward or additional return that an investor might expect to earn in exchange for locking up their capital for a long time.

• 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.

• 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.

Illiquidity poses challenges

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 “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 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, 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.

Higher costs in illiquids

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 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.

Overall, charging structures for illiquid assets are expensive when compared with liquid asset classes.

Added governance burden

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 additional governance burden on the trustees or their delegated representatives.

Increased operations complexity

The final factors to consider are operational, such as administration and performance reporting. Capital calls in particular 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. Quarterly or even annual reporting can be 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, 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, the most important consideration of all is whether illiquids will make a positive contribution to achieving their ultimate goal.

Jeremy Spira is a portfolio manager at Charles Stanley Fiduciary Management