Illiquidity: Feast or famine?

28 Aug 2019

With the perils of owning illiquid assets documented by the media in recent months, Mark Dunne asks if savers should be worried that pension schemes’ alternative asset allocations are growing.

How the mighty have fallen. In 2014, fund manager Neil Woodford established his own firm after turning every £1,000 of investors’ cash into £23,000 over 26 years at Invesco Perpetual. Pension schemes and retail investors rushed into Woodford Investment Management in the hope that they would benefit from his apparent Midas touch.

But in June this year angry investors, regulators and politicians queued up to criticize him after he was forced to suspend the Woodford Equity Income fund. It once had more than £10bn worth of assets under management but has now slumped to £3.7bn.

The reason why Woodford hit the panic button: Kent County Council wanted its £260m back and he didn’t have the cash to give it to them. He was having problems returning Kent’s money because a whopping 85% of his investors’ capital was tied up in illiquid assets and he was having trouble finding a buyer quickly enough.

Those saving into a pension scheme might be worried by these headlines. Could the same happen to them? Would they struggle to get the money they rely on to fund their twilight years when they needed it?


Since the financial crisis, the yields offered by high-grade debt have been far from attractive. Indeed, 10-year gilts offered 0.7% at the time of writing. With many defined benefit (DB) schemes maturing and focusing on the endgame, equities are playing less and less of a role in their portfolios. Instead, schemes have searched for regular and stable income streams, not growth.

This has led many to turn to assets outside of the equities, bonds and cash mix that traditionally filled pension scheme portfolios. Indeed, €1.6trn (£1.4trn) was invested in alternative, and largely illiquid, assets, such as property, infrastructure, private equity, hedge funds and private debt, by the end of June, according to data provider Preqin. This is a €300bn (£2.6bn) rise in three years.

In Mercer’s latest asset allocation survey, an average of 26% of pension scheme portfolios were allocated to assets other than listed equities and publically-tradable bonds. This is up from just 1% in 2003. Contributing to this increase is local government pool Brunel Pension Partnership. It has some of its £30bn of assets tied up in property, private equity, private debt, infrastructure and secured income.

Local Pensions Partnership, another pool, also has infrastructure interests and the £46bn Border to Coast Pensions Partnership raised more than £1bn from its member funds in July to invest in private equity and infrastructure, its first foray into private markets.

Institutional investors view illiquidity as a risk that they are paid to hold and fits in with their long-term investment horizon, says Mette Hansen, a director at Redington, a consultancy. “They set illiquidity budgets based on their future cash-flow needs, and within this budget they then determine the most suitable illiquidity premia for them to invest in,” she adds.

Hansen warns that those who are actively investing in alternative assets need a strategy and must know what they are buying. “For liquid assets they should ensure their consultants carefully review the actual liquidity and diversification of the underlying instruments,” Hansen says.

With £7bn in assets and £450m a month coming in, if someone tomorrow wants their £300 back, we can square them up.

Stephen O’Neill, NEST


Once the preserve of defined benefit (DB) schemes, their defined contribution (DC) cousins are being encouraged to invest in illiquid assets with the government looking at accommodating performance fees for illiquid assets within the 0.75% charge cap for DC funds. Many have taken up the challenge.

National Employment Savings Trust (NEST), the government-backed workplace pension scheme, is working on getting private credit, European corporate loans, global infrastructure debt, global real estate debt and US mid-market loan funds ready to start investing, it is hoped, by the end of September. Then the search starts for an infrastructure equity manager, which it hopes to start building a portfolio for next summer.

Far from being concerned over the risks that illiquid assets bring to a scheme, Stephen O’Neill, head of private markets at NEST, believes that DC schemes are arriving late to the alternatives party. “Speaking on behalf of the DC industry, we now have the scale and the cash-flows, and the predictability of cash-flows, that make it feasible for us to pick up some of the illiquidity premium that defined benefit schemes have had the privilege of earning for years,” he adds.

The need for stable and regular cash-flows instead of growth has put pension schemes in competition with insurers for assets, which could impact the size of the reward they receive for holding an asset that cannot quickly turned into cash.

Hansen says that yields in certain illiquid asset classes have compressed over the past few years, as more capital is chasing a limited pool of assets. “However, whether the “illiquidity premium” is narrowing is a subtly different question.”

In a bid to find suitable rewards for the risks taken, managers are looking for a “complexity premium”, sourcing deals which some might be unable to do owing to the complexities specific to each asset. They are also looking for value in markets that are underserved.

“Overall, there has been a definite increase in the weight of capital pursuing illiquid assets, particularly real assets,” Hansen says. “This has resulted in narrowing spreads but has also spurred managers to seek new areas in which they can find value.”

Solvency II means that insurers need highgrade, long-term inflation-linked debt, such as infrastructure. They will not touch “assets below a certain credit quality with a barge pole”, O’Neill says. So there is less competition for lower grade, otherwise known as riskier, assets.

O’Neill also says that in the direct lending market yields are not under pressure due to borrowers being incentivised to agree deals with a particular lender for reasons other than cost. “They want to have a one-to-one relationship to keep it off-market, to maintain a relationship with a trusted and flexible lender.

“There are all sorts of areas where you can pick up a premium despite the headlines that there is this firehose of money that is dampening returns,” he adds.

Illiquidity is not the only risk. NEST is moving into private lending, which is a market that has seen more and more loans agreed with fewer protections for the lender thanks to growing competition. These types of agreements are more popularly known as covenant light.

O’Neill says that some investors are doom laden about the “cov-lite” issue whereas others believe it is irrelevant. “The truth is somewhere in between in that it depends on the circumstances of the loan, the lender and the borrower.”

He adds that it is more of an issue in the broadly syndicated loans market, where an intermediary will put together the covenant document and then farm it out to dozens or even hundreds of investors. “The true credit worthiness of the loan is the true credit worthiness of the loan, not if it is cov-lite, cov-heavy or anywhere in between. We expect our fund managers to make sure that whatever the documentation says they are going to get their money plus interest back. That’s what the crucial metric is.”

Other risks are to be found in infrastructure where politics and regulation can affect investment returns. There are certain government subsidies that can help drive the returns on renewable assets, but this can change with a new government policy or a review of energy prices. “We have to make sure that we and our fund managers are alive to those and don’t get carried away with what the price and product is on day one, but what might happen to it in a different regulatory or government regime,” O’Neill says.

Hansen says that despite the risks investors are carrying for holding these types of assets, there are benefits aside from generating a return. “These assets provide diversification to investors’ portfolios and are often the principal reason why investors are content to take illiquidity risk in order to access them,” she adds.

If liquidity dries up in the illiquid part of the portfolio, not to be oxymoronic about it but, there is plenty of liquidity elsewhere.

Stephen O’Neill, NEST

Illiquid assets may have a role to play in meeting a scheme’s obligations, but they may harm its chances of de-risking its liabilities through buyouts. “This is a real issue in relation to scheme buyouts, as in most cases illiquid assets are not attractive for insurers and will have to be disposed of by the scheme before executing the deal,” Hansen says. “This is the case even for illiquid assets that would nominally be seen as “insurer friendly”, such as infrastructure, as in most cases insurers prefer to source their own optimised assets that fit in perfectly with their existing portfolio, rather than taking on some non-optimised asset from a scheme.

“We have seen cases where schemes have had to conduct fire sales of illiquid assets at the last minute to get a transaction across the line, and/or they have had to consider complex fundings involving the employer to make it work,” she adds.


O’Neill is not concerned about taking on illiquid assets and does not believe that he will be the subject of the same headlines that Woodford has found himself in during recent months. “Some people will be nervous because of headlines or spurious hairraising reports, but the reality is the difference between a retail fund and a massive institutional pension scheme are worlds apart in terms of their liquidity profile.” He adds that this is due to NEST being protected by the liquidity in its wider portfolio. The default fund houses 97% of the scheme’s assets and is owned by 99% of members. “If liquidity dries up in the illiquid part of the portfolio, not to be oxymoronic about it but, there is plenty of liquidity elsewhere.”

NEST has about £450m of cash coming in each month and positive cash-flow projections for the next 30 to 40 years. “The liquidity challenge for us is making sure that we can put the money to work in new assets and new projects in the illiquidity space,” O’Neill says. “It is not that if people want to extract their money they are not going to be able to get it. We have about £7bn worth of assets. The average retiree at NEST has a £300 pot. With £7bn in assets and £450m a month coming in, if someone tomorrow wants their £300 back, we can square them up.”

O’Neill appears to be secure in his plans to build a portfolio of assets that are not easily turned into cash. Such assets are needed for the benefits they provide pension schemes and insurers.

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