Sebastian Reger is a member of the Society of Pension Professionals (SPP)
Illiquid assets are often treated as a homogenous investment class. The reality is different – and assets across investment classes could become illiquid. But do trustees understand the liquidity risk (or illiquidity risk) which can arise in different parts of the portfolio?
Illiquid assets or ‘Illiquids’ feature in the asset allocation of most defined benefit (DB) pension schemes, and typically covers property, hedge funds or private equity funds. The common strategic rationale for investing in ‘Illiquids’ is diversification and a desire to earn an illiquidity premium. Reference to an ‘Illiquids’ bucket can give the impression illiquid assets are a well-defined asset class in their own right.
However, this would be a mistake. Today’s DB investment strategies, with their increased focus on liability and cash-flow matching, can easily spread assets with reduced liquidity throughout the portfolio. Against this background, understanding what drives asset liquidity is important and should form part of a scheme’s investment risk management.
Why does liquidity matter? Whether an asset is liquid or illiquid is generally irrelevant until the asset needs to be sold or used as collateralising a funding or hedging positions. Only then does an asset owner find that an asset either cannot be sold or used, or only at a great cost or loss.
Asset owners therefore need to understand the factors which cause illiquidity. Broadly speaking, illiquidity is driven by legal and commercial factors when looking at intangible assets (such as bonds), given the lack of liquidity in property tends to be easily understood.
Today most pension scheme assets will be intangible assets. These assets – such as bonds, securities and fund interests – are governed by their own distinct legal terms, which vary in detail and complexity depending on the asset, ranging from:
– high liquidity: a simple government issued debt security with straightforward payment terms and no restrictions on transferability;
– conditional liquidity: fixed income securities issued by special purpose vehicles with complex pay-out terms, built-in optionality and some restrictions on transferability;
– restricted liquidity: interests in private funds with very limited transferability rights.
Understanding the actual legal terms of an asset is critical to assessing asset-intrinsic liquidity characteristics. But there are additional legal restrictions, which can have an impact on the commercial factors. Laws can directly or indirectly restrict certain investor classes from investing in particular assets.
For example, the EU Securitisation Regulations 2017 imposed a restriction on DB pension schemes from investing in securitisations unless the relevant transaction complied with certain criteria. The precise impact of these legal factors will be more difficult to ascertain and will be situation specific, but investors need to be aware of forces which can affect demand and supply.
Commercial factors will manifest them- selves while liquidating positions, the price achieved, and the costs associated with any disposal (such as legal fees).
In aggregate the market for debt securities is enormous, but this masks that the market for an individual position can be small and lack liquidity. A corporate issuer with £100m of simple debt in issue may only attract the interest of a small group of national investors.
This means trustees may have to rely on the skill of asset managers to liquidate a portfolio which comprises lesser-known or complex positions in a timely manner and without suffering large bid-offer spreads.
A disposal of fund interests which themselves are backed by debt positions will be similarly influenced by the commercial factors affecting a disposal of the underlying debt positions. These factors can be exaggerated by market conditions at the time of disposal.
Liquidity risk, or better illiquidity risk, is a significant risk for any investment portfolio with substantial holdings in non-government debt and fund interest. Investors have to understand the position across the entire portfolio.