Allocating and managing illiquid assets through time

Portfolio liquidity risk is a key risk for multi-asset investors, and ultimately their clients, that have meaningful allocations to private markets. However, a typical approach to liquidity risk in the industry focuses on managing the shorter-term risk of running out of money to meet the different types of cash flows during an extremely stressed scenario. This aspect of liquidity management is critically important for any portfolio. However, we think there are also significant benefits to better understanding the longer-term more strategic illiquid asset properties and how they interact with broader client objectives.

To address this, we develop a framework to guide our thinking on what amount of illiquid assets clients can reasonably carry in their portfolios to meet their strategic objectives. The framework incorporates key aspects of a multi-asset portfolio, such as asset expected returns and liquidity profiles of different asset classes, combined with liquidity needs of a particular client. By putting these elements together, we can better evaluate how robust different portfolios are in terms of providing the needed liquidity profile to meet client objectives.

A key feature of the framework is detailed modelling of the individual private market (PM) asset classes that Railpen invests in. This is driven by the fact that different types of illiquid assets have several unique aspects that would be challenging to capture with a single ‘private asset’ label. An important part of illiquid asset modelling is incorporating investment uncertainty coming through not only fluctuating returns on capital, but also through uncertainty around how that capital is deployed and distributed over time. This cash flow uncertainty plays a crucial role in driving the overall liquidity profile of a given client’s portfolio.

We implement the framework exploring three different cases covering distinct illustrative clients: a Railpen closed Defined Benefit (DB) scheme, a Railpen open DB scheme and a “Canadian DB pension fund”. An example Canadian DB pension fund is used to illustrate the impact that (generally) net cash flow positivity, stable mandate, and sophisticated implementation can have on an investor’s capacity for illiquidity.

These case studies illustrate that it is critical to recognise the unique circumstances under which a client portfolio operates. An illiquid asset allocation that is suitable for one portfolio, might be completely unfit for another due to a different configuration of strategic client considerations.

For Railpen, factors such as generally net cash flow negative schemes and continuously evolving strategic client requirements imply a strong need for an illiquid asset allocation that has the commensurate level of flexibility to manage illiquidity vis-à-vis these unique constraints. In comparison, for an illustrative “Canadian pension fund” with a long-term investment horizon and little risk of significant strategy change, a key consideration becomes the need for adequate liquidity reserves to robustly manage the overall portfolio over the long-term and organisational capabilities to manage complex illiquid investment programmes.