May 21, 2024 | Quiet Counsel | 4 min read

Avoiding the Illiquidity Trap

We’ve written and spoken several times in recent years about the pros and cons of including private assets in portfolios (here and here and here), as we launched two infrastructure funds and a diversified private assets fund, for clients. As with all we do, we have strived for balance in our positioning of these investments – as we created these funds as a solution to some clients’ investment challenges, not as a product to sell to all clients.

Mike Wallberg wrote the following OpEd – which appeared in the Globe and Mail on May 2, 2024 – with the goal of focusing specifically on the risk that illiquidity poses when investing in private assets, something we are concerned is not well understood by all investors. We have republished it here with permission.

In investing, you can have too much of a good thing. Take private assets. Investment in real estate, infrastructure, venture capital, private equity and credit has worked well for investors with long-time horizons and limited liquidity needs for many years. But my colleagues and I are seeing a worrying industry trend: individual investors carrying alarming levels of private assets in their portfolios – 50 per cent or more in some cases – potentially without understanding the true nature of the illiquidity risk they’ve assumed.


Private matters

There is a lot to like about private assets: they theoretically offer a premium over public securities and because the assets are not valued every day the returns also appear less volatile. This appeals to institutions such as Ontario Teachers, BCI, CPPIB, and the Caisse who want to hit fund solvency ratios and match long-term liabilities against long-term cash flows. Armed with an actuarial map of the next 30 years, they can confidently allocate large percentages of their plans (many of them above 50 per cent) into illiquid assets because they know the balance of the portfolio can fund what’s needed in the near term.

Compare that profile with a typical private client like “Marcus,” a retired 65-year-old with $2-million in investable assets who spends $80,000 per year (4 per cent). He’s comfortable enough but if there is a health issue or an urgent funding need for a family member, he may not be able to access enough of his capital quickly.

Marcus is not a pension plan, and so liquidity matters to him. Any wealth he has invested in private assets may be subject to delays in accessing it; depending on the small print it could be one month, three months, or six months – but if the fund restricts redemptions, he could be locked out for years.

This column is for the Marcuses out there who underestimate the risk of being tied up in high allocations to private assets. In our view, Marcus and his adviser should carefully consider if any illiquid investments are suitable for his portfolio. While he may pick up a slightly better yield, a large allocation to this asset class is probably not suitable for him.


Stuck in the holdings with you

One of the compounding risks for individuals investing in private assets can be a correlation of their personal risk with the market risk. Imagine if Marcus was a restaurateur or the CFO of a small fintech company. Restaurant reservations and tech financings tend to dry up when markets seize. Line up enough Marcuses at the redemption window of private asset funds and they may find that the need for redemptions is greatest when the risk is greatest that the provider locks down or restricts redemptions.

Tim Kiladze has covered this phenomenon well over the past few years for The Globe and Mail, including the freezing of redemptions by private mortgage lender Romspen Investment Corp., the private debt fund run by Ninepoint Partners LP and Third Eye Capital Management, and Hazelview Investments’ commercial real estate fund. The behemoth Blackstone Real Estate Income Trust also limited redemptions in December, 2022, and as recently as last September was still only paying out 29 per cent of requests for that month. (It has since caught up).

A common trigger for prorating redemptions is when total requests exceed 2 per cent of fund’s value in a month or 5 per cent in a quarter. That’s not a huge buffer for funds that market themselves as open-ended.

To be clear, these redemption lock-ups are not a reason to avoid private assets. They are a feature of it. They are a risk you assume – for which you should be compensated, and which should be explained to you when you take it on.


Asset mix misfit

Pop quiz: What’s the hard-but-smart thing a good investment counsellor does when your equities are down 50 per cent and your bonds are up 10 per cent? Answer: Sell bonds and buy equities back to long-term strategic weights that match your risk and return objectives. Illiquid securities throw a wrench in this process, diluting your ability to buy undervalued assets and forcing you to carry the risk of being overweight the recent winners. Even ultrahigh-net-worth investors in Leith Wheeler private asset funds tend to limit that part of their portfolio to a maximum of about 20 per cent of overall invested assets. This allows for effective rebalancing.

If private assets are themselves the main “strategy,” though, and thus occupy half or more of a client portfolio, it can be very difficult to effectively rebalance weights when markets crash or soar.

Private assets can play a positive role in a diversified portfolio for the right investor, depending on a range of factors. We tell our clients to consider their cash flow needs, correlated risks, its impact on asset rebalancing, the attractiveness of the offer (and its fees), and their ability to live with illiquidity, possibly for an extended period. And then size their allocation appropriately to their overall risk profile.

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