How Allocators Can Avoid ‘Secondhand Smoke’ From Illiquid Investments

Investors face a “game theory problem” in determining the optimal size of their allocations to private markets and other harder-to-sell assets, according to new research.

Illustration by II

Illustration by II

It’s time for investors in private markets to consider systemic risks.

According to recent research from asset manager Allspring, even if investors don’t buy into the case for investing in private equity and other illiquid assets, such as low quality bonds, property, and infrastructure, they still need some exposure to reduce certain market risks. Conversely, investors that are bullish about private markets may want to pull back on their allocations to reduce systemic risks.

The research argues that investors can be harmed both by having too little exposure and by an allocation to private markets that is too large.

Allocators without illiquid assets in their portfolio can be negatively affected by those who hold the investments, leading to a so-called “secondhand smoke” effect. This is because investors generally sell public market assets first if they need cash during stressful times. As a result, when massive sell-offs occur in the public markets, investors who hold the least in illiquid assets will suffer the most. As the authors put it, “According to our model, liquidity demands must first be met by selling liquid public market assets, which bear the initial impact of any liquidity squeeze. This is analogous to a nonsmoker exposed to secondhand smoke. They are affected by their own actions and by those of others. Where this analogy breaks down is that investors holding the least amount of illiquid assets are often hurt the most.”

But a bigger allocation to illiquid assets isn’t always better. According to the paper, too much in private markets and other harder-to-sell investments puts financial strains on the entire market. When there is a large market shock, some investors will be forced to sell their illiquid holdings — at a significant discount — to meet their short-term cash needs.

“The tipping point occurs when you actually have to sell illiquid assets to start funding your cash flow needs,” Kevin Kneafsey, senior investment strategist and co-author of the report, told Institutional Investor in an interview. “Once you do that, you are in a totally different space in terms of the prices you are going to receive for the assets. And that creates a huge drop in asset values [and your] ability to fund an ongoing concern. That creates solvency issues.”


That means investors face a “game theory problem” in terms of illiquid allocations, according to the paper. “Allocating too little to illiquid assets leads to performance that is worse. Allocating too much to illiquid assets leads to performance that is much worse. Allocating just the right amount to illiquid assets leads to optimal performance.”

Ideally, the optimal level of exposure to private markets should be determined by three factors, according to the paper. They include the size and scope of potential market shocks, aggregate allocations of other market participants, and the investor’s own cash flow needs.

“Simply put, the larger the illiquid holdings of others and the larger their cash flow needs, the more fragile the system and, therefore, the more likely that it breaches the tipping point for any given shock,” according to the paper.

For allocators such as endowments and pension plans that means they should invest in illiquid assets in accordance with the cash required to cover their operating expenses. The more they need to fund their daily operations, the more flexibility they require during big market drawdowns.

“If the shock is big enough, it’s going to start taking down those with bigger allocations to illiquid assets,” Kneafsey said. “You get a big decrease in the amount of cash coming in and no change in the cash coming out. That’s what stresses the system.”