When it comes to paying for retirement, I’m banking on my ability to sell some artwork, a few tiny silver spoons, and an old Monk family vase (pronounced “vahz”). Throw some baseball cards, obscure stamps, and a really old coin into the mix, and I’ll be living the high life — that is, if I can find somebody to actually buy these things at a price that matches what I think they’re worth.
The good news for me is that it’s getting easier to convert all sorts of illiquid assets into liquid cash. For example, there’s now a platform that allows people to sell fractions of classic cars, which means an investor can build a diversified portfolio of cars that don’t work. I also just saw a new hedge fund focused exclusively on buying small batches of Kentucky bourbon and reselling them opportunistically to people who prefer their whiskey when it’s liquid. (I’ll be here all night.) The world seems intent on bringing more liquidity to the world of highly illiquid assets.
And there’s good reason for this: Illiquid investments such as timberland, agriculture, infrastructure, and real estate do, in fact, outperform traditional asset classes, such as stocks and bonds. Recent research by Francesco Franzoni, Eric Nowak, and Ludovic Phalippou shows that the unconditional illiquidity risk premium, at least for private equity, is 3 percent annually — meaning that if your private equity manager isn’t earning 3 percent above public markets every year, then he’s literally doing nothing of value. Other research by BlackRock’s Andrew Ang indicates lock-ups should be associated with a specific premium: If you are locked up for a year, you should earn an extra percent per year. If it’s a decade lock-up, you should get an additional 6 percent per year.
Facing skyrocketing costs of retirement and other social obligations, as well as lower future expected returns, allocator Giants are moving aggressively into illiquid assets to capture these higher returns. The portion of illiquid and alternative assets held by American pensions increased from 5 percent in 1995 to 20 percent in 2011, and is probably well above 25 percent today. At last count, a quarter of the assets held by sovereign funds are illiquid; today there’s close to
$7 trillion of alternative assets under management by professional money managers.
So illiquid assets would appear to be the solution to our pension crisis and all of the other underfunded social obligations we have as a society. Right?
Here’s the rub: Though Giants should be perfectly capable of shouldering this illiquidity, most are ill prepared to manage this risk. I know that may seem odd, as other parts of the financial services industry — like banks and insurance companies — see the management of liquidity risk as critical to their operations. But let’s not forget, illiquidity drove the 2008 financial crisis. It humbled Stanford and Harvard! Clearly, it should be top of mind for Giants, especially as they ramp up exposures to illiquid assets.
But it’s not. Over the past year, I’ve been doing a research project on liquidity, cash flow predictions, and risk tools, and I’ve found that almost all Giants are underprepared. I’ve learned that though investment teams may be passionate about illiquid assets, there has not been a commensurate focus by boards of directors, risk teams, and operations teams on illiquid risks.
All of the funds I’ve spent time with have some version of a homegrown or consultant-built spreadsheet that pushes Excel to the very brink of its capabilities. Some of these spreadsheets are, I admit, incredible. But Excel is error-prone because it’s manual and time-consuming and doesn’t afford any deeper data science capabilities. Also, to populate the assumptions in these spreadsheets, most funds rely on general partner or consultant estimates and predictions about capital calls and cash flows. It’s therefore very hard to unravel who actually set those assumptions and is accountable for their maintenance. In sum, most Giants don’t realize how much they should demand from their illiquid investments in terms of returns because most aren’t properly assessing their liquidity risks.
This is very dangerous. If you don’t have liquidity when you need it, you can end up defaulting on commitments, and selling an illiquid asset owing to need rather than desire can be very painful. Also, most illiquid investments come with deep J curves, requiring the payment of fees and costs long before any returns materialize. Are you sure that’s a J curve and not just an underperforming asset? How can you tell the difference? Usually the answer is cash flow.
Liquidity management — predicting cash inflows and outflows — is incredibly important. Assumptions and predictions should be monitored and reassessed, and specific people should be delegated the authority to monitor and update these assumptions. New technologies that allow for automation and peer collaboration should be pursued.
At a high level, the current focus on illiquid and alternative assets is great. But it has to be combined with good governance. If someone struggles to sell that Kentucky bourbon or that classic car he owns, he can ultimately just drink it or drive it. (Not at the same time, please.)
Unfortunately, institutional investors don’t have that luxury.