Is anything exercising private market investors more today than worries about illiquidity, and the accompanying concerns around valuations and valuation transparency?
As a Preqin First Close newsletter article noted recently, illiquid private markets historically have had a proven ability to preserve investor capital. “This can be credited to the discretionary control that managers have over their portfolios, along with infrequent and subjective asset valuations that help keep large losses out of quarterly statements.”
It warned though “these mechanisms can’t hold off losses forever. Persistent weaknesses in equity capital markets will eventually force markdowns in private capital too.” Higher-risk asset classes, notably venture capital, “have proven more sensitive to higher discount rates and may undergo a sizeable correction,” it added.
Such fears are filtering through to the markets. Inflation, sharp rises in interest rates across the world, continued recessionary fears and shockwaves in the banking sector (not least the fall of Silicon Valley Bank) contributed to an uncertain first quarter for venture capital, according to Preqin’s Q1 2023 Update for the asset class. Fundraising, deal flow and performance indicators all remained muted.
Investor anxiety about asset illiquidity is understandable, particularly in times of market stress. But shying away from the opportunities that private markets offer risks investors sacrificing the (potentially outsized) long-term returns available – returns that can often best be achieved during chaotic periods when valuations are down and there are chances to buy at lower prices.
The key instead is to be more comfortable with private market illiquidity, says Treble Peak advisory board member and former Mercer Senior Partner Divyesh Hindocha. And that means adopting an appropriate mindset.
The question that all investors should ask themselves is ‘do we really need to be 100% liquid all the time, and what are the opportunity costs of maintaining that liquidity? Hindocha explains.
Liquidity is a function of market participant behaviour. If nobody wants to buy what’s being sold, liquidity can evaporate, especially during crisis situations when you need it most. Even supposedly liquid portfolios can face problems. The fallout from Kwasi Kwarteng’s “mini-budget” last September is a case in point.
The liability-driven investment (LDI) strategies favoured by the affected UK defined benefit pension schemes turned out to be highly exposed to movements in gilt yields. When UK bond yields spiked – with the 30-year gilt surging from 3.7% to 5.1% – many schemes’ derivatives and repo contract positions moved against them. The pension plans were forced to offload liquid assets, including gilts, to meet the cash variation margin calls, adding to the downward pressure on gilt prices.
Comfort with illiquidity
So how can investors get comfortable with illiquidity? The answer lies in cashflow analysis, budgeting and planning.
Investors have what Hindocha refers to as an “illiquidity budget”: the amount realistically available to invest in illiquid, interesting opportunities. And it is often larger than investors think.
Identifying the size of that budget is where the analysis comes in.
What are your normal cashflow needs on an ongoing basis? What extraordinary situations and worst-case scenarios do you want/need to plan for over the next five years? It may be a family wedding, a divorce, a round-the-world trip, a house purchase. Ensure you have sufficient liquid asset coverage to meet those expenses.
Once this budgeting process has been completed, individual investors and family offices commonly find that at least 50% of their assets won’t be needed over the next five to 10 years and can remain invested, says Hindocha. For pension schemes and endowments , projecting the cashflows with a high degree of accuracy is easier, for individuals and family foundations it can be more challenging but should be achievable and is an integral part of good governance.
Illiquidity, for at least a part of your assets, is investors’ friend. So put that illiquidity budget to work.
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