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Barriers to Illiquids Being Broken Down

Regulatory and industry initiatives may soon offer asset owners greater access to risk, return and sustainability opportunities.

Fittingly for a concept that stresses the long-term nature of the investments in question, discussion of how best to get based pension schemes and other investors to put money into less liquid assets has been going on for quite some time.

Even in mature markets, only now does serious momentum seem to be building behind the removal of obstacles preventing such investment. In the UK, the Productive Finance Working Group (PFWG), convened by the Bank of England, HM Treasury and the Financial Conduct Authority (FCA) in November 2020, includes industry representatives and its activities are seen as a sign that the issue is being taken seriously.

But there is a long way to go. Which is strange on the face of it. Increasing the exposure of pensions and other long-term savings to less liquid assets has been touted for years as a multiple “win” strategy, killing several birds with one stone.

At a time of historically low returns, less liquid assets can promise to generate superior earnings. As populations age, such assets, because of their long-term profile, can be better aligned with the liabilities of retirement funds.

Furthermore, such investment can unlock the billions of dollars needed to modernise the creaking infrastructure of developed economies such as the US, Britain and others.

A question of value for money

Finally, less liquid strategies match nicely with the needs of ESG-focused investment, given much of the available opportunities to invest in sustainable infrastructure will be unlisted or in the private equity sector.

All in all, there seems nothing to dislike about such investments. So why the delay?

“The biggest barriers have been cost and the administration of less liquid assets,” said Katie Sims, Head of Alternative Solutions at Willis Towers Watson (WTW). “The charge cap on the management fees makes it difficult to pay for performance.

“This is being changed but there has been a lack of innovation on the management side.”

She added: “The administrative problem has been that the requirement for daily prices is difficult to meet when the asset concerned may be valued only monthly or quarterly. You have to find ways of pricing it in between.”

Charlotte O’Leary, CEO of Pensions for Purpose, which encourages the flow of long-term capital to impact investments, agreed. “The key obstacle talked about in the debate of illiquid assets – and how institutional investors may be able to invest more widely in them – is whether investors will receive value for money for their investments if underlying assets aren’t priced daily, because of their illiquid nature.”

Tension between costs and returns

She added: “Should scheme members, for example, wish to redeem assets before a monthly or quarterly re-valuation of assets, they could lose out when the asset is repriced a few weeks later.”

As O’Leary points out, concerns have recent risen to the surface about scheme members not being allowed access to their investment cash because of gating by managers, as happened with Neil Woodford’s fund. “Pension scheme members do expect and often require their cash at short notice,” she observed.

Jason Bermont-Penn, a Director on the Global Institutional Investor Team at Octopus Investments, said criticism of slow movement on this issue was not entirely fair. “Things have not taken as long as you might expect,” he said. “The illiquid asset class is quite young. Once it became mainstream and institutionalised, the market reacted quite well.”

At a meeting in March, the PFWG’s Technical Expert Group looked at the issue of less liquid assets in defined contribution (DC) schemes. One problem, it said, is that while costs are certain, future returns are not, leading many such schemes to focus on keeping costs low.

It added: “Less liquid assets tend to be more expensive and may take some time to generate value, and some of them may fail to do so. A key challenge for trustees and other decision makers is how to ensure they act in the interests of members, while facing this tension between the certainty of cost and uncertainty of future return.”

The total worth of assets under management in UK pension funds had a market value of £2.5 trillion in 2021. For the European Union, the figure was €3.3 trillion at the end of last year, and for the US the October 2022 figure was US$4.5 trillion.

Increasing move to alternative assets

Last year, the FCA authorised a new type of fund, the Long-Term Asset Fund (LTAF). According to law firm Farrer & Co, the purpose of such funds must be to invest mainly in assets which are long-term and illiquid in nature.

Things are on the move on the continent, as well. Earlier this year, the European Fund and Asset Management Association (EFAMA) welcomed proposals from the EU Commission to remove “unnecessary barriers that have limited investors’ access to long-term investment opportunities, while preserving a sound investor protection framework that prevents retail investors from being exposed to excessive risks”.

Sims said the time was right to be making such investments, but added: “You need critical mass. Innovation will probably start with large multi-employer pension schemes.”

O’Leary suggested the shortcomings of the traditional model of 60% equities to 40% bonds are prompting a re-think on the part of investment managers. She said: “The 60/40 portfolio model has served institutional investors very well over more than five decades and in the past institutional investors may have been reluctant to change these models before they had to.”

But, she added, five decades of falling interest rates, low inflation, low volatility and steady growth in share values had come to an end, with institutional investors moving increasingly into alternative assets. “The more recent ‘institutionalisation’ of private markets over the last decade has also helped investors feel more comfortable investing with private managers.”

Benefits for younger members

In October, private research and analytics firm Preqin forecast that the global market for alternative investments would double in size by 2027, from US$9.3 trillion to US$18.3 trillion.  It said: “Despite a challenging macroeconomic outlook, demand for private capital continues to show resilience.

“Demand remains strong as investors continue to seek alternative sources of returns in an uncertain economic environment.”

A key aspect of the appeal of private-markets investments to sustainability-focused investors, said Bermont-Penn, is that they involve raising new money for new projects. “The vast majority of share trading on listed markets is secondary, in that you are trading stock that has already been issued.

“You’re not creating true additionality. When you invest in private markets in, for example, care homes or renewable energy, you can say you’re creating new impact.”

In November this year, the PFWG issued guidance urging UK pension schemes to evaluate illiquid investments in terms of value rather than cost. O’Leary commented: “Whilst it’s too early to say how successful this will be, we are expecting this guidance to increase demand for illiquid assets amongst DC schemes in particular, which have a younger membership who can benefit most from the longer-term investment horizons and subsequent return premia illiquid assets can offer.

“This is especially true given the new economic backdrop of high inflation and low-to-no growth.”

Alternatives “here to stay”

Sims added said there was plenty of overlap between illiquid assets and the ESG investment agenda. “Illiquids can improve risk, return and sustainability,” she said, pointing out that much of the investment needed to reach a low-carbon economy will be unlisted or private equity.

It is important, she said, that the sectors concerned would be able to attract capital and important also for people to know that their money will help improve the future.

In its 2021-2022 survey, published in September, the Investment Association, the trade body for investment managers, wrote that renewable energy projects make up a significant proportion of investment in UK infrastructure projects, which mainly consist of offshore and onshore wind farms.

And in March, the then UK Pensions Minister Guy Opperman said he was “determined to pursue the path to opening illiquid asset classes to DC schemes. Adding: “I am firmly of the view that all DC schemes should be considering diversifying their portfolio.”

While passive investment in listed markets had worked well for more than ten years, and may do so in the long term, “it is right that trustees consider the role that illiquids can play in continuing to deliver the best possible opportunity of a comfortable retirement income for their members”.

Looking at the future, as once alternative investments become mainstream, are “alternative alternatives” just below the horizon? Yes, said Bermont-Penn. “There are nascent sectors out there that will become mainstream in the future.” He gave hydrogen energy, home generation and energy storage as examples.

“We find new sectors with proven technology and impact. Illiquids are very much here to stay, if only for the diversification benefits.

“The supposed once-in-a-lifetime events of the past 15 years show how dangerous it is to be invested in just two asset classes.”

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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