Investing in illiquid asset classes has become a market trend over the recent years, mainly driven by low interest rates and the inability to finance liabilities using returns from traditional fixed income and equity asset classes. Illiquid assets introduce new risks into investment portfolios that need to be actively managed. Static, cross-sectional approaches to risk management fail to cope with illiquidity risk. Investors need to turn to actively managing the maturity and associated cash-flows of illiquid assets over time.
Over the recent years, more and more institutional investors, including pension funds and insurance companies, have turned to investing in illiquid asset classes, like real estate, private equity, infrastructure, or leveraged loans. The main reasons for this trend have been record low interest rate levels and the resulting inability to achieve returns needed to meet liabilities using traditional fixed income and equity investments. In addition, traditional asset classes offer less than optimal diversification. Investors consider illiquid asset classes because they tend to deliver an illiquidity premium that compensates for the additional onboarded risk of not being able to sell the assets at any given point in time. Another reason for investing in illiquid assets often considered is gaining access to alternate risk-return profiles not offered by liquid assets to better diversify the portfolio through exposure to distinct risk factors or combining risk exposures in a novel way.
Accepting illiquidity risk as-is in a portfolio is insufficient. Illiquidity risk needs to be actively managed as do other risks. But how to manage illiquidity risk effectively? Before dwelling into answering this question, let us gain a common understanding of illiquidity risk from a portfolio perspective. An asset is considered illiquid if it cannot be sold at a given point in time without causing a drastic change in its price, especially under turmoiled market conditions. The illiquidity is usually due to the systemic lack of interested buyers because of the distinct characteristics of the considered asset. Consequently, the investor’s ability to manage the overall portfolio structure and risk exposures is impacted.
ILLIQUIDITY RISK REVISITED
Illiquidity risk is the risk of being unable to sell an asset at any given time for a fair price. Illiquidity stems from failing to compromise between time and money. In the context of managing a portfolio of both liquid and illiquid assets, illiquidity risk has a broader meaning. Indeed, illiquid assets create two new categories of portfolio risks usually not addressed explicitly.
First, illiquid assets make it harder to manage market risk at the portfolio level, that is, rebalancing the portfolio towards its target strategic asset allocation, resulting in rebalancing risk. They make it harder, if not impossible, to adjust the portfolio holdings to achieve the targeted risk level (for example, in terms of volatility) and risk factor exposures (for example, in terms of interest rate risk exposure). Consider, for example, a portfolio that includes an illiquid private debt holding with a 10-year time to maturity. Now consider a market disruption that requires reducing the portfolio duration, one of the managed risk factor exposures, because of a reduced risk capacity related to unrealized losses. As the 10-year private debt holding cannot be sold, at least not at a fair price, liquid bonds or other interest rate risk bearing assets need to be sold, if available at all, increasing the portfolio’s illiquidity potentially above the targeted threshold, resulting in a sub-optimal risk-return profile at best, and violated regulatory constraints, at worst.
The second, less prominent, risk introduced by investing in illiquid assets it the investment opportunity risk. What does that mean? Over time, investment opportunities materialize. For example, a government may issue an inflation linked bond for the first time in a while that matches specific real return liabilities of the investor. To grasp that opportunity, other assets in the portfolio must be sold without disrupting the portfolio’s target risk profile, in terms of volatility and risk factor exposure. This could mean having to sell real estate investments, a potential challenge due to their illiquidity.
When digging deeper into understanding these two portfolio risks related to illiquidity, a key risk dimension that is rarely considered can be identified. Indeed, typical portfolio risk management takes a static approach, looking at today’s portfolio holdings and characterizing their risks using historical data combined with mathematical models. But, a key trait of illiquidity risk is time, the time needed to find a buyer willing to pay a fair price for a given asset. Managing illiquidity is therefore tightly related to managing cash-flow, notably principal repayments, expected over time from illiquid assets.
Before designing a possible approach to managing illiquidity risk in a portfolio context, let us have a more detailed look at illiquid assets, focusing on the timing of the repayment of their principal, rather than intermediary cash-flows compensating the investor for risks onboarded, like interest rates risk. These cash-flows define the boundary between liquidity and illiquidity of those assets. Illiquid assets can be classified into two main categories:
- securities that exhibit a fixed maturity, known a priori, at which, subject to issuer specific risks, like default risk, the principal is repaid to the investor, and
- securities that do not repay their principal in the foreseeable future, either because they do not have an associated maturity or because the maturity is further down the road than the investment horizon.
The first category of assets typically includes fixed income kind of securities, like mortgages, insurance linked bonds, or private loans. Subject to issuer specific risks, the investors in those securities know when they will get repaid. Even though up to their maturity date, such securities may be illiquid, they include an explicit liquidity feature at maturity. Illiquidity risk management need to exploit that feature. The second category, usually more common, like private equity, infrastructure, or real estate investments does not exhibit a pre-defined maturity feature. Liquidity risk is therefore harder to manage. Illiquidity risk management will require engineering liquidity features into or around these securities, like associating risk capital or introducing explicit liquidation clauses.
A NOVEL APPROACH TO ILLIQUIDITY RISK MANAGEMENT
Key to successfully managing illiquidity risk in a portfolio context is actively structuring the investment in illiquid assets based on their expected cash-flows on the timeline in addition to cross-sectional volatility and factor exposure risk. To do so, we introduce a novel approach based on three key rules:
Rule 1. Know when you get the principal investment back
Rule 2. Diversify timing of the principal repayments to support mitigating rebalancing and opportunity risks
Rule 3. If rules 1 and 2 do not apply, hold a risk-free liquidity asset as capital against the unknown maturity risk
An ideal portfolio should invest at least 66% of its illiquid assets in fixed maturity securities, versus 33% in illiquid assets not bearing a fixed maturity. The actual percentage should be based on the available capital to allocate against the illiquidity risk underlying the latter category of securities.
RULE 1. KNOW WHEN YOU GET THE PRINCIPAL INVESTMENT BACK
When investing in illiquid assets, the focus should first be on those securities that exhibit a fixed maturity. Although fixed maturity investments bear an additional reinvestment risk at maturity (and leave the refinancing risk with the security issuer), that risk is to be preferred over illiquidity risk. If considering a buy-and-hold investment strategy for bonds, they can also be considered illiquid fixed maturity securities for the sake of portfolio structuring. As an alternative, securities that do not exhibit an explicit maturity, may be associated an implicit one through an upfront set goal. For example, a venture capital investment may be structured in such a way that after a fixed number of years, say five years, an exit strategy or an IPO is actively considered. Real estate investments may be associated a maturity date related to their expected amortization date. Infrastructure project financing can be structured in such a way that once the project is completed, the infrastructure is sold. Identifying maturity dates of illiquid investments is a compromise between actual maturity and expected principal repayment value.
RULE 2. DIVERSITFY TIMING OF THE PRINCIPAL REPAYMENT
The illiquid part of any portfolio should be structured in a way such that x% of the illiquid assets will mature every year, where x is determined by the overall portfolio risk. This introduces liquidity over time from illiquid assets, reducing the illiquidity related rebalancing and opportunity risks. A pragmatic value for x in a portfolio exhibiting a 5% volatility is 10%, about twice the volatility. Once illiquid assets mature, their cash-flows can be used to readjust the overall portfolio structure towards its target or pursue new investment opportunities. Alternatively, the existing asset may be re-financed, like rolling the financing of a 5-year mortgage at maturity.
Another alternative for structuring illiquid assets over time is to match liabilities with maturing illiquid assets, rather than apply a fixed percentage annual cash-flow rule. The liability match may be exhaustive or partial.
RULE 3. IF RULES 1 AND 2 DO NOT APPLY, HOLD CASH AGAINST ILLIQUID ASSETS RISK
For some illiquid assets, it is impossible to associate a principal repayment maturity date to. In that case, there exist two alternative approaches, or a combination thereof. One approach is to financial engineer a repayment maturity date or window into the investment. This could be done by adding a feature to agree with a potential buyer to sell the asset at a given date in the future for a pre-determined market price. For example, a windmill park construction project investment may be resold to the state at its completion. Or a private equity investment may include a clause towards an IPO after a certain time period. The other approach is to assess the illiquidity risk in terms of financial costs and allocate risk-free capital against that cost. For example, the financial cost of a real estate investment may be determined at 7% of its purchase value. This would mean that, in order to find a buyer for the asset at any given point in time, a price up to 7% below market price would have to be accepted. This would allow liquidating the asset in case a rebalancing or opportunity risk would materialize. Rather than sell the illiquid asset outright, the allocated risk-free capital could be used to cover a materializing risk. This may be the more appropriate approach if risk management were only to require a partial sale of the illiquid asset. Note that holding capital against illiquid assets comes at a cost that impacts the return from the illiquid investment.
Whichever of the three rules applies, it is best practice to highly diversify the illiquid assets in the portfolio. In contrast with liquid assets, where holding 30 to 40 assets is enough to eliminate any specific risk, illiquid portfolios should include a larger number of illiquid assets with very diverse characteristics and maturities spread over the investment time horizon.
To illustrate the proposed approach for managing illiquidity risk, consider a portfolio with a target risk profile of 5% volatility aiming at no more than 30% interest rate and 20% equity market risk contribution from illiquid assets. For the sake of simplicity, we only describe the illiquid part of the portfolio. Exhibit 1 illustrates a possible portfolio structure investing in ten types of assets and diversifying illiquidity maturities over a five-year period. About 80% of the illiquid assets exhibit a target maturity.
|Asset class||Risk factors||Cash-flow at maturity||1 year||2 years||3 years||4 years||5 years||Total|
|State supported residential mortgages||Interest rate, vacancy rate||Guaranteed, subject to default||2%||2%||4%||4%||8%||20%|
|Commercial real-estate mortgages||Interest rate, cash-flows from sales||Guaranteed, subject to default||4%||4%||6%||4%||2%||20%|
|Industrial assets financing||Interest rate, amortization||Guaranteed, subject to default||0%||4%||4%||4%||4%||16%|
|Collateralized consumer loans||Interest rate, economic growth||Guaranteed, subject to default||10%||6%||2%||4%||2%||24%|
|TOTAL EXPOSURE IN MATURING ASSETS||16%||16%||16%||16%||16%||80%|
|Residential real-estate||Vacancy rate, real-estate market||None||0%||0%||0%||0%||0%||0%|
|Venture capital private equity||Business models, economic growth||IPO||0%||0%||0%||0%||4%||4%|
|Infrastructure projects||Project timeline risk, budget risk||Sell back to state||0%||2%||2%||2%||0%||6%|
|TOTAL EXPOSE IN ALL ASSETS AT MATURITY||16%||18%||18%||18%||20%||90%|
Investors seeking to take advantage of the risk-return characteristics of illiquid assets need to amend their approach to managing illiquidity risk. At the portfolio level, managing illiquidity risk is tightly related to managing rebalancing and investment opportunity risk. Key to managing those illiquidity risks is managing and diversifying the maturity exposures from illiquid assets over time. As such, time becomes the second dimension along which a portfolio should be diversified, in addition to cross-sectional volatility and risk-factor exposure diversification. For those illiquid assets that do not exhibit an explicit or implicit maturity, capital needs to be allocated to cover potential losses from forced sales. The exposure to such assets with no maturity or a maturity beyond the investment horizon should be limited as much as possible and bound by available risk capital resources