Patient capital is a virtue

Illiquid assets. Private markets. Productive finance. Patient capital. Trustees of DC schemes are hearing more and more about all these different terms, but what does it all mean?

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We have sifted through the detail and put together a summary of the key issues to help you to understand why you should consider investing, whether the challenges are real, and how sustainable illiquid asset classes can really be.

Why should you think about investing?

Illiquid assets include any asset that cannot be bought and sold at short notice. You have to be willing to lock away your money for a period of time. Being prepared to lock away money can give members access to a huge range of opportunities. For instance, members could be invested directly in fixed assets like infrastructure and property. You couldn’t do this if you wanted your money back quickly. Young DC members in particular are invested for such long periods that they shouldn’t be concerned about having their money tied up to access these opportunities.

But what about risk?

By investing in illiquid assets you benefit from diversification - that is, holding a range of investments so you don’t get thrown off the tracks when one of them underperforms. And they will underperform at some stage with members being invested for so long. Just think, in the last twenty years alone, we’ve seen a global financial crisis, a global pandemic, Brexit, the European debt crisis and much more that has rocked markets. 

The benefits of diversification come through:

1. widening of the opportunity set of assets you invest in; and

2. investing in private markets rather than just public markets.

How does investing in private markets rather than public markets help with risk?

‘Going public’ used to be the go-to for companies. They would head there at the first opportunity. But we are now seeing this happen later and later. As a result we can invest in a wider range of more established (and so less risky) companies in private markets than ever before.

The number of companies in public markets has also fallen dramatically. Data from the World Bank shows that the number of US public companies fell from around 7,000 to 4,400 between 2000 and 2018 – a fall of almost 40%. This compares to data from PitchBook showing an increase in the number of private equity backed companies from around 1,700 to over 8,000 – a rise of 370%! Are investors in public markets chasing returns in a smaller and smaller pond? Coupled with sky high valuations from an uptick in company share buybacks and the low yield environment, there is a real risk that public equity markets are not the evergreen opportunity they used to be. While this example focuses on equities, there’s a lot to be said for other illiquid asset classes, from property to infrastructure and private debt.

Together with opportunities for returns, this all means that illiquid assets can be a cornerstone of a default strategy built to withstand all that markets, and the global economy, have to face in the coming years. This isn’t something new, DB schemes have been using illiquid assets for years!

Is it challenging to invest?

Investing in illiquid assets can prove more challenging for DC schemes than DB schemes given the wide use of investment platforms. We have set out below some of the key challenges, along with our solutions.

Platforms require daily dealing

Platforms and administrators have built their systems around members being able to move their money on any given working day – this is, ‘daily dealing’. It is not a regulatory requirement but it is the status quo and the required investment for change means we can’t expect a move away from this soon. 

However, trustees of DC schemes will invest in a wide range of liquid assets alongside any illiquid assets they choose to introduce. By looking at the whole strategy, trustees realise that more liquid funds can handle regular contributions and withdrawals. Trustees can created blended (or ‘white-labelled’) funds that include an allocation to both liquid and illiquid assets. Under the bonnet, the allocation to each can vary over time without affecting the member experience.

Of course, extreme scenarios need to be understood, but simple steps can be taken to limit the risks. For example, many schemes limit the size of their allocation to illiquid assets and use lifestyling to make sure members aren’t invested by the time they are able to retire. 

Platforms require daily pricing

On the face of it, daily pricing sounds challenging for illiquid assets. These assets are not traded regularly. This means they don’t have a ‘market price’ like public market assets, such as equity shares that are traded every day. However, there are other ways to value assets. Understanding how daily valuations treat all members fairly is important but it should not be a deal breaker. Remember, these fund vehicles are subject to stringent regulations and the long-awaited Long Term Asset Fund will be no different. 

Costs and charges

Costs are an important factor for any investment and should be considered in the context of your broader strategy. It’s no surprise that trustees worry about the cost of illiquid assets with legislation on charge caps, even though most schemes are well within the cap. While we support low costs, it’s also no coincidence that the Government are looking for ways to shift the focus from cost to value to make life easier for schemes looking to invest in illiquid assets.  

We were particularly pleased to see Government support for five-year smoothing in the charge cap calculation. This flexibility means trustees are far less likely to breach the cap if the allocation to illiquid assets goes above its strategic allocation, for instance because other assets perform poorly or members transferring to other schemes requires disinvestment from more liquid assets.

Performance fees can be particularly divisive. Some believe they protect members from poor performance, but others are fundamentally opposed. Is it a hurdle? We don’t think so. Some managers give trustees the choice and, with more funds coming to market, more competition may mean better pricing. Performance fees are, however, subject to a live consultation around whether they should be excluded from the charge cap.  

The lifecycle of illiquid assets

For some illiquid assets, investors receive the majority of returns towards the end of the asset’s lifecycle. For example, there are often upfront costs when managers are sourcing private markets investments. Features like this can reduce returns early on, with more returns coming through later. 

For most schemes, the trick here is to invest in an open-ended fund. These funds will hold assets at different stages of life so members are not disadvantaged if they disinvested at a certain time. With the increased focus on illiquid assets, we are expecting more open-ended funds to come to market. 

However, schemes will likely invest a much larger amount at the outset, including existing pots and not just current contributions. Because of this, some managers will have a ‘queue’ for investing or may ask you to stagger the investment over a period of time. We like to stagger any investment to limit the risk of trading on one bad day, so this doesn’t worry us.

More generally, the fact it will take some time doesn’t mean it’s a bad idea – it’s still an evolution of your investment strategy, most likely for the better. The trick is just to make sure the assets being held in the meantime are still targeting an appropriate return. 

What if you’re looking to consolidate?

By making it harder to trade at short notice, investing in illiquid assets may not be right if your scheme is likely to consolidate – this is true for any major change to your strategy.

However, trustees may have noticed that price competition amongst Master Trusts means that they can take some time to introduce more sophisticated investments, like illiquid assets. Introducing illiquid assets offers a clear opportunity for trustees of DC schemes to evidence that their scheme offers clear value for members.

What about sustainability?

We’re all finally coming to terms with the fact that sustainability is financially motivated. Some people argue that we need to extend the definition of fiduciary duty beyond financial returns to ensure sustainability is taken into account, but we don’t need to make that leap. Investing sustainably helps to manage financial risk and access financial opportunities. For DC schemes, it’s therefore a key consideration for your default strategy and it’s a great way to engage with your members.

In fact, given members of DC schemes can be invested for over 40 years before retirement (and another 30 years after that given the increasing popularity of drawdown in retirement), it’s even more important. Sustainability is a long-term matter. It’s a megatrend that will define the future of investment markets. And it’s not just about climate change, broader ESG will play an important role too.

Why use illiquid assets to invest sustainably?

With the right choice of manager, the fact that illiquid assets are held by the same, typically smaller pool of investors for a period of time, provides more scope to engage on sustainability in order to drive up the value of investments. This could be the private equity manager encouraging companies to factor ESG into their business plans or the property manager working to upgrade the energy efficiency of buildings. This contrasts with public markets which suffer from the age-old concern that company decision-making is driven by short term concerns about stock prices and may fail to invest appropriately for the long-term. 

The smaller pool of investors also means fund managers can have more influence on company decision making. In private equity, the manager may sit on the management board of underlying companies. Otherwise, in private credit, the manager can influence the terms and conditions of loans to include mechanisms like ‘ESG ratchets’, which are becoming increasingly popular and can penalise companies for poor performance on sustainability. 

What’s more, illiquid assets can involve providing new money to companies. These opportunities may not be easily accessed using public markets.

Taking climate change as an example, the breadth of new investment required for the transition to a green economy is huge. We’re talking about decarbonising energy generation, upgrading methods for electricity transmission, running more of the economy using electricity, transforming energy storage, and radically improving the efficiency of consumption. That sentence was a mouthful… but it highlights the point: there is plenty of opportunity. 

Are there challenges?

Of course there are. The availability of good data in private markets can present difficulties. It can be hard to work out if the products of companies you invest in are truly sustainable, but also how sustainably the companies themselves are run.

However, there are reasons to be hopeful. More and more investors are demanding change and companies will have to adapt. In the case of private equity, the extra requirements in public markets should also filter down. After all, the end goal for many private companies will still be to ‘go public’. 

Investing for the long-term…

All things considered, there is a strong case for including an allocation to illiquid assets as part of your DC scheme’s investment strategy. Not only do illiquid assets offer the timeless benefit of diversification to improve risk-adjusted returns, they also offer clear potential for sustainability and plenty of schemes have already shown that perceived challenges can be tackled head on.

If you would like to understand more about investing in illiquid asset classes as a trustee or sponsor of a DC scheme, please do get in touch.