The best way to harness illiquidity

To compound the issue, UK pension funds have traditionally been underweight in illiquid asset classes, where return premiums are still available. This is a missed opportunity. Cambridge Associates analysis demonstrates a direct correlation between those long-term investors willing to build substantive illiquid portfolios, with an allocation of 15 per cent or more, and outperformance.

Set realistic objectives

When considering such an allocation, however large, schemes should focus on three key principles. First, purpose – be clear and realistic in your objectives; second, implementation – good manager selection is critical to success; and third, patience – it is important to invest the time and resources necessary.

Manager selection is critical to success and becomes increasingly so as investors move up the risk curve

These principles are applicable across the main illiquid asset classes of private equity, venture capital, private credit and real assets, all of which offer a combination of growth, income and diversification, and can be adapted to a scheme’s objectives.

For growth, private equity should be central to an investor’s strategy. Between 2007 and 2016, private equity returns significantly outpaced the 3.8 per cent and 0.4 per cent returns from the MSCI World and Europe Indices, respectively. 

Additionally, a private equity portfolio can help diversify a fund’s equity exposure, providing access to smaller and more innovative companies. A mature private equity portfolio can also serve as a source of income, albeit uncontracted, with new funding requirements outpaced by the return of capital from existing relationships.

Private credit can be a useful tool for investors to earn meaningful income, while also offering the potential for capital growth. Direct lending, which has boomed since the retreat of traditional banks from the sector since the financial crisis, provides the lowest risk and most income-focused form of private credit.

Mezzanine finance, capital solutions and distressed credit sit further up the risk spectrum, and offer increased capital growth opportunities as well as the potential to diversify a scheme’s fixed income portfolio.

An allocation to real assets can play multiple roles in a portfolio. Some types deliver growth while others have liability-matching characteristics, such as inflation linked cash flows. Although real estate and infrastructure dominate the landscape, these broad terms cover a vast range of opportunities. Newer asset classes, including royalties, life settlements and the leasing of aircraft or ships, add the potential for meaningful diversification too, often with mispriced risk-return profiles.

Build relationships and resources

An illiquidity premium can be harvested across different strategies and during the various stages of a pension fund’s life, from growth to income generation. Once schemes decide on the purpose of an allocation, the real challenge begins with its implementation.

Manager selection is critical to success and becomes increasingly so as investors move up the risk curve where the consequences of skill, and human error, are more pronounced. This is clear from the wide dispersion of returns between the median and top 5 per cent of performers across asset classes.

To find and access the winners, pension funds need the time to build relationships and the resources to conduct rigorous due diligence. In addition to investment due diligence, this should also include reviewing a manager’s internal operations and compliance procedures, as well as conducting legal assessments of fund documentation.

Finally, patience is key. Research shows that it can take six years to assess a private equity fund’s performance meaningfully, and new investors should avoid looking at portfolio-level performance for two to three years, at least. But for those willing to stay the course, there is an illiquidity premium to be earned – a premium that is looking increasingly important to pension funds and their pensioners alike. 

Joshua Featherby is investment director at Cambridge Associates