The current chancellor of the exchequer fired the starting gun on the rush to illiquids last summer, with a Mansion House speech that announced that he had signed up many of our largest and most successful pension providers to a ‘compact’ to invest 5 per cent of their default funds into unlisted equities.
Sensing a win-win situation, Jeremy Hunt predicted that he would unlock up to £50bn of new investment funding for Britain’s young high-growth companies, while at the same time boosting pension pots by 12 per cent, adding £1,000 to the annual retirement incomes of average savers, and of course much more than that for higher earners.
It seems that for the past two decades the desire to diversify portfolios has sent so much of our own pension money offshore to emerging markets – to the Brics, Civets and other regions – so that foreign investors are rapidly becoming the only ones funding much of our infrastructure investment and young company growth.
So, the drive to increase pension holdings in commercial property, private equity, green energy projects and un-listed shares is on.
For those now considering adding illiquids to clients’ portfolios, I offer you three golden rules to make the most of these exciting opportunities and boost the growth prospects of a client’s portfolio without going too far out on a limb.
Rule #1: Line up investment payouts with client’s intended cash flows
Illiquids should be regarded as long-term investments. However, look through the customary Financial Conduct Authority warnings for clients around ‘it’s a long term investment’ because what an actuary hears from this statement is that much of the value of this investment is going to be in the yearly cash flows it generates rather than a payout at the end.
You will see examples of this today with infrastructure stocks and venture capital trusts, which generate high levels of annual dividends.
Illiquid investments are growing in popularity as a satellite investment alongside a core portfolio.To meet my first golden rule, choose illiquids that are expected to generate a natural income that meets client’s cash flow requirements.
If they are not yet retired, you could select early stage private equity funds in which your investments only bear fruit after some years of the manager seeking out targets, deploying funds, improving companies, and only later taking profits.
However, for an active early retiree gallivanting through their free time, buying into infrastructure projects that have already completed their build stage can generate an immediate flow of income that will automatically adjust upwards with inflation so a client’s retirement income can keep pace with the increasing cost of living.
Rule #2: Listen to what the market is telling you
This is where illiquids are very different to securities like shares or bonds listed on the world’s major stock markets. Those listed securities will behave in a rational way.
Several platforms now produce market commentary at lunchtime or close of business that explain that prices went up or down in reaction to the latest release of inflation, employment figures, or interest rate data.
Stockbrokers will publish buy/sell/hold recommendations along with a target price that they expect a share to move to in the near future as investors appreciate something the stockbroker has spotted. It is all very logical.
The market behaves in this way because of the depth of liquidity in modern markets. Individuals come to the market to buy or sell and you will not see even a ripple on your seismometer.
Be prepared to forget all those plans that this was ‘a long term investment’ and sell out early if someone offers you a really good price.However, the world of illiquids is topsy turvy to this. With illiquids, anyone wanting to sell is likely to drive the price down, as they have to tempt someone who was not intending to buy to come in for their share. Similarly, at times when there is a surfeit of buyers, prices will be bid up as demand exceeds supply.
Those investing in illiquids should act like a visceral trader: listen carefully to the market and buy when you hear others selling.
Equally, be prepared to forget all those plans that this was ‘a long term investment’ and sell out early if someone offers you a really good price.
It might just be that they need to catch up on their Mansion House compact obligations and their desire to buy your illiquid asset trumps any sound approach to valuation.
Rule #3: Be quick to exit if things are going south
This is a bit like what to do when a building catches fire – those that move fastest to the exits will survive the blaze. Investing in illiquids is not like The Towering Inferno, The Poseidon Adventure or Die Hard in that the last to get out when a fire sale is coming often take the greatest losses.
Some years ago, when I was running an annuity book, I talked to my bond investment manager and heard he had never had a bond he was holding default. I probed a bit and realised that this was not just his skill in selecting good risks, but his fleet of foot nature in getting out as trouble began to manifest itself.
Of course, a hasty exit will probably mean your client taking a loss, and at the time he or she may well be unhappy about that. However, they will thank you later when they see those that were initially reluctant to take that early loss travel all the way to the bottom.
To conclude, we note that illiquid investments are growing in popularity as a satellite investment alongside a core portfolio.
Large defined contribution schemes already hold between two and 15 per cent of their assets in illiquids, as they try to lay their hands on some of those additional returns for their members.
Your clients may benefit from this too, and these three golden rules could help them navigate any potential downside risks.
Adrian Boulding is director of retirement strategy at Dunstan Thomas
