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December 17, 2020 07:00 AM

Commentary: Weatherproofing multiasset portfolios with illiquid alternatives

Real-time cash-flow forecasting may hold the key to true diversification

Thomas Meyer
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    Thomas Meyer
    Photo: Oliver Doll
    Thomas Meyer

    Sophisticated institutions have long been investing in illiquid alternatives, such as private equity and real assets, to improve the diversification and performance of their portfolios. But during the COVID-19 crisis, many institutional investors across the globe found their portfolio risks were far more concentrated than expected. It appears, at least in practice, implementing a well-diversified portfolio to weatherproof against market shocks is more difficult than widely assumed.

    In a recent public meeting for the California Public Employees' Retirement System board of administration, Greg Ruiz, head of CalPERS' private equity program, reflected on why its renowned program has recently underperformed relative to peer benchmarks. In his review, he identified a "lack of disciplined capital deployment and lack of strategic consistency," as the two key factors that affected performance.

    Mr. Ruiz's reflections could well be the key to riding out the current global pandemic, if we can ascertain just how limited partners can sustain their approaches to alternative allocations, to weatherproof portfolios against the storms in the market. To understand this, we must take a look at the role of market practices and short-termism and whether frequent cash-flow forecasting may hold the key to true diversification.

    The ‘denominator effect’

    Many institutions invest in a collection of assets, following a decades-old best practice strategy, approximately defined as 40% equities, 30% bonds, 10% hedge funds, 10% private equity, and 10% real estate and infrastructure. Following these rules implicitly allows market quoted assets to drive portfolio dynamics. If we consider an allocation as the capital within an asset class, divided by the total capital of the portfolio, when one asset class, such as equities, takes a hit, it skews the relative value of other less liquid asset classes, such as private equity. In this sense, the value of private equity blooms, while the overall portfolio (the denominator) reduces significantly. This is known as the denominator effect; a typical phenomena arising during crises.

    This temporary overallocation of illiquids within the total portfolio causes many limited partners to take a typical short-term market risk perspective and put a stop on any new fund allocations, or even sell off current commitments in the secondary markets, in favor of rebalancing allocations and increasing liquidity during volatile conditions.

    This self-harming act, a result of overly rigorous market rules designed for liquid asset classes and not for illiquid alternatives, sees LPs create a self-fulfilling prophecy. Firstly, injecting artificial volatility from the public markets into the private markets. Secondly, selling off private assets in usually highly unfavorable conditions due to declining asset values. Instead of using these conditions to buy illiquid assets at a discounted value, many LPs flee the market in their hordes, precisely at a time when it is mostly likely to dry up.

    Keep calm and carry on

    Private equity and real assets resist the volatility caused by increased market transactions as a means to rebalance and provide stability to multiasset portfolios. It is one of the rudimental characteristics that define it from traditional assets, such as equities. Take the global financial crisis in 2008 and 2009 as an example, where an illustrative portfolio of private equity funds showed a contraction of distributions by 65%, while contributions decreased by 20% relative to predictions. This is a development to be expected during a market crisis, where valuations for all assets are collapsing.

    However, this impact occurred over a relatively short term. In 2012, the same sample of private equity funds had caught up and its cash returns, as well as its overall performance, were well beyond what was predicted/expected in 2009. To draw a key lesson from the global financial crisis and other crises: A consistent approach to fund commitments is critical. Institutional investors that stay the course and hold tight with private equity and other alternatives allocations will ultimately benefit from risk-adjusted returns generated by funds once markets recover. As CalPERS' Mr. Ruiz confirms, while consistently committing to private equity does not always guarantee success, inconsistently deploying capital will most certainly result in underperformance.

    In most of these situations, the old dictum to "keep calm and carry on" is the advisable course of action. However, this is easier said than done. One of the contributing factors that perpetuates the artificial risk mindset of most LPs in a crisis is the lack of counterargument from their illiquid asset teams. Here, risk management is predominantly approached through business acumen and due diligence, rather than through the quantitative models and tools needed to communicate risks in the "value-at-risk" language their organizations urgently demand.

    It’s all about cash flow

    Weatherproofing has to start long before a crisis. If, for instance, an integrated cash flow forecasting solution had existed back during the GFC, its timely insight, backed by robust data, would perhaps have enabled a strong counterargument from the illiquid asset teams, eliminating the hasty decisions that a public market risk perspective often triggers.

    The dynamics of fund cash flows play a critical and challenging role in meeting diversification targets. Sophisticated asset managers confirm that careful liquidity planning is essential to achieve this, but often this insight is either stuck in the back office, never to make its way to the trading desk. Or based on yearly forecasts that become quickly outdated and offer little accuracy to guide portfolio allocation decisions in the here and now.

    Much of the challenge around cash-flow forecasting models is that they need to be able to work with infrequent, unstructured and poor-quality data that is the signature pattern of illiquid alternative assets. The algorithms need to use both proprietary private market data, supplemented by data obtained from market vendors, and triangulate to fill the remaining gaps. In situations where investors try to build an in-house system for cash-flow forecasting, the development quickly turns into a quagmire, overcomplicated by attempts to capture all details, where accessing and maintaining such data becomes a nightmare, and no model is considered good enough.

    Instead of striving for illusive precision, when it comes to long-term forecasts, the key to gaining control is making cash-flow forecasting a continuous, e.g., monthly, discipline within the investment process. This can be achieved by an integrated front-to-back, cash-flow forecasting solution that can readily make real time data available across the organization.

    By integrating with a firms' investment book of record, such a solution could deliver critical visibility on liquidity and exposure across all asset classes. This vital tool can enable LPs fast access to consolidated data, to accurately and credibly assess liquidity exposure and reliably inform allocation decisions.

    Innovation like this would not only enable LPs to compare apples (public markets) and oranges (private markets) more accurately, but empower illiquid asset teams with statistical data, to quickly demonstrate what they already know to be true but lose sight of in the haze of a global market event: that private assets do not correlate, in the long term, with their public market counterparts. This is the fundamental premise upon which multiasset portfolios are formed, to weatherproof, come rain or shine.

    Thomas Meyer is Luxembourg-based product manager, director of alternative investments at SimCorp. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.

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