Weatherproofing your multi-asset portfolio with illiquid alternatives

Read the article and learn about:

• The impact of consistent allocations, on diversification and performance
• Obstacles, including the denominator effect, which challenge multi-asset allocation strategies
• The rebalancing nature of illiquid investments in times of market volatility
• The rationale for a real-time, integrated cash-flow forecasting solution

Thomas Meyer
Product Manager, Director Alternative Investments, SimCorp

Connect with Thomas on LinkedIn

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 that is able to withstand market shocks, is more difficult than widely assumed. In this article we explore the role of market practices and short-termism, which stand in the way of strategic allocations, and why real-time cash-flow forecasting may hold the key to true diversification.

Recently, CalPERS Head of Private Equity, Greg Ruiz, reflected on why its renowned program has 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. In essence, this often leads to portfolios that are overexposed to certain vintage years, and that are poorly diversified, thus destroying the expected benefits of risk-adjusted assets, such as alternative investments.

Ruiz’s reflections could well be the key to riding out the current global market event, if we can ascertain just how LPs can sustain their approach to multi-asset allocation, in order to weatherproof their portfolios against the storms in the market. To understand this, we need to first look at what obstacles lie in the path of diversification.

The ‘denominator effect’ ?

‘Animal spirits’ may occasionally be one such issue, but there are also other dynamics in play. 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% infrastructure’. Following these rules implicitly allows market quoted assets to drive the portfolio dynamics. 

If we take the typical definition of 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 impact that crises have on institutional multi-asset portfolios.

This imbalance creates a temporary over-allocation of illiquids within the total portfolio, causing many LPs to take a typical short-term market risk perspective and put a stop on any new fund allocations, or even selling off current commitments in the secondary markets, in favour of rebalancing allocations and increasing liquidity, during volatile conditions.

For long-term oriented investors there is a ‘cost of looking’ - if LPs are too much influenced by temporary market swings they essentially inject artificial volatility from the public markets into the private markets. This self-fulfilling prophecy causes an additional challenge, where selling off private assets is usually only possible under highly unfavourable 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 to sell off what they can, precisely at a time when it is mostly likely to dry up.

In this sense, basing investment decisions on the denominator effect can be considered an act of self-harm, where the LPs add man-made risk to their allocations, caused by overly rigorous market rules, that have simply not been adapted to the characteristics of illiquid assets, especially in times of crises.

If we look at the current global market event, it appears investors have to some degree been absorbing the lessons of past market crashes and have correspondingly adjusted their internal rules. At least at this point in time, it looks as if the fear of the ‘denominator effect’ in reaction to the COVID-19 downturn, is overblown, with a recent survey suggesting only 26% of investors are cutting their allocations to private equity. However, there is always the potential of a ‘second wave’, meaning that the ‘denominator effect’ may well strike.

Keep calm and carry on

Private equity and real assets resist market transactions as a means to rebalance and provide stability to multi-asset portfolios. It is one of the rudimental characteristics that define it from traditional assets, such as equities. Despite this, a second, major problem is the disconnect between short-term signals and long-term performance.

Take the GFC (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 feared in 2009 . To draw a key lesson from the GFC 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. Indeed and as CalPERS’s Greg 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 therefore the advisable course for action. However, this is easier said than done, as often there are also cultural issues at play. One of the contributing factors that perpetuates the artificial risk mindset of most LPs in a crisis, is the lack of counter-argument from their illiquid asset teams. Here, risk management is predominantly approached by acumen, due diligence, contractual terms and conditions, and monitoring, but these teams do not have the quantitative models and tools to communicate risks in the ‘value-at-risk’ language their organizations urgently demand.

If 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 counter argument from the illiquid asset teams, eliminating the hasty decisions that a public market risk perspective often triggers.

It’s all about cash flow

Consequently, weatherproofing has to start long before a crisis, with a consistent approach to meeting and maintaining allocations. The ensuing hunt for liquidity that many LPs fall into, in volatile times, tells us that 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 it is 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. Essentially, the models employed, must be able to triangulate, in order 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, where they overcomplicate matters by attempting to capture all details, where accessing and maintaining data becomes a nightmare, and finally no model is 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 (IBOR), such a solution could deliver critical visibility on liquidity and exposure across all asset classes.

Integrated cash-flow forecasting is a vital tool that enables LPs fast access to consolidated data; both from vendors and the firm’s own 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 to clearly demonstrate, using statistical data, what they already know to be true but is lost 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 multi-asset portfolios are formed. To weatherproof, come rain or shine.

¹ Such as infrastructure, real estate, forestry and farmland, energy, and commodities
² See Mendoza (2020)
³ See Gottschalg (2020)
⁴ See Aalberts et al. (2020)
⁵ See Aalberts et al. (2020)

BIBLIOGRAPHY
Aalberts, Edo, Peter Cornelius and Lucas van der Kamer. 2020. ‘Cash Flows During Financial Crises’. Paper. AlpInvest. June.
IPEV. 2018. ‘International Private Equity and Venture Capital Valuation Guidelines’. December.
Gottschalg, Oliver. 2020. ‘Initial insights into the possible impact of the Covid-19 crisis on private equity cash flows in 2020’. Working paper. April.
McNulty, John. 2020. ‘Eaton: Denominator Effect Overblown’. Private Equity Professional. May.
Mendoza, Carmela. 2020. ‘CalPERS head of PE on why its program has underperformed’. Private Equity International. September 15.