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.