John Greaves, director of fiduciary management at Railpen, speaks to Piyasi Mitra about how the pension fund assesses an investor’s capacity to invest in illiquid assets.
Railpen, the investment manager of railway pension schemes in the UK, has developed a framework to help investors assess their capacity for illiquid assets. Railpen oversees £34 billion of AuM and the framework is aimed at 100+ defined benefit pension clients that it supports.
Railpen set out the framework in a recent research paper and highlighted that key considerations included liquidity sources, private market cash flows and portfolio liquidity risk management. Railpen’s approach includes an analysis of market conditions and stress-testing of liquidity assumptions to support portfolio construction.
John Greaves, director of fiduciary management at Railpen, discusses the framework and addresses common misconceptions about investing in these alternatives. It’s not as easy as some people think to extract the illiquidity premium from unlisted assets, he says.
How does Railpen’s new framework tackle the challenges and opportunities of adding illiquid assets to a client’s portfolio?
In the research paper, we aim to answer the question of what an appropriate allocation to illiquid assets might be for different types of investors. When developing it, we had to think about how to maintain a high quality of implementation through time. We touched on areas like vintage diversification and maintaining market relationships and access while having the flexibility for different scenarios.
The scope of the research did not extend to assessing the benefits that illiquid assets can bring to a portfolio, but rather how much is a reasonable maximum allocation – assuming there are benefits that one would otherwise look to maximise. The challenges included uncertain returns (like all growth assets), smoothed valuations, uncertain cashflows, unpredictable secondary markets, fund and asset structures, cost and potential misalignment between asset owner and manager if externally managed.
What are the key parts of Railpen’s framework for allocating and managing illiquid assets, and how have they changed based on your latest research?
Enhanced liquidity management is one of the key outcomes. Liquidity management is often focused on surviving short-term extreme funding scenarios where there are large draws on cash reserves from derivative margin payments and other funding calls. Our research focused on market liquidity – which is managing a portfolio of liquid and illiquid assets through time in a way that you can steer the portfolio through a wide range of scenarios without undermining its ability to generate good long-term returns. Our approach to liquidity management has changed significantly in recent years. We are more focused on the liquidity structure of investments, what an exit would look like, and what we can do to the portfolio to improve flexibility.
For closed defined benefit (DB) schemes, what unique considerations exist for allocating illiquid assets compared to open DB schemes?
Closed DB pension schemes naturally have a shorter investment horizon than open schemes. Typically, the long-term goal is a buyout, which requires full liquidity. Some investors can in-specie illiquid assets but that is increasingly rare and doesn’t work in our multi-client setup as the sections in the scheme own slices of the underlying investments, rather than whole assets. This makes in-specie very challenging even if the insurers had appetite. With a reasonably short investment horizon and a requirement to be fully liquid, this really focuses the mind on running off illiquid assets cost-effectively.
For longer duration assets this typically involves secondary market transactions. While we can create an internal market for our sections, we are conscious that we must treat the buying and selling client fairly so we keep a close eye on secondary market transactions and will transact externally where required. Of course, there is growing interest in running closed DB schemes, either in a consolidation vehicle or large schemes with the sponsor’s support. With this sort of objective, the tolerance for illiquidity might persist for a little longer but eventually all closed schemes must be fully liquid to manage the pension cashflows appropriately.
What role does diversification play in your approach to allocating illiquid assets?
The benefits of illiquid assets weren’t the focus of the research but clearly, diversification is one of these benefits. Many illiquid assets access parts of the market that are hard to access through liquid public markets. The underlying cashflows that you can access might be driven by different factors which can be very helpful to diversify the risk of the overall portfolio. While the impact of lagged and smoothed, appraisal-based valuations can give the perception of diversification, that isn’t true diversification, so we try not to focus, or rely, on that too much.
“While the impact of lagged and smoothed, appraisal-based valuations can give the perception of diversification, that isn’t true diversification, so we try not to focus, or rely, on that too much.”
What, according to you, are the misconceptions about investing in illiquid assets, and how does Railpen address these in client communications?
There is a big push to ensure retail investors have access to the potential for additional returns and diversification in illiquid assets. Typically, this is through a workplace pension but there is growing interest in fractionalisation to give retail investors access. I think there is a misconception from some stakeholders that it is quite easy to extract a premium from these assets versus liquid assets and all investors should be able to benefit from it. It is much harder than one might think and the additional premium comes at a cost. There is no free lunch in investing. Investing in illiquid assets requires sophisticated investment expertise.
We ensure our board and clients understand the risks and the uncertainty of investment outcomes when allocating to these assets. Another misconception is about liquidity. It can take a very long time to exit certain assets so we ensure clients fully understand these risks.
“I think there is a misconception from some stakeholders that it is quite easy to extract a premium from these assets versus liquid assets and all investors should be able to benefit from it.”
How do you see the regulatory landscape evolving for pension funds investing in illiquid assets?
The regulatory landscape is supportive and perhaps directive to encourage investors to allocate to illiquid assets, particularly domestic assets. The focus should be on creating the conditions for great assets to come to market: strong economic growth, fair and equal shareholder rights, stable policy, and a supportive long-term strategy for the UK.
