Knowledge summary
- Cash might not be appropriate for strategic benchmarks.
- Privates may not be as illiquid as commonly perceived.
- In most cases, recent market stress hasn’t translated into fundamental distress.
Erika Murphy, CFA is a portfolio manager on a team that manages multi-asset class portfolios on behalf of institutions, including pension plans, and endowments and foundations. Here she shares her insights on three topics she has been asked about during recent conversations.
1. Consider allocating cash opportunistically.
In our E&F client portfolios, we typically focus the strategic asset allocation around asset classes that can capture a risk premium, such as equities, bonds, and alternatives. We favor these asset classes because they also offer an opportunity to capture additional security selection alpha. Cash, however, does not capture either. For these reasons, we prefer to allocate to cash opportunistically rather than in a policy benchmark. For example, you might see our E&F client portfolios holding more cash later in the economic cycle and during recessions—but we do not want to be forced to hold that cash exposure in early cycle environments when we could deploy it to higher returning asset classes.
2. Manage private markets’ liquidity in context.
In large part, private market liquidity depends on the maturity of the privates’ program, the type of private exposure you hold, and market conditions.
For a young, less diversified privates’ program
You might not be able to rely on distributions to fund any contributions because new funds do not typically distribute capital back to limited partnerships (LPs) in the first three to five years. This is because most newer funds focus on deploying capital over the first three to four years. You might need to tap your public market exposure for your liquidity needs, and that can have implications for your asset allocation.
For a mature program in privates
It takes a new privates’ program at least five to seven years to mature, depending on the sub-asset classes targeted. Use of secondary purchases of older funds may allow private programs to mature faster. Generally speaking, however, credit funds are shorter duration, buyouts are in the middle, and venture capital tends to be longest duration. Once mature, historical distributions have covered most of the required funds during capital calls, on average. In other words, mature privates’ programs can be self-funded during average market conditions. During downturns, when liquidity might be more challenged, both capital calls and distributions tend to go down together, but it is possible that mature programs will not be fully self-funded for a period (i.e., less distributions than can cover capital calls).
Market conditions and stress scenarios
The contribution and distribution relationships described above hold when looking at historical averages, but if you look past the averages and evaluate a stress scenario like the Global Financial Crisis, there are additional considerations that may change the playing field.
- Contributions and distributions may fall relative to historical averages. For example, buyout contributions are historically 50%-80% lower than average in stress events, depending on the vintage year.
- However, contributions still often outweigh distributions in many private asset classes. In 2008, private equity capital calls were sometimes 3x distributions, and in some cases private credit calls were north of 5x distributions—especially if you held distressed exposure. Asset allocators with private exposure should have a liquidity plan in advance of stress conditions to address imbalanced capital calls that may occur over a market cycle.
- Later in the cycle, it could make sense to hold the line on private exposure and make sure you have ample public market exposure to cover any capital calls, especially for any distressed allocations.
Evergreens
Endowments and foundations should also be aware of evergreen private structures, which provide access to private assets but do not require capital calls or have a traditional fixed lifespan. These fund structures typically leverage the secondary markets to invest in mature private assets—such as higher quality buyouts, for example, and provide some ongoing liquidity to investors in the fund.
3. The recent market sell-off may be more driven by negative sentiment than by weak fundamentals.
This may be an uncommon take, but in my view, there is minimal distress right now. In public markets, we are seeing attractive valuations in some pockets: China, small caps, and value remain areas of economic uncertainty—however, we are observing consensus estimates stabilizing and we are hearing from some of our underlying security selection managers that markets have already priced in much of the downside risk.
In private markets, venture capital valuations have been slashed due to fundamental concerns, and some attractive opportunities are emerging in the secondary private markets—especially in higher quality buyouts. We are not hearing much about forced sellers. Some large asset owners might want to trim their private equity exposure, but not many of them are forced to sell at any price.
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