Efficient flows – Understanding liquidity in alternative investment funds
By Tom Kehoe CAIA, Global Head of Research, AIMA – We are at a very interesting inflection point in our capital markets. Ten years following the last significant global liquidity crisis which fuelled the subsequent global financial crisis of 2008, commentators are starting to talk up the next one.
After a long post crisis period where ultra-loose monetary policy supported an unprecedented USD15 trillion of quantitative easing by central banks globally which boosted asset prices and profit margins, conditions in global markets today are considerably different.
For a start, central banks are normalising interest rate policies with several central bank rate hikes being implemented this year, supported by a policy to have more monetary tightening. Geo-political concerns led by the protectionist policies of the Trump administration and Brexit are both creating currency tremors and inflationary pressures – global liquidity has contracted quite substantially.
Anticipation and preparation are essential for all fiduciaries. There are seasons to our capital markets and perhaps, for now, the halcyon days that markets have enjoyed over the past ten years are waning. In response to this period of ever-increasing disruption, together with the CAIA Association, the fourth instalment in our series of trustee education, ‘Efficient Flows: understanding liquidity in alternative investment funds’, explores liquidity.
This paper examines four facets of liquidity and how to think about them across an increasingly diverse alternative investment fund universe. Explaining the key concepts surrounding liquidity, it appraises the different types to the different levels offered by a variety of alternative investment funds. Apart from the efficient management of capital, liquidity concerns the alignment of manager and investor interests, who need confidence that they are being offered the greatest liquidity available without affecting the ability to grow capital. For managers, who must accommodate the needs of their investors, liquidity arrangements must also be tailored to their strategies.
Following 2008, many managers responded to investor calls for greater control over fund liquidity, custody arrangements and transparency for investments. Managers began to collaborate and form bespoke liquidity conditions for specific alternative investment funds or groups of investors to match the requirements of invested instruments, and established investor-level gates to prevent forced portfolio liquidation to meet redemptions.
For illiquid or niche strategies, the use of gates is more popular. By contrast, 90 per cent of CTA and 80 per cent of macro-related funds today deploy no gates. But most liquid strategies now attempt to close the gap between themselves and traditional long-only funds: many liquid equity-focussed strategies now offer monthly liquidity options.
For those funds that are long term and illiquid, infrequent redemption periods are common and frequent liquidity windows work against the strategy. It is essential that these managers have a large pool of committed capital. Many illiquid funds are beginning to launch new share classes with more favourable liquidity terms like soft lock-ups, and often offer investors incentives to keep capital with the manager for extended periods, as in private equity fund vehicles. In terms of notice periods, managers should be able to plan with the capital they manage. There should be an awareness between the manager and investor that certain strategies need time to realise value.
Broadly, from an investor’s perspective, portfolio and fund liquidity should operate in partnership. Liquid underlying assets allow shorter redemption notice and lock-up periods. Liquid funds provide less latitude to managers to gate or suspend redemptions, resulting in a smaller price impact and negative effect on remaining fund liquidity in the event of a redemption.
Managed accounts can be customised to meet an investor’s specific goals and offer greater transparency. Many arrangements now allow the fund’s underlying positions to be viewed live, and the investor is much better positioned to assess liquidity. According to Credit Suisse*, demand among institutional investors for managed accounts reached a seven-year high in 2018, with 58 per cent of investors indicating that they currently use managed accounts. A further 29 per cent said they plan to increase their allocations.
For Investment Managers, the AIMA Due Diligence Questionnaire (DDQ) contains helpful questions relating to the liquidity of the underlying assets in the fund portfolio and speed of possible liquidation. It also helps address whether gates and side-pockets have been utilised previously and under what circumstances.
Interest alignment between managers and investors is becoming increasingly common. Related to this, there is an ongoing debate as to what is the right fee structure that investors ought to pay fund managers in return for them holding their capital. Some of the industry’s largest investors acknowledge that when alternative investment funds offer greater levels of liquidity to investors, they should be compensated accordingly. All things being equal, where a funds underlying investments are highly liquid, investors consider where in the lifecycle the fund is when determining whether the fund should be greater compensated via a fee increase. Another way to consider the trade-off is that many hedge funds offer reduced fees to investors who agree longer lock-ups. Albeit this is an emerging trend, it’s highly unlikely that any compensation being agreed between the fund managers and the investor will be settled by the level of liquidity on offer to the client.
As in every investment arrangement, communication between investors and managers is key when it comes to liquidity. Managers should clearly explain their liquidity arrangements to investors. Investors, meanwhile, need to know which questions to ask. Our recent paper offers a guide to help them in this process.
*Mass Appeal, Bespoke Approach: A Tailored View of Managed Accounts, Credit Suisse (2018)