Is the convergence of liquid and illiquid alternatives really in the best interests of investors?
By Stephen Oxley (pictured), managing director, Institutional Relationship Group, PGIM – I read a prediction in one of those crystal-ball gazing missives that financial firms like to put out at the start of every year. It forecast that there will be continued blurring between hedge funds and private equity. I must admit I baulk at such an idea and find myself asking whether the convergence of liquid and illiquid alternatives is a desirable end and, if so, whose interests might best be served by an erosion of the distinction.
The argument for this perceived trend starts with the observation that some liquid alternative investment managers (hedge funds) are offering private market vehicles, while other investment firms have created semi-liquid ‘evergreen’ investment vehicles that contain private assets. Clearly, managers of capital will find it convenient if they can persuade their clients to lock up their money or offer what are essentially illiquid assets in a format which relies on matching redemptions with investments. But, is it in the interest of investors, the owners of capital?
The evolution of alternative investments in two parallel universes consisting of liquid (essentially hedge funds that trade public markets) and illiquid (private assets such a real estate, private credit and private equity) has happened not only because both worlds involve quite different investment activity, but also because they have very different liquidity profiles. Blurring the taxonomy will not help investors navigate this complex, two-fold world.
To support their forecast of the merger of liquid and illiquid alternatives, the authors make the point that hedge funds are fund structures, not an asset class. We can debate this point endlessly, but what is important is that hedge funds can behave like an asset class. They have two important characteristics; they are liquid and aim to diversify long-only public markets portfolios. As we move into a period when arguably valuations are stretched and volatility in both equity and fixed income seems likely to increase, having a diversifying component to a liquid public asset portfolio makes even more sense. And that exposure needs to be housed in an appropriate liquid structure. It is the investment activity that prescribes the structure, not the other way around.
Institutional investors need to think about not just asset class diversification when constructing portfolios but also liquidity diversification. Being diversified by liquidity helps ensure liabilities can be met and that investment funds are in a position to rebalance or take advantage of market dislocations. Private market investments should also be considered in the context of how they relate to each other. There is value in modelling the pacing of commitments, drawdowns and cashflows.
Apparently, investors are reorganising their manager research teams to adapt to the new zeitgeist. I do not see much evidence of that. To analyse the attributes of a good private credit manager versus a fixed income relative value manager or a long/short equity manager versus a direct lending strategy requires different skills and experience, not least because the structure of their portfolios, the legal entities, regulation, the cashflows, risks, outcomes and fee structures are very different.
Perhaps the blurring-of-the-lines trend is really born of a desire to make life easier for the alternatives marketer – if they only had one conference to go to, one set of people to talk to and one perpetual vehicle to put them in. As Taylor Swift might say, “Maybe this is wishful thinking, probably mindless dreaming.”