The Observer


Explicit policies for handling unanticipated cash requirements are a crucial tool for investors in illiquid assets

by Kristy Jansen, Tilburg University and Patrick Tuijp, Ortec Finance, University of Amsterdam

Over the past decades, the average illiquid asset allocation of the largest pension markets in the world has increased significantly, from an average of 4% in 1997 to 25% in 2017. Although there exists a large body of research that studies the benefits and challenges of investing in illiquid assets, the attitude and behavior of investors in illiquid assets have not been studied in details yet. The growing trend of pension fund investments in illiquid assets shows the importance of understanding how investors view illiquid assets and how they deal with the illiquid nature of these assets.

As a first step towards achieving this understanding, we have interviewed five Canadian pension funds (203 billion, or approximately 9 percent of total pension assets in Canada) and nine Dutch (342 billion, or approximately 26 percent of total pension assets in the Netherlands) on the investment and management decisions towards illiquid assets. Canadian pension funds on average invest 34% of their portfolio in illiquid assets, while this equals 14% for Dutch pension funds. We have interviewed these survey participants regarding the role of illiquid assets in the strategic asset allocation, the valuation of illiquid assets, and liquidity management.

The complete research has been published as a Survey Paper by Netspar (Network for Studies on Pensions, Aging and Retirement).[1]

Best practices
Four best practices emerge from the results of the survey. First, investors should have a clear motivation for investing in illiquid assets, as this may depend on the role that illiquid assets play in the overall portfolio. Second, investors should be aware of the valuation methods used for illiquid assets that they invest in, so as to correctly interpret their portfolio value, risk measures, and solvency position. Third, to assess the adequacy of liquid resources in the portfolio, investors should regularly analyze their current and future liquidity needs. Fourth, investors should have an explicit policy regarding which methods to use and in which sequence to free up cash when immediate liquidity needs arise.

Strategic asset allocation
When asked about the main reasons for investing in illiquid assets, survey participants most often indicated the attractive risk-return tradeoff, with diversification benefits as the second reason. The Canadian survey participants indicated steady cash flow and liability hedging as main reason more often than Dutch survey participants. Figure 1 summarizes the results for Canadian and Dutch survey participants separately.   

In terms of asset allocation towards illiquid assets, Canadian survey participants often mentioned that they may deviate from strategic asset allocations depending on a specified target return on investment for illiquid assets, while Dutch pension funds most often indicated ALM studies as the main basis for their allocation decision. One Canadian survey participant stressed that the fund would like to achieve a higher allocation to illiquid assets, but that insufficient investment opportunities that meet their target return were available at the time. Canadian funds in our survey report that they apply a formal or informal upper limit for the allocation towards illiquid assets varying from 15 to 80%, while many Dutch pension funds in our survey report upper limits of 20 to 25%.


Figure 1 - Reasons for investing in illiquid assets This table summarizes the number of Canadian and Dutch survey participants who mention one of the following main reasons to invest in illiquid assets: steady cash flows, smooth valuation, risk-return trade-off, liability hedging, and diversification. The total number of survey participants is five, and survey participants could mention more than one reason.

Valuation of illiquid assets
For the valuation of illiquid assets, Canadian funds in our survey manage their own illiquid assets and managers were stated to usually apply discounted cash flow (DCF) methods for real estate and infrastructure, and EBITDA[2] multiples or the public market equivalent (PME) for private equity. As opposed to Canadian pension funds, their Dutch counterparts generally manage illiquid assets externally, where the external manager applies similar approaches for valuing illiquid asset classes.

Most of the Canadian and Dutch survey participants indicated that they determine expected returns on illiquid assets through a benchmark-plus-spread approach. The spread may include elements such as liquidity and asset management skill, although these components are not necessarily made explicit.

Liquidity management
Regarding the liquidity management policies, many funds indicated that they have either implicit or explicit policies to ensure that sufficient resources are available to fulfill immediate obligations. These policies include maintaining a cash buffer, using the repo market, or securities lending. The survey participants mentioned that their least preferred option is selling existing positions to generate cash. Should it be necessary to do so, then they would prefer to sell liquid assets (e.g. liquid listed equities and government bonds with high ratings) first since they hold large quantities of these and since such assets can be sold against relatively low costs. This liquidity preference highlights the importance of the relation between, on the one hand, the allocation to illiquid assets and, on the other hand, the remaining available liquid asset buffer for liquidity management purposes. Although all survey participants indicated that they would approach liquidity needs in this manner, not all of them have explicit formal policies in place.

Many survey participants perform liquidity stress tests to analyze whether sufficient cash and liquid instruments are available to cover immediate obligations under adverse market conditions. The survey participants report that the cash buffer should be sufficient in most cases, and they do not expect forced selling of assets to free up cash under adverse market conditions. The main cause of an immediate cash requirement mentioned by survey participants is the need to make margin payments on derivatives. Survey participants indicated that for other sources of immediate cash requirements, such as capital calls by private equity funds and payments to retirees, they apply either cash flow planning or specifically set cash aside.

[2] EBITDA is the abbreviation for Earnings Before Interest, Taxes, Depreciation and Amortization.

Kristy.jpg Kristy Jansen, PhD Candidate, Tilburg University The Netherlands

Kristy Jansen is a fourth year PhD Candidate at Tilburg University and affiliated with the Dutch Central Bank, both located in the Netherlands. Her primary research interests are asset allocation and pricing of illiquid assets and the trading behavior of institutional investors. Kristy started her PhD in 2016, directly after she had finished two Master’s degrees. Kristy earned a Bachelor’s degree in Econometrics, a Master’s degree in Quantitative Finance and Actuarial Science, and a Research Master’s degree in Finance from Tilburg University.

Patrick_Res.jpg Patrick Tuijp, Team Leader Scenarios & Asset Valuation, Ortec Finance

Patrick Tuijp leads the team that is responsible for the calibration and customization of Ortec Finance’s real-world scenario set, the accompanying client service support, and scenario-related consultancy projects for the global client base of Ortec Finance. Patrick obtained his PhD in Finance at Tilburg University. He was an Assistant Professor of Finance at the University of Amsterdam from September 2013 until September 2015. Patrick joined Ortec Finance as a Quantitative Financial Analyst at the Scenarios & Asset Valuation solution in September 2015 and became Team Leader in March 2019.