PGIM and GIC redraw the illiquidity risk premium map

Private markets are not only driving this ‘new age’ economy, they are also comprising a larger and larger slice of institutional investor portfolios and that is leading to some new realizations, according to Bruce Phelps, managing director and head of IAS at PGIM -- the $1 trillion investment management business of Prudential Financial. Phelps and his colleagues within the PGIM institutional advisory unit are watching closely how investors not only measure liquidity, but how they manage risk in light of carrying more assets that they are not able to offload quickly should cash be needed to meet benefit payment needs in the case of pensions or to rebalance assets. Along with the Singapore sovereign wealth fund GIC, Phelps and his team worked to come up with a framework that allows investors to meet their liquidity needs alongside the need for portfolio performance. Their findings are detailed in a new report, “Building a Better Portfolio.” With more than $100 billion in assets, the GIC has investments in private equity and real estate. “Portfolios with large allocations to private assets need to meet substantial cash flow obligations,” said Kevin Bong, director of GIC’s EIS department in a press statement. “This is especially challenging in today’s environment. The framework we have created enables long-term investors to analyze the liquidity consequences of different commitment strategies and stress scenarios. This will help investors target the best portfolio performance for a given level of liquidity risk.” “Going into the pandemic, there was a fair amount of cash on hand,” said Phelps. “Because if there was to be a disruption, investors wanted to have money on hand to put to work. Investors are ready to invest more.” Bruce Phelps But he says the question is more serious than that, it is about the confidence CIOs can have that they are able to add private assets and meet liabilities consistently no matter the current market conditions. Phelps observed that it was the markets of 2008 and 2009 that drove so many investors to broaden their holdings in the illiquid space and holding on to those assets certainly paid off. Currently the secondary market in private equity has dried up but there are very few forced sellers of illiquid assets, Phelps observed. Consequently, it is also a tricky time in predicting liquidity demands when GPs make capital calls stemming from prior commitments as well. He argued a portfolio construction framework was needed as more and more investors allocate to private market assets such as hedge funds, private equity, private real estate and private credit. PGIM recently enhanced and expanded its asset allocation framework called OASIS, which stands for Optimal Asset Allocation with Illiquid Assets. It is set up to help investors analyze their portfolio’s ability to respond to liquidity demands. The framework measures the potential tradeoffs between asset allocations, portfolio performance and the frequency of certain liquidity events of differing severity. GIC provided the insight to explicitly model the cash flow requirements in private portfolios to better gauge a portfolio’s liquidity. Junying Shen, senior associate of PGIM, has been working with chief investment officers to help them determine how much of an allocation they can safely carry to private assets. Junying Shen “The liquidity experience of the investor depends on the entire portfolio, not just the private assets,” said Shen. “We have to put the portfolio in context to see if the liquidity is available. It really depends on what the allocation looks like if your portfolio is exposed too much to illiquid assets when we look at cash flows.” The team wanted to know what would happen to overall portfolio liquidity would look like in a market downturn and what it would mean for private assets. Coming out of the pandemic, a strong recovery -- no matter the asset allocation -- the private market portfolio expands. The shape of the market recovery, whether L-shaped or V-shaped, could have different impact of the portfolio liquidity and performance. Specifically, during an L-shaped recovery, which is a slow rate of recovery, the number of liquidity events are higher and the performance is lower. Often investors treat private equity like small-cap stocks, added Phelps, and then put those assets in a traditional asset allocation framework. “We have felt that was not the way to go,” he said. “Really market volatility is not your biggest worry (mean variance optimization) -- instead it is about finding yourself in a position forced to sell due to liquidity.” Bringing the cash flow characteristics to the fore is a way to help CIOs change the mix to see what changes about the probability of insufficient cash flows, according to PGIM. “The world is moving more into private markets,” added Phelps. “And if you are a CIO and you see opportunity in private markets you need a tool to ensure your success. “

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