Institutional investors should ensure they have enough liquid assets to avoid capital calls, given that the economic recovery from the coronavirus pandemic is likely to be fairly slow. Those are some of the key findings of a new study by GIC and PGIM.

The Singaporean sovereign wealth fund teamed up with the US-based manager to publish a new study on Monday (April 13) that upgrades the latter’s asset allocation framework, which covers illiquid private assets, integrating liquidity measurement and cash flow management to construct a multi-asset portfolio. The private market investment teams of GIC, including private equity and real estate, were also involved in the study.

While GIC and PGIM's research efforts weren’t prompted by the outbreak, the record levels of volatility clearly demonstrate the importance of portfolio liquidity to all investors, including GIC, Grace Qiu, senior vice president of the institution’s investment strategy department (EIS), told AsianInvestor.

“We worked on the paper with PGIM over the last 12 months, recognising early on the relevance of liquidity to portfolio management for PGIM’s institutional clients and GIC,” she said.

"We decided to undertake this research because there was no asset allocation methodology for a portfolio containing both private and liquid public assets that formally recognised the unique liquidity characteristics of private assets," added Bruce Phelps, head of institutional advisory and solutions for PGIM.

Portfolios generally recover from volatility shocks, but a liquidity shock can often be a matter of survival.

"Portfolios generally recover from volatility shocks, but a liquidity shock can often be a matter of survival," he added.

The modelling framework defines a U-shape and V-shape recovery as one that lasts more than four years and less than one year respectively. Under the former, rebalancing and capital call liquidity shortages would arise.

The study comes as the coronavirus pandemic continues to send waves of volatility through the stock and bond markets that have seen billions of dollars evaporate over the course of a few weeks.

As a result, asset owners may encounter unexpected and unpredictable liquidity challenges when fund managers, or general partners (GPs), make capital calls from previously made commitments.

“Both parties recognised the importance of gaining a good understanding of the impact of liquidity on investors’ portfolios, especially so for large asset owners,” said Qiu.

U-SHAPE VS V-SHAPE RECOVERY

The importance of portfolio liquidity is particularly important now, with many large investors having built their exposure to private assets in recent years to improve their investment returns.

Some of the most notable examples include Korea’s Public Officials Benefit Association, which has more than half of its W13.9 trillion ($11.7 billion) portfolio in alternatives. Japan’s Government Pension Investment Fund, for example, has also built its allocation to alternatives. While this accounts for just 0.37% of its ¥161.8 trillion ($1.49 trillion) in assets, that is still $5.51 billion.

The economic landscape is unlikely to improve any time soon. According to the latest "Analyst Pulse Survey" from Fidelity International, more analysts now expect disruption caused by the virus to drag on all year, rather than just the first half.

"Institutions with large allocations to illiquid private assets were faced with redemption or other cash requests," said PGIM's Phelps. "These requests were difficult to meet as the private assets could not be sold – at any price. 

"We believe that recent events will highlight the importance of incorporating liquidity risk management in portfolio construction and become a key focus for CIOs.”

Under GIC and PGIM’s study, there is a marked difference in returns between a V-shaped recovery and a U-shaped one. If an investor had a baseline portfolio with an initial $1 billion in AUM and an asset allocation of 15% in US buyout funds (see table below), and it chose to maintain the target net asset value percentage of the overall portfolio, it would enjoy a return of 11.3% in a V-shape recovery. But that return would be 6.6% under a slower economic recovery.

Click for full view

During the U-shape recovery phase, a moderately severe capital call liquidity shortage would also occur three times on average over a 10-year horizon. Such shortages arise when investors exhaust both the committed but uncalled reserve, and the uncommitted reserve in the liquid passive portfolio for capital calls.

Qiu said that GIC was well aware of the need to maintain liquidity in its investment portfolio.

“GIC uses liquidity for multiple purposes: to facilitate our day-to-day operations; to carry out total portfolio rebalancing; to support active investing strategies across GIC, and; to serve as dry powder to take advantage of dislocation opportunities,” she added.