Kondi Nkosi | Country Head | South Africa | Schroders | mail me |
Private markets are less liquid than public markets. Locking up funds for a significant period is unfamiliar to many private investors. Regulators worldwide are concerned about risks associated with private assets during market stress.
A key regulatory focus is on liquidity mismatches in open-ended funds investing in illiquid assets. These mismatches occur when funds allow excessive flexibility on redemptions.
Private asset managers are addressing this challenge by evolving fixed-term funds into indefinite-term funds. They are also introducing open-ended semi-liquid funds and offering new regulated structures.
Semi-liquid, or ‘evergreen’ funds
Semi-liquid funds balance liquidity with the potential for attractive returns by combining liquid and illiquid assets. These funds do not require capital lock-ups like closed-ended vehicles. However, redemption windows are infrequent and subject to limitations. These structures suit investors with longer-term time horizons.
The semi-liquid fund market is growing, with more providers offering diverse strategies. In these structures, investors transact with the fund manager at the prevailing Net Asset Value (NAV). This allows immediate deployment into a diversified portfolio at the fund’s current NAV.
Investing at NAV reduces public market beta compared to daily traded listed closed-ended funds. Closed-ended funds rely on secondary markets for liquidity, where prices depend on supply and demand. However, liquidity in semi-liquid funds is lower than in listed closed-ended options.
How does liquidity work?
Semi-liquid funds deal less frequently, often monthly or quarterly. They include notice periods and can “gate” when thresholds are breached, limiting redemptions at specific dealing dates.
Well-constructed semi-liquid portfolios diversify by geography, sector, and asset type. A small allocation to liquid investments can provide regular and consistent liquidity. Liquidity management tools like redemption limits and liquid investment realization help control fund liquidity.
Understanding a fund’s liquidity mechanics is crucial for wealth managers allocating clients’ capital.
Portfolio construction and risk mitigation
Portfolios must prudently spread risk to avoid concentration risk. For example, exposing the portfolio to varied vintages creates baseline liquidity through distributions. Geographic, asset class, and sectoral diversification reduce risks from shocks impacting overall portfolio liquidity.
Semi-liquid funds may allocate some assets to more liquid investments. These assets can be sold more easily to meet redemptions on specific dealing dates. Investment managers must deploy new subscriptions efficiently while maintaining diversification.
In evergreen funds, cash balances or liquid securities pools are actively managed. The balances depend on subscription activity, redemption levels, and portfolio distributions. Funds maintain cash to meet redemptions and avoid selling long-term private assets at discounts.
Open-ended funds can use secondary sales to manage portfolio liquidity. Selling portfolio investments raises cash during low subscriptions and high redemption requests. Secondary markets have grown more liquid, but cyclical discounts remain common. Diverse portfolios enhance flexibility when selling assets.
Specific liquidity management tools
Managers design liquidity tools to align with the asset class’s long-term nature and prevent forced asset sales.
These tools vary by fund and investment strategy:
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Redemption notice periods
Investors must provide advance notice, often three months, for quarterly redemptions. This reduces impulsive behavior driven by market volatility.
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Redemption limits
Managers cap redemptions, such as 5% quarterly or 20% annually. Limits ensure liquid assets or cash meet redemptions, protecting illiquid assets from forced sales.
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Redemption suspension limits
During exceptional circumstances, managers may temporarily suspend redemptions and subscriptions to protect shareholder interests.
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Lock-up periods
New funds may impose lock-ups to develop portfolios and achieve diversification. Periods vary by asset class and strategy.
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Special procedures after suspension
When NAV calculation is suspended, shares cannot be issued or redeemed. Managers may introduce measures to liquidate assets and return funds.
These mechanisms balance investor access with fund stability. However, they may introduce risks and vary by jurisdiction and regulation.
What happens when an investor redeems their holding?
Redemption requests in semi-liquid funds are first offset by subscriptions within the same period. If subscriptions exceed redemptions, the fund may commit additional capital or make secondary purchases. Net outflows are met using the fund’s liquidity mechanisms.
If redemptions exceed thresholds, they are reduced pro rata to treat investors fairly. Unmet redemptions roll into the next dealing period unless canceled by the investor.
Liquidity management in other structures for private investors:
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Closed-ended funds
Closed-ended funds now feature innovations like single capital calls, shorter investment periods, and lower minimums. These features attract more private investors. Some managers operate liquidity windows, allowing investors to trade shares with others or a buyer of last resort.
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Closed-ended listed funds
Closed-ended listed funds, like UK investment trusts (ITs), offer liquidity comparable to traded equities. They are accessible through intraday trading and attract retail or mass affluent investors.
IT share prices may deviate from NAV, creating potential discounts when selling. While this attracts some investors, it must factor into decisions. Historical market disruptions have occasionally hindered matches between sellers and buyers.
In conclusion
In traditional ITs the share price can move independently of the stated NAV. Investors may face a situation, if selling, where the share price is at a (potentially significant) discount to NAV. Many investors favour the IT structure for exactly this reason, attracted to the potential to take advantage of a dislocation between the trading price and intrinsic value, but it must be factored in when making the decision to invest in these assets.
Obtaining liquidity has caused some issues in the past, with isolated instances of adverse market environments compromising the ability of sellers to find a willing buyer on the other side. In our view, this should be managed by appropriate portfolio construction and due regard to an individual client’s circumstances, such a time horizon, risk appetite and need for liquid access to their capital.
Related FAQs: Liquidity in private investments
Q: What are the main challenges associated with liquidity in private investments?
A: The main challenges include the highly illiquid nature of private investments especially private equity investments, long holding periods before an exit and limited secondary market options for selling stakes. Additionally, transaction costs and the degree of risk associated with these investments can impact liquidity.
Q: How do private equity funds manage liquidity for their investors?
A: Private equity funds often manage liquidity by providing a well-structured exit strategy, which includes planned buyouts or secondary market sales. They may also offer periodic liquidity events or distributions to help liquidity profile and cash flow for investors.
Q: What is the typical liquidity profile of private equity investments?
A: The liquidity profile of private equity investments is typically characterised as highly illiquid, as capital is usually locked up for several years until the fund can achieve a successful exit. This contrasts with more liquid investments like public equity or mutual funds.
Q: What are some strategies for equity investors to enhance liquidity in private market investments?
A: Equity investors can enhance liquidity by diversifying their portfolio across different fund structures, investing in private credit or selecting funds that have a history of successful exits. Additionally, understanding the investment minimums and structure can help in better asset allocation.
Q: How does the exit process affect the liquidity of private equity investments?
A: The exit process is crucial for liquidity as it determines when and how investors can realise their returns. Successful exits, such as through buyouts or public offerings, can significantly improve the cash flow and returns for equity investors, enhancing the overall liquidity profile.
Q: Are there any regulatory considerations impacting liquidity in private equity?
A: Yes, regulatory considerations such as those from the Financial Conduct Authority can impact liquidity by setting rules on fund structures and investment practices. This can affect the ability of institutional investors to enter or exit private equity investments.
Q: What role do institutional investors play in the liquidity of private equity funds?
A: Institutional investors often provide substantial capital to private equity funds, which can influence the liquidity profiles. Their investment choices, including the degree of risk they are willing to take, can affect how funds structure exits and manage cash flow.
Q: How can past performance of private equity funds inform future liquidity expectations?
A: Past performance can provide insights into a fund’s historical success in achieving exits and managing liquidity. Investors should analyse the track record of a private equity fund in terms of cash distributions and exit strategies to better understand future liquidity expectations.
Q: What are some common misconceptions about liquidity in private equity?
A: Common misconceptions include the belief that private equity investments are as liquid as public equity or that high returns guarantee easy exits. In reality, private equity investments are typically highly illiquid and achieving a profitable exit can take years.
