Testing the limits of a liquid diet

There is nothing private bankers like better than to find a few charts that can be called into action to convey a clear story in their presentations to clients.

For those many private bankers putting the case for shifting some money from liquid to illiquid assets, January furnished some highly useful chart opportunities.

Private investors expecting easy money in 2014 from a repeat of last year’s stellar stockmarket performance were quickly disabused of that notion in the first few weeks of the year. Stockmarket indices around the world dipped on fears about emerging market growth, presenting a sharp contrast with January 2013, when equities raced ahead.

Private bankers say returns on liquid assets are likely to be much lower this year than last year, with returns on many bonds likely even to be negative. It is time, they say, for private investors to increase holdings of illiquid investments in response – with a particular emphasis on private equity and real estate – though most are reluctant to set out benchmarks for illiquid assets’ share of the overall portfolio.

The case for illiquid investments is strong, at a time when stock and public bond market returns are likely to diminish, says Henrik Lundin, chief investment strategist for Nordea and head of asset allocation for Nordea Private Banking in Stockholm. “But it has been a big struggle to get clients to invest in something that is not very liquid,” he admits. “This creates some tough discussions with clients.”

One reason for this reluctance is the memory of the 2008 financial crisis, when investors responded to the prospect of economic and financial Armageddon by seeking to liquidate all their assets. They discovered, to their great shock, that some of their hedge fund assets in particular were more illiquid than they had thought, as hedge fund managers struggling with waves of redemptions imposed limits on what could be withdrawn and when. In addition, the notional, unrealised value of some private equity assets was marked down heavily in 2009 – making investors nervous.

Mr Lundin suggests clients might be reluctant to invest in illiquid assets because of the fear of a repeat of the 2008 crisis – making them determined to be “100 per cent sure they can sell their investments”.

Mark Andersen, co-head of asset allocation for UBS Wealth Management in London, subscribes to the consensus among private bankers that it is time to put more money into illiquidity, but he also accords with the general view that it is hard, in practice, to persuade them to do this.

Clients at UBS and other private banks hold 25 to 30 percent of their assets in cash and highly liquid short-term instruments, he estimates, citing his own experience and industry surveys. This arch-conservative approach will produce poor returns for a portfolio, but as private bankers try to convince clients of the need to take on more risk, “the first step is to get them start thinking about volatile investments, such as equities. Illiquid investments are the second step, which comes after that.” In other words, many investors are still, mentally, far from the point where they can countenance significantly more illiquidity.

Nonetheless, UBS recommends allocations of up to 11 percent of a portfolio in private, illiquid markets, for clients willing to go down this road.

However, private bankers argue that a close examination of the 2008 crash actually increases the case for illiquidity, rather than decreasing it.

“The novelty of the financial crisis is that it increased attention to illiquid investments because listed markets fell so much,” says Didier Duret, chief investment officer at ABN Amro Private Bank in Amsterdam. 

Private bankers say that the valuations of private equity funds rapidly returned to their previous values as the financial crisis eased. Moreover, private equity houses were able to take advantage of the credit crunch by snapping up assets at bargain basement prices, a strategy which increased their returns.

Far from believing that illiquid investments add risk to a portfolio, Mr Duret thinks they reduce it. “From a wealth preservation perspective, over the medium term it makes sense to have private equity and hedge funds”, he says. “They will increase the expected return you can get without increasing the risk you have to take by very much.”

ABN Amro Private Bank sees private equity opportunities in European SMEs (small and medium enterprises), while steering clear of larger deals because they tend to be highly leveraged. In the mid-cap area, private clients have backed Ciné France 1888, a private equity fund established by ABN Amro to fund French film production.

For clients who want something a little more liquid – though relatively high-risk –ABN Amro advocates distressed emerging market corporate and sovereign debt, which is extremely cheap because of a dearth of active investors.

Mr Duret suggests a liquidity compromise for clients with under $20m (€14.5m) or so, who are fearful of illiquidity – investing in hedge funds with relatively illiquid strategies, rather than private equity, which requires several years’ commitment. He acknowledges that there is a “psychological aspect” to investing in illiquidity, which private bankers should take account of, with some investors worrying about the lack of a quick exit from their investment.

Bank Julius Baer also extols the virtues of exposure to illiquidity. Simon Lamprecht, specialist in premium solutions in Zurich, cites the “illiquidity premium” for private equity – the earnings premium above listed equities which investors can demand as a quid pro quo for placing their money in investments unlikely to produce a positive return for several years. Mr Lamprecht puts this at an average of 3 per cent.

Julius Baer favours small and mid-cap private equity investments in Europe, avoiding most large buyouts, because pricing for them has reached pre-crisis levels.

The case for investing in illiquidity in 2014 is made by so many private bankers and other professional money managers that private clients can be forgiven for asking whether they have missed the boat. Has it become so popular that there is little value left?

“The expected returns in certain illiquid markets are less than they were 12 months ago,” says Iain Armitage, head of investments for Emea at Citi Private Bank. “But they haven’t come down as much as our expected returns for public markets.” Citi’s expected returns for promising areas of the illiquid market have fallen from 20 to 23 percent to 14 to 18 percent, he says.

Within the illiquid market, Citi Private Bank is keen on real estate as well as private equity. It sees potential in urban regeneration projects for commercial and residential property in British and mainland European cities. Mr Armitage believes these could offer returns of more than 15 percent, including both yield and capital growth.

The ‘liquidity trade-off’ – the higher returns available for accepting illiquidity – is one of the four main themes presented by Citi Private Bank in its Outlook document for 2014.

However, the Outlook also notes the high dispersion of private equity and real estate returns. For private equity buyout funds, the difference between top quartile and bottom quartile performance over the past three years is 19.2 percent, compared to 10.1 per cent for US equity mutual funds. Citi Private Bank believes that this dispersion can be navigated, however, by picking managers with a good track record. Citing data from Preqin, the alternative asset research firm, it finds that  the managers of 65 percent of private equity and real estate funds with top or second quartile performance go on to manage a top or second quartile successor fund.

Hedge funds are not necessarily illiquid - some produce daily net asset values and allow rapid withdrawals of all of an investor’s cash. However, private bankers say that the less liquid funds have their own illiquidity premium, relative to the more liquid ones. “The better hedge funds don’t have daily liquidity,” says Mr Andersen at UBS Wealth Management. He gives the example of hedge funds specialising in distressed debt, many of which offer withdrawals only monthly or quarterly.

Although private bankers are keen for clients to increase the illiquid part of their portfolios, they are reluctant to push them too aggressively. “The worst thing that can happen is for a client to buy assets that aren’t liquid, and then to give up on those assets after a few years,” notes Mr Lundin of Nordea. This can happen, he notes, if a client is persuaded to invest in private equity despite an inherent preference for liquidity. Many private equity funds charge penalties for early withdrawal.

Nordea is actively considering illiquid investments in real estate and infrastructure. 

Private bankers also emphasise the need to find illiquid investments that match investors’ risk preference.

For example, Matias Ringel, New York-based head of fund research at EFG Asset Management, part of the Swiss banking group EFG International, sees potential in private equity in oil exploration and production in under-unexploited US regions such as North Dakota. “It’s a high-risk strategy, so you have to be extremely careful, but private investors like continuous incomes”, he says. Revenues from oil wells can produce steady annual income streams of about 10 percent, estimates Mr Ringel.

In his view, lower-risk illiquid strategies for private investors include commercial and residential real estate lending in those northern European cities where property owners enjoy strong legal protection - with particularly strong current opportunities in Dublin and Berlin.

The wealthier end of Julius Baer’s client base for instance – those with $20m-plus invested through the bank – has a greater capacity for illiquid investments; in many cases such clients can afford to tie up money for longer.

Richer private clients are often more accepting of private equity investment because it tallies with their own experiences of setting up companies: “They know the rules of business,” says ABN Amro’s Mr Duret. “They understand a business’s life cycle, including negative cashflow and the fact that you have to wait for a while before having a payout.”

Private banks, however, caution against a uniform approach. Because of the huge variation in each client’s individual circumstances, most are reluctant to set out precise guidelines for allocations to illiquidity – Julius Baer is rare in setting out something approaching a benchmark for illiquid asset allocation.

“We don’t have a maximum recommended limit,” says Mr Lamprecht. “Some investors have 40 per cent of their money in private equity.”

He cites the example of an ultra wealthy client with a net worth of €200m, based primarily on his own business. He might, in fact, have a liquid worth of only €3m or €4m.

“We have to question, therefore, whether he is capable of adding another illiquid investment, given that he has a huge private equity investment in his own company,” says Mr Lamprecht. 

Putting deleveraging to work

Good private bankers try hard to make their conversations with investors as jargon-free as possible. These days they are being forced, nonetheless, to teach them a new word: deleveraging, the process by which banks reduce their liabilities to meet stricter national and international capital rules. This requires selling existing loans and reducing new lending, particularly for riskier loans and for business outside their home country.

This is an illiquid field, since few loans are actively traded. Investors’ reward for learning this neologism, however, is potentially high returns that are difficult to find in all but the riskiest public fixed income markets.

In Europe, where private bankers see the greatest opportunities, deleveraging leaves a huge funding gap which gives investors huge pricing power.

Iain Armitage, head of investments for Emea at Citi Private Bank in Geneva, cites estimates by consultancies and investment banks suggesting that European banks will have to shed about €3tn from their balance sheets over the next three to five years. To meet this gap, private equity investors have raised €250bn or so, he says, leaving a funding gap of  €2.75 tn which presents huge further opportunities. “This story is going to run and run for some time to come,” says Mr Armitage.

Deleveraging presents opportunities for investors with both high and low risk appetites, Citi Private Bank believes. “There is something for everybody,” says Mr Armitage. This includes lending to distressed companies, and to mid-caps which have been starved of bank finance despite strong financial fundamentals, as banks concentrate on larger clients.

Bank Julius Baer sees particularly strong opportunities from the retreat of cross-border financing in the eurozone, including a fall in lending by international banks to peripheral member states. Commerzbank said in February it had sold non-performing loans in its Spanish commercial property portfolio worth €710m.

Many other lending opportunities are, however, far safer than this. “The market in lending to European companies is highly bifurcated,” says Simon Lamprecht, specialist in premium solutions at Bank Julius Baer in Zurich. “If you’re big enough, you can tap the liquid public bond markets at record low rates, created by loose central bank monetary policies. If you’re smaller, you have no alternative but to seek loans from private equity firms.”

In response to this trend, private bankers advocate investment in private debt funds run by US private equity managers with a long track record, such as KKR and Apollo.