Are Illiquid Investments Attractive Today, Or A Trap?
- William Bourne
- Jun 13
- 6 min read
Illiquid investments are in focus at the moment. Harvard and Yale are reportedly both selling private equity in the secondary markets; and the Swedish government has announced a review of how four large AP state pension funds manage their unlisted investments. On the other hand, the U.K. Government is putting substantial pressure on pension funds to invest more in investments which by their nature are illiquid.
In this article I look at the impact of the rise in bond yields on illiquids, how returns might look in the new environment, and how much a pension fund might sensibly allocate to illiquids in the context of its liquidity needs. I finally try and address the question in the title.
Higher long bond yields are a big negative
Long-term bond yields have risen substantially around the world. For example, the US 30-year Treasury is back above 5% for the first time since before the Global Financial Crisis in 2008. As that is the long-term risk-free rate, at least for now, there are implications for illiquid investments in three important ways. The first is that the return hurdle to compensate for the risk and the illiquidity has risen substantially. Even the safest infrastructure debt needs to offer a meaningful premium over 5%.
The second is that the cost of the debt which many illiquids rely on to juice up returns has risen sharply. The impact may only be felt when they refinance, but it is a sword of Damocles sitting over their heads.
The third is that the valuation of long-term income streams, ultimately the only reason investors hold any asset, has fallen. Infrastructure and private equity will be more impacted in this respect than private credit by reason of their longer duration.
Stock market exits have nose-dived
The other major change is the growing failure of stock markets to act as sources of capital for businesses. Behind this lie a host of reasons such as increasingly onerous regulation making public listings less attractive, and the rise of passive investing where investors are unable to assess or take the risk involved in IPOs.
So far this year there have only been 9 Private Equity (“PE”) exits through IPOs in the U.S. and Europe, compared to 116 last year. As a result, General Partners of PE firms have had to rely on other ways of exiting investments. Increasingly these involve partial sales to third parties and exits through secondaries.
Infrastructure
What returns can be expected from illiquids in the future? The asset class matters of course. The simplest is infrastructure, which tends to invest in long-term and relatively low risk contracts. The default must be to expect yields to track long term bond yields, albeit at a premium. At the margin, if bond yields rise a lot further, investors may prefer the credit of well-managed infrastructure to that of a discredited U.S. Government, and the former may outperform the latter.
Private credit
Private credit is of shorter duration and so will be less impacted by higher long term bond yields. The risk here for investors is poor underwriting and rising defaults in a lower growth world. The lesson of history is very much that manager selection is the key to returns. Investors who invest in managers with proven due diligence processes and experience of dealing with distressed assets will get their return premium. Those who don’t may not.
Private equity
Private equity is perhaps where the biggest debate lies. For many years, it has held out the lure of higher returns than public equity, based on its ability to add value to its assets away from the glare of publicity. Critics say that historic comparisons take no account of greater leverage, and that the performance statistics are either hand-picked (e.g., S&P in 2000-2009 when the small-cap effect still worked) or are not oranges and oranges (e.g., public indices include many sectors such as real estate or banks which private equity does not).
The 2024 Cliffwater report[1] into U.S. public pension funds’ performance found that over ten years their PE investments returned an annualised 13.9% vs a total portfolio return of 9.6% at the median fund. But as an argument for PE, it is spoiled by the fact that their listed equities returned 14.4% over the same period. The poor overall return was driven by a negative contribution from diversification (listed and unlisted) overseas.
The Linchpin view of the future
Looking forward, the combination of lower economic growth, a much higher cost of debt, lower valuations and a high fee take does not bode well for private equity returns. Some listed investment trusts have sold assets to ‘prove’ that their valuations can stand up. But it rather depends on what they sell – was it the jewel in the crown?
None of these asset classes are homogenous, of course. All three have a wide spectrum of risk appetite, and some such as venture capital are more binary in their outcomes. In mainstream PE there has always been a large range between the top and bottom quartiles (e.g., the range around the median US public fund quoted above was 18.4% to 6.9%). The gap between top and bottom quartile is likely to extend in a tougher world as the premium on good decision-making increases.
What allocation is sensible for a long-term pension fund?
Which brings me to the question of how much it is sensible for an open and active pension fund to hold in illiquid assets. I have included real estate in the numbers below, though I recognise that it has better liquidity characteristics than private markets.
The first task of any pension fund is to ensure that it has sufficient cash in its bank account to pay pensions on time. Illiquids create an immediate challenge, because it takes time to liquidate them. By their nature, little notice is given of either calls on investors’ money or on funds being returned. That again causes difficulties with cash management.
Excessive illiquid weightings also reduce flexibility. Some may argue that pension funds do not need much, because they are long-term investors. However, my view is that the ability to take advantage of investment opportunities is valuable. For example, when U.K. gilts yield more than a fund’s discount rate, as now, there is a primary case for increasing allocations. But if the allocation to illiquids is too high, the funding to do that almost inevitably comes from listed equities.
Private sector funds suffered in a different and worse way in 2022. Collateral calls on their leveraged strategies forced them to raise money overnight. As their portfolios were largely composed of illiquids and gilts, they were forced to sell the latter regardless of the price. Again, the lack of flexibility proved very costly.
A typical LGPS fund (open, active, Defined Benefit) might hold between 20% and 30% of illiquid assets, perhaps 5 to10% in each of real estate, infrastructure, and private equity, something in private credit, and possibly other alternatives such as hedge funds. Railpen wrote an interesting report[2] into the management of illiquids which suggested that an allocation of over 40% would for them lead to an unacceptably inflexible portfolio.
Should the LGPS go there?
The LGPS is under substantial pressure from the Government to invest more in illiquid investments. It is a not dissimilar fund to Railpen, so prima facie the 40% level might be taken as a reasonable maximum for the LGPS in aggregate too.
Against that PE is in aggregate unlikely to deliver the level of returns which it has historically, for all the reasons above. Infrastructure and private credit are less affected by lower growth and higher bond yields, but both rely to an extent on leverage, which may reduce the returns at the margin.
The latter two asset classes also differ from PE in that they offer a surfeit of new opportunities, which means that new investments can be done at attractive rates. In PE, the opportunity set today is more likely to be secondary purchases of one sort or another. These may still be attractively priced, but there is less scope to add value.
The key point (again) for investors is to go with tried and tested managers in all asset classes. One implication for the LGPS is that pools building up internal teams will need to pay for proven expertise, including perhaps performance fees.
Whether individual funds should take their weightings near Railpen’s 40% will ultimately depend on their (and their pool's) circumstances. Manager and strategy selection must play their part, as well as the composition of the chosen illiquid portfolio. For example, local investments will exhibit less liquidity, so a higher allocation there argues for a lower total weighting to illiquids. On the other hand, mainstream PE has a well-developed secondary market and private credit has shorter duration, both arguing for a higher weighting.
At Linchpin we lean towards a lower weighting in illiquids, less for their shortcomings and more because we place more value on flexibility. In particular, over the next five years we expect government bonds, ultimately better matches for the LGPS’ long-term liabilities, to present attractive buying opportunities. In our view the opportunity cost of being unable to take advantage because of lack of liquidity is high, and we therefore prefer to maintain flexibility.
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