Principal at fixed income asset manager offers a view on liquidity issues that could impact the returns profile that many asset managers see in alts
The rush towards private assets and the ongoing popularity of alternatives may involve a liquidity trade-off that some asset managers aren’t taking into account. Using the example of private debt, those products offered investors a ‘liquidity premium’ between three and four per cent above the yields on public debt products. As interest rates have risen that delta between the more illiquid private debt investments has shrunk and one asset manager thinks it’s time for institutions to take more care with their private asset allocations.
Liam O’Sullivan, Principal at Toronto-based fixed income asset manager RPIA explained what he means by a liquidity premium and what that premium can mean for institutions and pension funds now. He outlined how institutions can gauge the value of that liquidity, or lack thereof, while they assess their asset allocation. He offered a view as to why in this market environment, liquidity may be worth considering closely.
“Institutions are facing some challenges in this environment. They’re investing in a period where more flexibility and more responsiveness is critical, and private assets aren’t giving you that,” O’Sullivan says. “Institutions have a little more tolerance to take on private assets because of their long investment horizon, but they still face those challenges. At the same time, the reward is simply not there.”
O’Sullivan compares private and public debt yields from 2014 to 2024. Over that time, private debt has generally yielded about four per cent above public. That’s the liquidity premium. Since interest rate hikes began in 2022, that delta has collapsed to “basically zero.”
Even if outperformance is not currently a factor, many advocates for alternatives and private assets will say that the nature of their returns is enough of an appeal. Because they aren’t priced as frequently, the returns profile is smoother and institutions don’t have to cope with nearly as much volatility. O’Sullivan argues that the price fluctuations are happening either way, these assets just appear less volatile because of the longer gaps between pricing. The benefit, he says, is illusory.
For pension funds, O’Sullivan sees another impulse towards greater focus on public debt and public assets: their liabilities. As funding status for Canadian pension funds has improved in recent years, he says many pension fund managers have a growing degree of liability awareness. He sees a growing move to de-risk portfolios and have assets more closely match liabilities, which largely manifests as a move towards public fixed income assets which can more closely mirror the liabilities a pension fund needs to pay.
O’Sullivan is careful to emphasize that he doesn’t think private assets are inherently flawed. He believes they can play a crucial role in institutional portfolios at different times in the cycle. However, this is a moment where rising yields and a changing macroeconomic environment have weakened the case for private assets against public assets. The dramatic rise in the value of private assets, O’Sullivan notes, occurred during a sustained period of low interest rates and a broadly bullish environment for most asset classes. Higher interest rates have changed that outlook.
O’Sullivan notes that we have begun to see private portfolios experience valuation write-downs, arguably made worse by the less transparent nature of private assets. Many private loans have begun to lose performance in a higher interest rate environment, pointing to some signs of stress in the private asset space.
“The other piece of the puzzle is just the sheer volume of assets that have flowed into some of these asset classes. I mean, if the landscape was very different a decade ago,” O’Sullivan says. “Now, so much capital has been committed in these private strategies that lending quality lending standards have probably been deteriorating over time. The quality of portfolios originated over the last few years is of a lesser quality than portfolios originated a decade ago. The environment’s changed and the sheer volume of money that flowed into the asset class doesn't bode well for future returns.”
Unlike retail investors who may struggle more with liquidity issues emerging from their private asset allocations, institutions have more assets and longer-time horizons which makes managing these issues a little bit easier. Nevertheless, O’Sullivan insists that these core issues persist with private allocations.
“At this point in the cycle, you should get that alternative exposure through public alternatives with some liquidity rather than locking capital up for a long period of time and sacrificing the transparency,” O’Sullivan says. “If I was an institution I would be thinking very carefully about private exposures and where I'm making an allocation to a private asset class. I don't just want to be getting more beta, I want to be getting alpha and I want the exposures I'm getting to be genuinely unique.”
