Since the Great Equity Meltdown, Landmark Partners has noticed an increasing focus on liquidity among leading institutional investors. In the past, most investors used a variety of asset allocation models to optimize their risk-adjusted returns. For some investors with successful alternative investment programs, this led to substantial commitments to illiquid assets.
Although the asset allocations were viewed as a fraction of the overall portfolio, the commitments were made in absolute dollars. When the markets fell in late 2008 and early 2009, these commitments came to represent an unexpectedly large fraction of the overall portfolio value. In some cases, investors faced a real risk that they would not have sufficient liquidity to pay their capital calls and still generate portfolio income required for other organizational objectives.
We believe that institutional investors would be well suited to develop liquidity-based constraints as part of their asset allocation and commitment process. We have developed a methodology for this purpose that is described in our white paper, “Commitment Planning: Liquidity Constraints.” There are three main steps in this methodology:
1) Define the crisis situations a portfolio should tolerate;
2) Integrate liquidity constraints into commitment plans; and
3) Evaluate the portfolio’s liquidity prior to every new commitment.
The first step is the key to the process: The investor needs to characterize the crisis situations that the portfolio is expected to tolerate. On the one hand, the investor needs to identify the liquidity that will be available in the crisis – this depends on the current value of his liquid assets, the fraction by which that value might fall in the crisis and the fraction of the remaining value that he is willing to sell to meet liquidity needs. On the other hand, the investor needs to identify the liquidity needs that he may have to cover is the crisis – this includes unfunded commitments to private equity, plus any net outflows from the portfolio that may be needed to fund the investor’s other activities. As long as the available liquidity in the crisis exceeds the required liquidity, the investor can expect to be on solid ground. The Landmark white paper gives the three equations necessary to describe required and available liquidity.
The second step, integrating liquidity commitments into commitment plans, is generally fairly simple to implement. Most private equity investors have access to various commitment planning tools that project future drawdowns, distributions, remaining undrawn commitments, and Net Asset Value (NAV). Usually investors use these tools to drive the NAV to some desired allocation. However, the outputs of the commitment planning process also include the inputs for the liquidity constraint defined in the first step. As a result, the investor can adjust the commitment plan to make sure that the liquidity constraint is met in addition to the allocation target.
For example, we sometimes see plans that call for large near-term commitments in order to quickly meet an increased private equity allocation. In some of these cases we have identified the potential for a near-term liquidity crunch – if a crisis should occur while large commitments are outstanding, it might be difficult to meet the ensuing capital calls. When these situations are identified they can usually be alleviated by simply slowing the rate of commitment, and accepting that the private equity program may take longer to build.
The third step, checking the portfolio’s liquidity prior to each new commitment, is the way the investor knows how to respond to a crisis. In late 2008, many investors knew that the world was not proceeding according to the plans they had developed earlier in the year, but many of them did not know whether they needed to adjust their commitments as a result. The simple tests described in the Landmark white paper give the investor a solid basis on which to make this decision.