Railpen creates framework to assess investor capacity for illiquidity

5 December 2023 – Railpen, fiduciary and investment manager of the £34 billion railways pension schemes, today announces the creation of a framework that aims to help investors assess their capacity to invest in illiquid assets and manage these investments through time.

The framework focuses on the illiquidity aspect of private markets, rather than the potential for additional return or diversification. It has been developed for Railpen’s 100+ Defined Benefit (DB) pension clients, including both open DB and closed DB. It is hoped the research can help the wider pension industry tackle this important strategic investment issue.

Outlined in a research paper published today, Railpen’s framework incorporates key multi-asset portfolio assumptions, client long-term objectives and unique illiquid asset cash flow properties. The research paper showcases the differences in capacity for illiquidity via three distinct illustrative clients: a Railpen closed scheme, a Railpen open scheme, and a hypothetical Canadian pension fund.

The framework considers the following elements to decide on capacity for illiquidity:

  • Client asset portfolio: this includes defining the opportunity set, expected returns and risk, and the strategic asset allocation of a client.
  • Client liquidity sources and uses: Each client faces a unique set of liquidity events. Some of the most important liquidity sources and uses in a multi-asset portfolio context include pension benefit payments, asset class rebalancing, derivative position collateral needs, and private market cash flows.
  • Private market cash flows: more specifically for private markets, the framework incorporates asset class-specific cash flow profiles to capture unique liquidity characteristics that these investments exhibit.
  • Portfolio liquidity risk management: the previous three components generate client portfolio dynamics over time for a set of assumptions on asset portfolio, expected liquidity needs and private market cash flows. However, to complete the picture the framework defines relevant metrics against which client liquidity is measured, evaluated and managed. The exact measures may differ by client; however, the general principle is focusing on managing the medium-to-long-term risk of being forced to make unattractive and costly portfolio decisions to create needed liquidity.

With all the building blocks in place, a simulated portfolio is run to generate a probabilistic assessment of portfolio liquidity and what-if analyses under different assumptions.

John Greaves, Director of Fiduciary Management, said: “Allocation to illiquid assets is an important strategic consideration for Railpen that plays a significant role in achieving long-term client objectives. We understand that an illiquid asset allocation that may be suitable for one portfolio, might not be fit-for-purpose for another due to a different strategic client considerations.

“We have therefore developed this important framework to enable us to assess our different clients’ capacity for certain assets across the private markets spectrum from real estate to private equity. As more and more investors embrace the benefits of illiquid assets we hope this research can help others navigate this important strategic investment issue.”

High-level findings:

For a typical closed scheme with a goal to fully liquidate the portfolio it is critical to have a sufficiently long runway to smoothly manage the exposure down, coupled with the ability/willingness to tap into the secondary market if needed.

When designing a portfolio for an open scheme it is important to maintain high-quality private markets investment implementation, while also being in a position to steer the allocation to a new target in the case of a significant strategy change.

While the “Canadian pension fund” is a less constrained investor, illiquidity capacity should also be considered for portfolios with high illiquid asset allocations. In particular, the research illustrates how liquidity buffers that are designed to withstand various portfolio liquidity events can help determine the appropriate level of illiquid asset exposure.

Illiquidity findings

John Greaves, said: “There are a number of common threads running across all these illustrative client case studies. Taking into account client-unique objectives, constraints and opportunity sets should play a crucial role when evaluating capacity for illiquidity. Any potential illiquid asset allocation should link up with these specific client requirements to deliver a portfolio that has the needed level of portfolio steerability.

“Ultimately, capturing all these considerations requires having the appropriate governance model through which client strategy is effectively linked to illiquid asset investment implementation. This research has helped us develop new processes and areas of governance to help us manage the investment programme. It has also helped us to shift culture a little to be much more aware of liquidity risk across the entire organisation.

“We believe that the outlined framework can be a useful tool in addressing these issues when designing and managing illiquid asset investment strategies.”