As recently as 10 years ago, private markets represented a minor holding in private client portfolios versus their more sizeable positions in listed bonds and equities. Today, they represent the largest segment of our alternatives program, which makes up nearly 20% of assets under advice at LGT Crestone. At the heart of this growth is a rapid evolution of private markets and the means by which private clients can access the asset class. This includes closed-end fund vehicles, used heavily by institutional investors, and evergreen vehicles, which are today dominating flows across private wealth.
Like anything that evolves rapidly, it’s important to review developments from time to time to assess the broader implications. In this month’s Core Offerings, we discuss how evergreen private market vehicles have improved liquidity dynamics and the impact on asset allocation. We also explore how this liquidity is generated and argue that not all liquidity is equal.
Firstly, it’s worth revisiting how the market has evolved and how institutions continue to invest in private markets broadly. The closed-end fund takes its name from the fact that it has a limited life—typically, 10 or more years with potential extensions.
Closed-end vehicles align to the illiquid nature of private markets on both an inbound and outbound basis, whereby capital is called when investments are made and distributed as and when they are exited. This is shown in the illustrative chart below:
Unlike public securities, which can be bought on an exchange at any time, private assets must be sourced, structured, priced and executed.
There certainly remains a meaningful place in private client portfolios for these structures, but their liquidity parameters, as well as operational complexities, present portfolio management and administration issues. This is something that evergreen structures seek to address.
The new breed of private market vehicles for private clients are typically referred to as ‘evergreen’.
The new breed of private market vehicles for private clients are typically referred to as ‘evergreen’. This means they are available to buy and own on a perpetual basis. The table below provides an example of funds that are available in the local market and their high-level subscription and redemption terms.
Although much of the focus of these funds is on outbound liquidity (i.e., when the investor can get their funds back), inbound liquidity is arguably the more important development. This is because it enables private clients to typically invest monthly with limited notice and to gain access to a (fully invested) portfolio of assets immediately in line with desired allocation targets.
One of the most significant implications of this relates to those investors who are building allocations from scratch or from a low base. An investor can invest a dollar in private markets today via an evergreen fund and compound that dollar immediately. Conversely, if the investor commits to multiple closed-end funds over many years in order to target an overall dollar exposure, they are initially only compounding cents. Compounding the full dollar commitment only begins many years later once capital is invested to that point. Simply put, the impact on portfolio outcomes of initially introducing private markets exposure via evergreen structures is efficient and simpler when compared to a closed-end fund approach. That is not to say evergreen is the only way to invest. In fact, our preference is to combine both, but it is a factor that is often missed.
The ability to maintain and adjust exposures through the cycle using evergreen funds is significantly enhanced, as is the ability to build meaningful diversity into portfolios in a considered way (i.e., including geography, sector, manager, stage, type and vintage year).
In terms of outbound liquidity, the ‘new normal’ is for a fund to aim to meet liquidity of up to 5% of net asset value (NAV) in any given quarter. There are, however, meaningful variations across prior notice and post settlement periods. Where funds are able to meet these redemption terms, full or partial redemptions can be used for portfolio rebalancing and/or repositioning, medium-term cashflow needs for non-portfolio purposes, as well as other requirements, such as death or divorce proceedings. The experience with equivalent closed-end equivalent vehicles is to wait for distributions to be returned over the following decade, unless a means of (private) secondary sale can be facilitated. This typically takes place at a discount to NAV.
Now, for the big caveat…evergreen fund redemption terms mean that liquidity is by no means guaranteed. In the event of meaningful redemptions, particularly those beyond the imposed limits, it could take months, quarters or even years in certain scenarios. Whilst well structured evergreen vehicles should be able to broadly meet reasonable redemption requests during normal market conditions, such liquidity should not be relied upon in the same way as a public equity exchange-traded fund, for example.
The impact on portfolio outcomes of initially introducing private markets exposure via evergreen structures is efficient and simpler when compared to a closed-end fund approach.
Redemption gates are 5% of net asset value per quarter (Partners Group Global Value can apply a 2.5% maximum if in the best interest of the fund).
When you combine asset level diversification with vintage diversification it results in asset exposures that are both numerous and at varying points of their respective life cycles.
So, how do evergreen vehicles translate what is an inherently illiquid asset class into one that has some form of structured liquidity on an ongoing basis? The enabler here is diversification, and critically asset level diversification (i.e., the number of assets or funds) and vintage diversification. The latter relates to assets or funds acquired over multiple prior years and not simply a discrete or limited number of years (vintages).
When you combine these two components, it results in asset exposures that are both numerous and at varying points of their respective life cycles. Some of these are young and in value-creation mode, while others are nearing maturity and thus ready to exit. In the situation of a mature and highly diversified portfolio, natural portfolio liquidity via asset sales and resultant distributions should arise through the cycle. This is because the portfolio should always have a portion of its assets exposed to the mature end of its life cycle and be close to exit.
This point is arguably the most critical to evergreen private market solutions that offer some form of outbound liquidity. This is because the natural portfolio level liquidity should form the primary basis on which liquidity is provided, as opposed to other components. These other components are typically cash or traded securities, positive net subscriptions (that can be offset against redemptions) and fund level credit lines.
If there are significant redemptions on any evergreen product, full liquidity in a traditional sense may not always be available and shouldn’t be expected.
To demonstrate this point, the above chart shows a pro-forma liquidity analysis of natural liquidity generated through time using private equity funds tracked by Hamilton Lane. It also shows a pro-forma portfolio liquidity analysis based on the portfolio parameters of its evergreen private market strategy launched in 2019. The grey dotted line shows a 20% redemption limit, which has become the market norm (annual limit) for evergreen private markets vehicles.
The following chart, however, shows actual annual distributions of the live fund through to March 2024. Here, the distributions are currently averaging below 20% per annum. On the positive side, liquidity has been generated naturally from the portfolio, but it has averaged below 20% per annum so far. There are rational explanations for this (such as portfolio ramping and recent market disruption) and other liquidity routes are excluded. But the important point to make is that if there are significant redemptions on any evergreen product, full liquidity in a traditional sense may not always be available and shouldn’t be expected.
While private market assets will likely never be as tradeable as publicly listed investments, investors can leverage the improvement in underlying liquidity.
While investors need to be cognisant that private market assets will likely never be as tradeable as publicly listed investments, astute investors can leverage the improvement in underlying liquidity that we have explored. This will enable them to broaden their investment universe and build better risk-adjusted portfolios.
Notwithstanding some caveats, what does this improved liquidity in private markets mean for asset allocation? The simplest way to explore this dynamic is to conduct efficient frontier analysis, which seeks to build efficient multi-asset portfolios utilising forward-looking asset class risk and return assumptions. At the same time, consideration should be given to the expected interactions between those asset classes. The outcome of this is to derive the most efficient mix of asset classes that provide the highest return for any given level of expected risk. Such portfolios can be plotted on a chart (as in the example below) and are referred to as the efficient frontier.
The absolute level of liquidity available to private clients in private markets has fundamentally changed for the better. This should ultimately provide the case for private clients to add incremental exposure to private markets.
The chart above shows three different efficient frontiers, each constructed by applying a different constraint to alternative or unlisted asset exposures. The 0% alternatives constraint represents a completely publicly traded portfolio; a 20% alternatives constraint, which is a typical exposure for our clients; and a 45% alternatives constraint, which is more typical of endowment-style investors who have lower liquidity needs. The analysis shows that relaxing the alternatives constraint to invest in more unlisted assets enables investors to target higher expected returns for any given level of expected risk. Alternatively, they can minimise expected risk for any given level of targeted return. The outcome is a more efficient total portfolio at the cost of lower liquidity.
We are not advocating that all investors should allocate nearly half of their portfolio to alternative assets! Each investor will have his or her own individual needs and tolerances for liquidity. These range from investors who may need 100% liquidity at a week’s notice to long-term university endowments, who typically need little liquidity. In addition, increasing illiquidity in portfolios will reduce the flexibility and ability for investors to adjust portfolios in the face of changing market conditions and take advantage of market dislocations.
That said, whilst the caveats discussed previously are critical to understand, we believe the absolute level of liquidity available to private clients in private markets has fundamentally changed for the better. This should ultimately provide the case for private clients to add incremental exposure to private markets, which, in turn, should improve portfolio outcomes through the cycle.
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