Investors Piling into Illiquid Assets to Avoid Discipline of Market Prices

Calling Elizabeth Warren….

The latest “you can’t make this stuff up” ruse on behalf of investors to hide from plunging asset prices is to run for the supposed cover of illiquid assets, where lax valuations allow fund managers to fudge valuations, meaning pretend things are less bad than they are.

Not only is choosing to prefer flattering and misleading accounting over economic reality not a wise idea, but virtually all of the illiquid asset classes, like real estate, infrastructure investing, and private equity, rely on the liberal use of borrowed money. That means they are riskier, in investment terms, than those embarrassing, loss-exposing asset types like stocks and bonds. In other words, if the objective were to be retreating from risk, rather than trying to camouflage it, this would be the last place you’d want to go. But Wolf Richter tells us investors are herding to the false cover of so-called “alts” (alternative investments):

BlackRock, the world’s largest asset manager, polled 174 of its largest institutional clients, including corporate pension funds (34%), public pension funds (25%), insurers (25%), endowments and foundations (7%), investment managers (6%), official institutions (1%), and others (4%). This might be an adequate sample of all institutional investors.

The poll, conducted in December, sought to find out about changes in their asset allocations for 2016. The results are not exactly a vote of confidence for this stock market.

“Institutional Investors to Embrace Illiquid Assets….” That’s how the headline of the announcement started out. And they would do so “to combat macro-economic trends, anticipated market volatility, and divergent monetary policy.”….

With reductions in equities and bonds, what are they going to buy?

“Long-dated illiquid strategies,” that’s where asset allocations are heading. In order of magnitude of the shift: private credit (“over half” plan to increase their portfolios), real assets (53% increase v. 4% decrease), real estate (47% increase v. 9% decrease), and private equity (39% increase v. 9% decrease).

The report offered two reasons why investors are fleeing into illiquid assets: to earn the higher return premia that illiquid assets offer, and most prominently, to escape the volatility of stocks and bonds.

Illiquid assets — because they aren’t regularly traded, there is no pricing data — have an advantage over stocks and bonds for institutional investors in these trying times: their losses don’t have to be booked every time a statement goes out. Losses aren’t known, and certainly aren’t disclosed, until years down the road.

And it’s not as if these investors aren’t aware of the fact that they are just playing accounting games. Consider this section from CalPERS’ private equity workshop last November:

In some ways, I hate singling out this workshop panelist, Bob Maynard, since he’s candid about the issue of the smoothing being questionable. But his remarks illustrate the point: that the investors know full well that this supposed advantage amounts to gaming of reporting systems and the larger political processes that are tied to them, and they embrace this gimmickry.

Allan Emkin, Pension Consulting Alliance: The next question is what do you individually and your boards see as the role of private equity in the portfolio?

Bob Maynard, Chief Investment Officer, Public Employees Retirement System of Idaho: We’re I think more skeptical of private equity than many and actually I’ve been quite surprised at the experience we’ve had, which has been dead solid on the average. Our time-weighted returns are almost exactly yours [turning to CalPERS’ head of private equity Réal Desrochers], that 1.34 above what you could put in the public markets is exactly our experience, so we’ve actually gotten average institutional experience, so it’s worked out better than we were expecting.

We knew we were entering an area where we would not have much influence over what we could do.

Ah, in fact, ah, we recognized however that we were going to get some pressure to look at local investments in private side, we did know that our actuaries and accountants would accept the smoothing that the accounting would do. It may be phony happiness, but we just want to think we are happy and they actually do have consequences for ah, ah, actual contribution rates we are going to be able to put in place. So we’re looking for it even if it just gave public market returns, we’d be in favor of it because it has some smoothing effects on both reported and actual risks, as seen that way.

Once you get into the area, this is kind of a like a rental car return type investing. Once your front wheels are over the spikes, you can’t back up. You’ve got to keep kind of going forward. If we’re going to have a little bit, we’ve got to at least have enough to have a difference in the portfolio, which means get to at least 5 to 10%. And by the time we got to the 2000s, we had gotten to that point, so it did make an appropriate difference. So we’re there, it’s demonstrated benefits in the portfolio, we’re happy if it gives public market returns, anything extra, because of its effect having some smoothing of the risk as seen by the accountants and actuaries and, um, just don’t, you’ve got to keep going once you are there.

As you can see, this is an unusually straight-forward acknowledgment that what is driving the selection of private equity is accounting treatment that Maynard admits is “phony.” And he does not expect to get any other benefit from private equity.

Richter underscores that point:

This is not a strategy to reduce risk — some of these illiquid assets are very risky. It’s a strategy to reduce the requirement to book losses when asset prices head south.

But it’s even worse than that. First, this predisposition for risky, illiquid assets is the worst possible choice in a deflationary environment. The place to be is cash and cash equivalents, and high quality bonds.

Second, in the runup to the last crisis, investor appetite for illiquid assets not subject to mark to market discipline (as in unlike corporate bonds, the modeling allowed for particularly flattering valuations) led for them to be manufactured on a grand scale. From a 2010 post:

An incentive failures that has gotten a free pass in the crisis is the way money is managed in the Anglo Saxon world: annual time horizons and measurement against benchmarks. One of the factors that keeps pushing investors into greater risk taking is competitive pressure. If your performance lags, even it is because you are making better risk/return decisions, you will lose assets (and if you are at a big firm, you will be replaced). Yet we see remarkably little impetus to change a system which rewards the fund managers and gatekeepers (who have a particularly powerful role in keeping this system intact) since they earn….annual fees! A classic “And where are the customers’ yachts?” problem.

And too much risk is a no-no too, but the measurement of risk was volatility of returns. So what did we see in the crisis just past? A rise in popularity of strategies that used illiquid assets….which were therefore marked to model…which therefore did not show much (any) price volatility until their credit quality decayed.

Indeed, one of the features of the crisis was, just as the dot com era saw companies like Pets.com and boo.com being “manufactured” to meet investor appetite, so too were appealing-looking investment strategies ginned up this time around. From an extraordinarily prescient April 2007 paper, “Cracking the Credit Market Code,” by Henry Maxey of Ruffer and Company (no online version; more on this paper in future posts):

This leads us to the theoretical holy grail of hedge fund strategies: leveraged spread strategies in illiquid assets.

Illiquidity in the assets is essential. The danger with liquid assets is that market forces can change prices for both fundamental and haphazard reasons. Ordinarily holders of assets expecting a 20% return will accept commensurate volatility, but in a world demanding smoothed returns, this is unacceptable. Consequently, it becomes key that the capital value is not left to the vagaries of the market place.

Without a liquid market to price an asset, pricing is supplied by, for example, models. These frameworks tend to be self-serving because they are developed by players, such as ratings agencies and investment banks, who are more incentivised to give investors what they want than to ensure the price is an accurate reflection of the fundamentals. Prices, therefore, don’t change until the fundamentals, e.g., default rates, force a reassessment of the model inputs.

Everything hangs on default and downgrade. Actual default or downgrade become the critical events rather than markets’ forward looking pricing of that event, so problems are withheld until discontinuous pricing events occur rather than being anticipated in a continuously priced market. The capital prospects for the asset beyond 12 months are not of primary importance while the leverage yield spread provides the necessary return/volatility performance figures. Such a strategy is encouraged by a lack of visibility of the underlying portfolio (strategy secrecy), and a lack of regulation.

Yves here. This is a key point: it wasn’t just the demonized, presumed “dumb money” that took losses in this game. Hedge funds and prop trading desks were on the wrong side of many of these trades too.

In other words, perverse measurement incentives led investors to seek out precisely the sort of risks that were highly failure prone because they were not subject to market price discipline and investors would continue to demand them even as their fundamentals were decaying. For instance, in 2005, as the Fed was tightening, demand for prime mortgages fell, as you’d expect, while spreads for subprime mortgages tightened. That was the reverse of what had happened in any previous credit cycle (spreads on risky loans widen first, and more than those for more pristine borrowers). That was a reflection of the distortion created by CDO consisting of largely of credit default swaps, the perverse effect of the Magnetar trade which drove demand to the worst mortgages in the later part of 2005 through early 2007. And that resulted from investor appetite for safe-looking assets (the AAA tranches that proved to be anything but) and more venturesome investors thinking they could go long one tranche and short another, an idea so disastrous that at Morgan Stanley, it racked up the biggest losses of any trading strategy evah.

Now the entire point of illiquid investments is that they supposedly don’t go boom in such a dramatic way. But the crisis just past showed that they lead investors to underestimate the risks of those strategies and overdo them in a very big way. And the undue enthusiasm for investments with flattering valuations evident in the BlackRock survey suggests the odds of a recurrence of bad outcomes, meaning major losses, is high.

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27 comments

  1. allan

    “… and private equity (39% increase v. 9% decrease)”

    Increasing the assets deployed in private equity is the last thing this economy needs.
    More cash is available to finance PE takeovers of companies, followed by slash-and-burn right-sizing and out-sourcing, followed by layoffs, reduced employee wages and benefits, followed by decreased macro demand and poor performance of public companies, followed by increased demand for alternative investments such as PE.
    Rinse and repeat.

    On the bright side, more multi-million dollar birthday parties for PE titans, so that will help the economy a little.

  2. diptherio

    Maynard’s testimony is astounding. He says, in so many words, that they are willing to invest in riskier assets because they reduce the appearance of risk. He would be happy with public market returns from investments that are much riskier??? Investing 101 fail.

    Of course (and why should I be surprised at this point), the reason he says, “we’re happy if it gives public market returns, anything extra,” is because the “we” refers to him and his staff and no one else. The “phony” risk smoothing benefits them, personally, not the retirees whose interests they are supposed to be protecting. Increasing risk while appearing to decrease it is obviously not in the interests of the beneficiaries…but then, why would we expect pension fund managers to act in the interests of the beneficiaries?

    1. James Levy

      Because it is hard for juries to look at well dressed white guys pleading on the stand that “I acted in good faith!” and find them guilty because the concept of fiduciary responsibility is complex while the pleading of a “nice” handsome guy with a wife and kids who says he was only trying his best is simple and convincing?

    2. TheCatSaid

      That’s the part that stood out for me, too. At least Maynard’s giving an honest answer. Everything in the system is set up to reward the approach he describes, plus peer pressure, plus group think.

      Were there any fund managers working for large firms who refused to go along? Did they lose their jobs, or did they live to experience gratitude from their clients? (I’m excluding the Big Short “heroes”).

  3. James Levy

    I’ll be the guy to ask the dumb questions: what are these illiquid investments? they don’t seem to be catalogued and characterized here; how can a fund that needs returns on investment put money into things it can’t actually sell when it needs money? and how can investments that are illiquid, and whose chief virtue seems to be that you can value them at anything you please, return dividends? and how can you assess the return on investment when you don’t know what the value of the investment is?

    I’ll sign this, Confused in the Berkshires

    1. Arizona Slim

      I think they’re talking about pouring money into real estate. Again.

      And we know how well that worked out the last time it was tried. As in, housing bubble of the previous decade.

    2. hemeantwell

      I’ll second Jim’s request for clarification. It does seem that illiquidity can become a very overdetermined idea. I was reminded of Pearlman’s book, Railroading Economics, and how the illiquid investment of railroads in various forms of fixed capital spelled disaster in highly competitive conditions >>> time for cartels. But the illiquidity being discussed here seems to be more of a function of institutions being able to assert a value derived from a method of calculation that cannot be questioned.

    3. flora

      I took ‘illiquid investments’ to mean investing in PE as limited partners, instead of investing in a publicly traded stock/bond index fund, e.g. I may be wrong.

    4. jrs

      Yes thank you, I wondered how many paragraphs I was going to read not knowing what type of assets were being discussed.

    5. griffen

      Private credit, real assets*, real estate, and private equity.

      It’s in the link summary from the wolf street reference too.
      *typically this includes timber, land and so on I think.

      1. TheCatSaid

        And assets such as works of art, Stradivarius violins, collections of antiques, rare porcelains, etc.

  4. flora

    “Not only is choosing to prefer flattering and misleading accounting over economic reality not a wise idea, …”

    Ask Enron or Arthur Anderson,LLC how well that worked out.
    Thanks for this post.

    1. Synoia

      If in lamp post futures, please ensure they have arms or cross pieces which provide an effective drop above road level.

      Non of those plainly vertical lamp posts, and none that are too high for the intended purpose.

    2. alex morfesis

      They dont make lampost like they used to either…person might die from the fall if its a more modern above the trees type

  5. kevinearick

    Global Depopulation

    Ok, so, here’s the business card version for the liars fabricating lies in a garage:

    The global middle class has rendered itself redundant, again, and the co-dependent communists are in clean-up mode. Labor is on break, watching porcupines.

    Talk all the sh- you like.

    And here’s the summary for Cliff Notes readers:

    The old-school teachers were correct; the middle class has lobotomized itself with calculators, accepting the GIGO readout as fact. Government is the calculator. The global majority is now collecting a welfare check, whether it works for FANG, Sony or any of the proliferating governments, passing worthless securities among themselves, all talking sh- about each other with politically correct language.

    I can throw a stone and hit 50 fishing boats rotting in the water, or go up top and hit 50 houses rotting in the dirt. If I wanted to waste my time on a train, I could hit a thousand empty offices and a thousand empty condos. And if I wanted to waste my time on a plane, I could take a random flight to anywhere and do the same damn thing.

    The infrastructure isn’t funneling all the critters into the street into a shrinking city at the same time by accident. And Merkel isn’t inviting young Muslim males to rape her girls by accident; Europe must have economic slaves, like all the rest. Brussels is the past, not the future.

    Men and women are incapable of understanding each other, making trust that which is rare and valuable, for survival and reproduction. For a man to take advantage of women, he must have a female accomplice, and vice versa, to create the divide and conquer, actuarial ponzi feeding the pair. If the global middle class wants to engage itself in WWIII and accelerate the process, it is certainly welcome to do so.

    The robots managed by AI snippets will depopulate themselves accordingly, and the natural economy will reboot itself, like it always does. The great lie has always been the CONcensus. Trump is correct in one regard – it’s all a game, keeping busy workers busy, like a spoiled brat using a magnifying glass to set insects on fire, in a coliseum with a big screen TV.

    Enter at your own risk.

    1. Plenue

      “Men and women are incapable of understanding each other”

      Bullshit. Like most of your inane ramble.

  6. GlassHammer

    First the Smart Money creates wild volatility in asset prices and then it hides in illiquid assets to avoid reporting the risks/losses that resulted. And in a couple of months the Smart Money will jump back into the market and start the process over again.

    And this is how human economic behavior is determined for our society.

  7. Oguk

    I get it, so the people who say markets are the solution to everything are actually fleeting markets when the writing is on the wall. Because “illiquid” is a fancy way of saying there’s no market, as in active trading, buying and selling, for these things. Have I got that right?

  8. susan the other

    Just puzzling about illiquid assets. If illiquid assets can hold their value -so that you cannot sell before other assets (nearby real estate) have sold for a discount and every sale before yours takes a cut out of the huge discount that must be met, then by the time the tsunami of mark-to-market gets to you the price might be going back up a little because you hung on to your “premium” real estate come hell or high water – then you have sacrificed years waiting for the price to “come back”. Had you sold earlier you could have reinvested in double-down properties and still made some money. So it’s sixes. But at least it holds its value. In this new world of Not a return on investment but a return of investment. More or less. I think this is analogous to countries devaluing their currencies but waiting as long as possible to do it to get the best return over time. And stretching out the agony over time hoping they can prevail as a reserve currency.

  9. Knute Rife

    Well that escalated quickly. We’ve already hit the last stage in the kick-the-can/IBG-YBG investment strategy: hiding investments in unpriceable pseudo-assets.

  10. cnchal

    First, this predisposition for risky, illiquid assets is the worst possible choice in a deflationary environment. The place to be is cash and cash equivalents, and high quality bonds.

    If all these investors went to cash, wouldn’t the stock and bond market approach the value of zero?

  11. Whine Country

    Hate to disagree with everyone but this is pure genius. Now that we’re assured that our banks are not TBTF, the pension funds et al are ready to step into fill the void. An illiquid and difficult to value investment virtually guarantees that these geniuses can make the argument that they have only a liquidity problem and not a solvency problem when they lack the funds to pay their beneficiaries. That’s more difficult to do with easily valued assets. So now when they don’t have enough money because of the lack of LIQUIDITY – well, guess who is going to have to step in to lend them a few bucks? The Fed could use some real assets on its balance sheet so as to diversify don’t ya think? As an aside, does anyone think it’s just a coincidence that balance sheet has the initials BS?

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