Illiquidity | Feature


in the weight of capital pursuing illiquid assets, particularly real assets,” Hansen says. “This has resulted in narrowing spreads but has also spurred managers to seek new areas in which they can find value.” Solvency II means that insurers need high- grade, long-term inflation-linked debt, such as infrastructure. They will not touch “assets below a certain credit quality with a barge pole”, O’Neill says. So there is less competition for lower grade, otherwise known as riskier, assets. O’Neill also says that in the direct lending market yields are not under pressure due to borrowers being incentivised to agree deals with a particular lender for reasons other than cost. “They want to have a one-to-one relationship to keep it off-market, to main- tain a relationship with a trusted and flexi- ble lender.


“There are all sorts of areas where you can pick up a premium despite the headlines that there is this firehose of money that is dampening returns,” he adds.


Illiquidity is not the only risk. NEST is moving into private lending, which is a market that has seen more and more loans agreed with fewer protections for the lender thanks to growing competition. These types of agreements are more popularly known as covenant light. O’Neill says that some investors are doom laden about the “cov-lite” issue whereas others believe it is irrelevant. “The truth is somewhere in between in that it depends on the circumstances of the loan, the lender and the borrower.” He adds that it is more of an issue in the broadly syndicated loans market, where an intermediary will put together the covenant document and then farm it out to dozens or even hundreds of investors. “The true cred- it worthiness of the loan is the true credit worthiness of the loan, not if it is cov-lite, cov-heavy or anywhere in between. We expect our fund managers to make sure that whatever the documentation says they are going to get their money plus interest back. That’s what the crucial metric is.” Other risks are to be found in infrastruc- ture where politics and regulation can


affect investment returns. There are certain government subsidies that can help drive the returns on renewable assets, but this can change with a new government policy or a review of energy prices. “We have to make sure that we and our fund managers are alive to those and don’t get carried away with what the price and product is on day one, but what might happen to it in a differ- ent regulatory or government regime,” O’Neill says. Hansen says that despite the risks investors are carrying for holding these types of assets, there are benefits aside from gener- ating a return. “These assets provide diver- sification to investors’ portfolios and are


to make it work,” she adds.


THE 97% CLUB O’Neill is not concerned about taking on illiquid assets and does not believe that he will be the subject of the same headlines that Woodford has found himself in during recent months. “Some people will be nerv- ous because of headlines or spurious hair- raising reports, but the reality is the differ- ence between a retail fund and a massive institutional pension scheme are worlds apart in terms of their liquidity profile.” He adds that this is due to NEST being pro- tected by the liquidity in its wider portfolio. The default fund houses 99% of the


If liquidity dries up in the illiquid part


of the portfolio, not to be oxymoronic about it but, there is plenty of liquidity elsewhere. Stephen O’Neill, NEST


often the principal reason why investors are content to take illiquidity risk in order to access them,” she adds. Illiquid assets may have a role to play in meeting a scheme’s obligations, but they may harm its chances of de-risking its lia- bilities through buyouts. “This is a real issue in relation to scheme buyouts, as in most cases illiquid assets are not attractive for insurers and will have to be disposed of by the scheme before executing the deal,” Hansen says.


“This is the case even for


illiquid assets that would nominally be seen as “insurer friendly”, such as infra- structure, as in most cases insurers prefer to source their own optimised assets that fit in perfectly with their existing portfolio, rather than taking on some non-optimised asset from a scheme. “We have seen cases where schemes have had to conduct fire sales of illiquid assets at the last minute to get a transaction across the line, and/or they have had to consider complex fundings involving the employer


scheme’s assets and is owned by 97% of members. “If liquidity dries up in the illiq- uid part of the portfolio, not to be oxymo- ronic about it but, there is plenty of liquidity elsewhere.”


NEST has about £450m of cash coming in each month and positive cash-flow projec- tions for the next 30 to 40 years. “The liquidity challenge for us is making sure that we can put the money to work in new assets and new projects in the illiquidity space,” O’Neill says. “It is not that if people want to extract their money they are not going to be able to get it. We have about £7bn worth of assets. The average retiree at NEST has a £300 pot. With £7bn in assets and £450m a month coming in, if someone tomorrow wants their £300 back, we can square them up.” O’Neill appears to be secure in his plans to build a portfolio of assets that are not easily turned into cash. Such assets are needed for the benefits they provide pension schemes and insurers.


Issue 85 | June–July 2019 | portfolio institutional | 37


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