Monday, 24 April 2017
Last updated 2 days ago
Jan 27 2017 | 7:21pm ET
Editor’s note: Illiquid assets have grown immensely as an asset class, but the process of selling them – especially in the midst of large market dislocations – remains neither easy nor straightforward, explains Jeff Hammer and Paul Sanabria of Houlihan Lokey. The situtation raises the risk of potentially debilitating asset-liability mismatches among asset management firms, and highlights the value of having the right advisor.
The Asset-Liability Mismatch for Money Managers
By Jeff Hammer and Paul Sanabria, Houlihan Lokey
A central function of modern risk management for banks is to manage liquidity risk, which in this context is defined as the risk created by the maturity mismatch between long-dated assets and short-dated liabilities. At a minimum, an institution must be able to continuously roll over funding at a rate lower than the rate it earns on the assets it is supporting; otherwise banks would never originate the long-dated assets like corporate loans and mortgages that are so important to the health of our economy. When the assumption of continuous funding is violated, very bad things can happen (see Lehman Brothers circa 2008).
In the asset management universe, recently we have seen startling examples of how an asset-liability mismatch can negatively impact asset managers who invest in long-dated or illiquid assets while offering frequent liquidity (daily, monthly, or quarterly, depending on a fund’s terms) to investors. One high-profile example is the 2015 lawsuit brought by the Public Sector Pension Investment Board of Canada against Boaz Weinstein’s Saba Capital hedge fund, in which the pension fund sought immediate liquidation of its investment in Saba (the pension fund was formerly Saba’s largest investor), forcing a hasty corporate bond auction to meet the request (The New York Times DealBook, “The Perils of Forcing a Sale of Illiquid Assets,” 9/28/15).
The impact of the June 2016 Brexit vote on UK property funds is without question a more timely, and much more substantial, example of the dire situation in which a fund can find itself when requests for immediate redemptions bump up against illiquid financial assets in funds with inadequate cash on hand to meet those requests. As of July 6, 2016, less than two weeks after the vote, no less than six property funds (representing more than half of the UK’s GBP25 billion property investment sector) had frozen trading and halted redemptions, causing a significant liquidity issue, eroding investor confidence (not to mention fund value), and contributing substantially to the anxiety in the global markets (Financial Times, “Three more UK property funds halt investor redemptions,” 7/6/16). The heavy inflows that these funds had enjoyed since 2009 had already begun to reverse as investor concerns about Brexit rose ahead of the vote and, ultimately, added to the liquidity woes of these funds following the vote.
We believe these cases clearly demonstrate that that in the event of dislocations caused by large redemption requests from funds invested in illiquid assets, advisors can have an important role to play in mitigating perceived conflicts of interest between a fund and its investors, minimizing legal liability to the fund, and ultimately maximizing value of the illiquid assets.
On the asset side, we examine institutional investors who have increasingly focused on illiquid assets as a mechanism to boost returns in the never-ending search for alpha.
Unlike public markets such as the equities exchanges, the dissemination of information in the illiquid financial assets markets can be inherently uneven, resulting in some investors possessing information that others do not; as a result, certain investors gain an edge that they believe will lead them to the nirvana of premium returns. In addition, their pricing almost always incorporates a liquidity discount, which, along with the information asymmetry, creates the alpha that makes investment in these assets worthwhile.
For example, over the past few years, investors have piled billions of dollars into high-yield bonds and leveraged loans in a search for yield during a period of historically low interest rates and relatively stable credit quality. But what happens when investors need to sell illiquid financial assets? What prices do the assets fetch on the open market? What is the genuine ‘open market’ for illiquid financial assets?
On the liability side are the limited partners or retail investors, who are essentially making a conscious decision every day to “roll” their investment back into a fund; if investors become uncomfortable with performance and the value of fund assets, they may decide to stop rolling their investment.
Unfortunately they are most likely to do this at the most inopportune time: when market conditions have caused the value of a fund’s assets to decline steeply, forcing a fund manager to resort to fire-sale prices to raise cash. The investment theses for these assets may still be intact over the longer term, but that is irrelevant when investors are demanding cash today. We have seen this dynamic playing out in the junk bond sector with $7.1 billion of capital outflows from high-yield funds in 2015, and a handful of funds electing to suspend redemptions for this very reason.
And therein lies the rub: illiquid assets have grown immensely as an asset class, and with good reason, but the process of selling them is neither easy nor straightforward. What many market participants don’t fully appreciate is that the seller’s actions, not simply market conditions, can be highly determinative of the amount of proceeds that can be realized, and whether these proceeds will match or vary from the seller’s book value. Engaging an advisor in these types of scenarios – either as a precautionary measure or in reaction to a catalyst – can be extremely beneficial to all parties as the right advisor will have many tools at its disposal, ranging from fund-level options like fund recapitalization, fund tender offers, or fund M&A to asset-level options involving segmented portfolio sales.
Jeff Hammer and Paul Sanabria are co-heads of Illiquid Financial Assets for Houlihan Lokey. Statements and opinions expressed herein are solely those of the author(s) and may not coincide with those of Houlihan Lokey.