Railpen has shared a new framework to help defined benefit (DB) investors assess their capacity to invest in illiquid assets and manage investments through time, showing how liquidity buffers can help determine the appropriate level of illiquid asset exposure.

The new framework is focused on the illiquidity aspect of private markets, rather than the potential for additional return or diversification.

It was developed for Railpen’s DB pension clients, including both open DB and closed DB, although it also aims to help the wider pension industry tackle this important strategic investment issue.

The framework incorporates key multi-asset portfolio assumptions, client long-term objectives and unique illiquid asset cash flow properties.

Railpen clarified that while the exact measures may differ by client, the general principle is focused on managing the medium-to-long-term risk of being forced to make unattractive and costly portfolio decisions to create needed liquidity.

The framework was shared alongside a research paper showcasing 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.

This showed that, 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 and willingness to tap into the secondary market if needed.

When designing a portfolio for an open scheme, meanwhile, Railpen found 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.

In addition to this, it found that while the “Canadian pension fund” is a less constrained investor, illiquidity capacity should also be considered for portfolios with high illiquid asset allocations.

Railpen director of fiduciary management, John Greaves, stated: “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.

"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.”

---