Here’s how advisors can manage clients’ liquidity risk in private markets

Private-market funds inherently have liquidity constraints, but there’s more nuance to these products than meets the eye.

During a webinar last month, Nimar Bangash and Puneet Grewal, co-founders of Toronto-based alternative investment platform Obsiido, broke down how financial advisors can manage their clients’ liquidity risk in private markets, particularly when it comes to evergreen funds.

Here are some of the tips they shared. They come in the wake of multiple fund managers announcing freezes or limits to investor redemptions on certain private-market funds.

Not all illiquidity is the same

Advisors should beware that “not all illiquidity is the same” across private-market funds, said Grewal, who’s also the chief operating officer at Obsiido and a practicing securities lawyer.

“The first step, really, is to review and compare the liquidity terms for each of the investments,” she said.

“Focusing on the redemption frequency, the gates, notice requirements, lockups and all that, I think it’s important to understand that even among very similar strategies, these details can vary quite dramatically. And they’ll make all the difference when markets tighten, or there’s a liquidity crunch.”

Both closed-end funds and evergreen funds have lock-up periods that dictate how frequently investors can make redemptions, Grewal explained.

Closed-end funds have a hard lock-up period, which means no redemptions from these funds are permitted for a set period of time. This period typically lasts 10–12 years.

Evergreen funds have a hard lock-up period too, usually lasting one to three years, but they could also have a soft lockup, which allows investors to redeem early, subject to a withdrawal fee or penalty. It’s important to note that each time you make a subsequent investment in an evergreen fund, you’ll have a new timeline associated with that early redemption penalty, Grewal noted.

Keep track of investments

Advisors must keep track of notice periods for redemption requests, the associated redemption cutoff dates and payment dates for when you’ll be able to access redemption proceeds.

For example, with evergreen funds, investors typically need to provide a fund manager with 30–90 days notice to make a redemption. But if they miss the redemption cutoff date, then their redemption request will roll into the following redemption period.

“So, what may have started off looking like a quarterly liquidity opportunity [in an evergreen fund] could easily turn into a six-month wait, maybe even longer,” Grewal said.

As a best practice, advisors should maintain a calendar to keep track of these details, she recommended.

Take note of redemption gates

Advisors should also review gate provisions in fund documents.

Gate provisions allow fund managers to limit or halt redemptions during a given redemption period, preventing runs on the fund. They can exist at the investor level or the fund level.

“So, there may actually be a gate on how much of your investment specifically you’ll be able to redeem during a particular period, or there may be a gate on how much of the redemption requests a fund can actually fulfill,” Grewal said.

Some fund managers gate or halt redemptions if redemption requests amount to 5% of the net asset value of a fund in a given quarter. There may also be redemption gates imposed based on thresholds set for a fund on an annual assets under management (AUM) basis, she noted.

Understand where a fund’s liquidity comes from

Another factor to consider is a private-market fund’s sources of liquidity.

Advisors should read fund documents to understand whether the manager has access to credit facilities or a liquidity sleeve for a particular fund, which is typically a small allocation to cash or cash equivalent securities that can act as a liquidity buffer so that fund managers don’t have to sell the core holdings within a fund portfolio.

If cash proceeds are not possible, there may be a reference to redemption notes in the fund documents. These notes “are essentially short-term IOUs that are issued when immediate liquidity isn’t available,” Grewal explained, which means “that you’ll get access to cash proceeds at a time in the future.”

“All of these [details] will help determine whether the redemption terms are sustainable in the long term,” she added.

Another thing to note about redemption notes is that they’re not eligible for registered accounts “and can create potentially a tax liability inadvertently, if you do accept that note in lieu of cash,” said Bangash, who’s also the CEO of Obsiido.

“These things go layers deep. It’s sort of an onion to unwrap them,” he added.

“And unfortunately, there is no standardization — every fund could have a different set of liquidity terms.”

Review the fund’s history

It’s equally important to review the history of distributions, redemptions and gates for a given fund or similar fund(s) that a fund manager offers.

This will give advisors a sense of whether the manager has been able to fund redemptions consistently or has run into issues in the past where they’ve had to stop paying out distributions or limit redemptions.

Check whether the manager has a track record of gating funds, and if so, how they’ve handled those gating circumstances, Bangash recommended.

“The reality is, within private markets, within evergreen and semi-liquid structures, depending on where you are in a given cycle, every asset class will face pressure,” he said.

“And there may be an instance where gates may go up to protect the existing investors from having to fire sale assets out of the portfolio, but it depends on how the manager and fund handles those circumstances, how they communicate, the time it takes to unwind the gating circumstances.”

Further, a lot of the private-market funds that are increasingly becoming available in the Canadian market are feeder funds that invest in a master fund, Bangash noted.

Because feeder funds rely on redemptions from the underlying master fund, liquidity is layered, and therefore payouts could take longer than anticipated.

Review the fund manager

Advisors should analyze a fund manager’s overall investment lineup before deciding whether to invest in a particular fund they offer.

“It’s not just about the one strategy. It’s important to understand how diversified that manager is across their fund lineup, how their AUM is distributed,” Grewal said.

She noted that a larger firm with multiple funds can usually manage liquidity “far more effectively” than a smaller firm that only has a single private-market fund to its name due to the amount of experience they have in the private markets.

Other factors to consider

Some other factors to consider include a fund’s investor base and whether it uses leverage.

Understanding who’s invested in a private-market fund can help advisors gauge how likely the fund is to face liquidity stress.

Institutional investors, for example, tend to have longer time horizons than the typical retail investor, so if a fund’s investor base includes institutional investors, that should provide you with “some additional comfort that there might not necessarily be a run on the strategy in a stressed environment,” Bangash said.

As well, it’s beneficial to understand the use of leverage and terms that accompany that leverage, he recommended.

This is because “in a situation where a fund is under pressure or is facing stress, the creditor is at the top of the capital structure, so if they are then looking to repatriate, or unwind any loans or credit facilities that are extended to that fund, that only creates further stress within the structure of the portfolio,” Bangash said.

Education is key

Given the complexity of these products, advisors must educate clients about liquidity risk in private markets both when they initially choose to invest in the space and on an ongoing basis.

Inform clients not just about the potential that comes with investing in private markets, but also the associated tradeoffs, including delayed liquidity and valuation lags, Grewal said.

“Education can’t be just a one-time conversation. It needs to continue to evolve as markets and client circumstances evolve,” she said.

Also, as a client’s life circumstances change, it’s possible that their risk tolerance and liquidity needs will also change. Advisors should pay attention and adjust client portfolios accordingly.

“It’s very difficult to avoid illiquidity in private markets, so it’s more about managing it deliberately, transparently and ensuring that it meets your clients’ expectations,” Grewal said.