Saturday, April 6, 2019

Focus on liquidity before jumping on the PE bandwagon

A well-known GP has been known to say that PE performance “isn’t a return until you can buy a beer with it.”  - Chris Schelling

Following this beverage analogy, liquidity is required to slake our thirst for funds to smooth consumption. Wealth is generated and stored to offset needs that cannot be met with current income. 

Liquidity means being able to sell investment with immediacy at a known price. That beer has to be in the refrigerator and ready for immediate consumption. One of my leading concerns for 2019 is liquidity. To be truthful, liquidity has always been one of my leading investment concerns. Liquidity can come in many forms and it does not mean that everything can or should be sold at fair value on any day. It does mean that there should be limited structural and market restrictions on the access to invested money.

Liquidity is the ability to gain access to cash. For any portfolio with different levels of liquidity, a financial crisis means that you will have to sell liquid assets first which will change the risk composition of the portfolio.  Portfolio imbalances as a response to cash needs are normal. Investors accept low returning cash for a portion of the portfolio to minimize imbalance risk and liquidity costs. However, an extended downturn that impairs income will require more funds from wealth which increases portfolio tracking error.

Patient money can invest in less liquid assets and take the portfolio variation risk from different liquidity levels. This is the key reason why endowments can load up with private equity in ways that cannot be done by investors who need more liquidity. Patient money does not have to worry about short-term business cycle risk. Patient investors can look beyond portfolios built to support consumption smoothing. Of course the money manager has to convince a board of trustees that patience is a virtue with potential mark-to-market pain.

Our core concern with PE investing is that the desire for higher returns will mask the need to focus on liquidity. The risk is especially present when we are potentially late in the business cycle. Do a liquidity stress test assessment before focusing on further private equity investing. 

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