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Start at the end: How to size and structure private allocations for corporate plans

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Many corporate defined benefit plan sponsors are evaluating the evolving role of their return-seeking allocations, including the part that private assets play. Some, having significantly derisked, are looking for ways to make a smaller return-seeking allocation work harder. They may also be contemplating changes in the size and structure of private allocations that have grown disproportionally to more liquid public assets, which were necessarily tapped for derisking.

Whatever the motivation for evaluating private allocations, a thoughtful, holistic review of plan liquidity and return requirements can facilitate an integrated approach to investing in private assets. We think plan sponsors should consider a “start where you want to end up” approach to the private allocation decision. This involves thinking through the desired end-state allocation, including any risk-transfer activity (e.g., lump-sum windows or annuity buyouts), and then working backwards from there. Starting with the end-state in mind may help avoid the risk of being over-allocated to illiquid private assets late in the glidepath, while still harnessing their potential to enhance returns.

Building a liquidity buffer — and being a liquidity provider

Liquidity is a key consideration given the need to make beneficiary payments, particularly for plans close to or at the end state. Exacerbating this, many plans at this stage will likely hold large allocations to corporate bonds, which are typically less liquid. However, we believe private assets’ lack of liquidity is not an insurmountable challenge and that some plans may even be surprised by their ability to be a liquidity provider.

To meet liquidity demands while retaining flexibility to allocate to privates, we think plans should consider carving out a liquidity buffer to meet near-term and intermediate liquidity needs (e.g., over five years). To illustrate, Figure 1 shows a hypothetical plan that uses cash and Treasuries to back projected cash flows over the first three years, and public equities and more liquid corporate bonds for projected cash flows in years four and five. Plans want to avoid forced selling in stress scenarios, and we believe this time horizon would allow sufficient flexibility to reduce equities and corporates to reconstitute the near-term liquidity buffer. We think defensive equities could help in years four and five, as they may mitigate losses in more challenging environments for risk assets (reducing the potential impact of rebuilding the liquidity buffer) while still offering upside potential relative to the liability, thereby fulfilling their return-seeking role.

At the other end of the spectrum, the long run-off for most plans may allow plan sponsors to be a liquidity provider with a portion of their assets. In Figure 1, almost 50% of the representative 12-year duration liability is attributable to cash flows coming due more than 10 years from now. With an appropriate liquidity buffer in place, such a plan may be comfortable allocating to illiquid assets — perhaps up to 50% of the return-seeking allocation at the end state — to support these longer-term cash flows.

Figure 1

Plans that are earlier in their glidepath might consider capping their private allocations at this end-state level (our “start where you want to end up” point). Alternatively, they could invest in private assets with shorter life cycles, such as private credit and late-stage private equity.

Of course, each plan should evaluate its unique cash-flow profile, but we think this could be a useful framework for evaluating near-term liquidity needs relative to the ability to provide liquidity. Plans also should take into account special situations that may require supplemental liquidity, such as less predictable cash-flow patterns (e.g., lump sums or cash balance benefits), risk-transfer objectives, and reserves to back margin calls or capital calls. Sizing is critical, reflecting the importance of liquidity to enable derisking allocation changes along the LDI glidepath or potential corporate actions, such as lump-sum windows and/or annuity buyouts.

For plans moving toward a state of annuitization, a sale in the secondary market may be worth consideration. This reflects the reality that while asset-in-kind practices of annuity providers have become somewhat more flexible, particularly around publicly traded fixed income assets, few insurers have accepted illiquid assets such as private equity. Over the past decade, there has been significant growth in secondary market fund transactions. However, plans should be aware of the unique aspects of the secondary market. Investors seeking to sell private investments in a secondary market transaction often must negotiate with a counterparty, and the negotiated price may reflect a discount to the NAV, depending on market conditions. Additionally, if the investment to be sold is held within a commingled fund, investors may need permission from the general partner to transfer ownership.

Investing in the evolving private equity market

We think recent trends in the equity “ecosystem” make it an ideal time for plan sponsors to evaluate their approach to private market investing. In particular, we believe changes in how private companies raise capital and when they go public (the subject of the recent paper, “When public and private equity converge: An allocator’s guide”) should be reflected in asset allocation and portfolio construction decisions. For example, with additional options to fund growth outside of an IPO, startups are staying private longer. As a result, the timeline to liquidity for some private equity funds has been extended. For a plan sponsor, this may accentuate the liquidity risk associated with private equity.

However, the trend toward staying private longer has also expanded the private equity opportunity set. For example, late-stage growth funds typically seek to invest in companies one to three years before an IPO and may offer a faster return of capital than early-stage venture or buyout managers. This could enable plan sponsors to better manage their liquidity budget and support liabilities, particularly as they derisk and seek to avoid a disproportionate private weighting within the return-seeking allocation.

We see several other potential advantages related to late-stage venture capital (VC). As Figure 2 shows, the median net internal rate of return (IRR) of late-stage VC has been competitive with early-stage VC while exhibiting a more attractive risk profile. Late-stage VC is also a larger market, which may provide the breadth needed by many plans. Finally, the market potentially offers faster velocity of capital and greater visibility into distributions.

Figure 2

A portion of the superior risk-adjusted returns shown in Figure 2 may be due to the lower “failure rates” among late-stage companies. While early-stage VC companies may be pioneers of new industries with evolving business models, late-stage companies may have established business models and greater traction in the marketplace, potentially resulting in lower failure rates. This risk profile may be a better fit with a corporate plan’s investment objectives, which are often focused on managing funded-ratio volatility and drawdowns.

Of course, none of this is to say that the late-stage market is without risks of its own. For example, a market retrenchment or a shift to a “risk-off” environment with respect to equity investments or capital spending may cause these companies to experience a delay in liquidity events. A recessionary environment would also be challenging because we could see a confluence of poor fundamentals and a weak IPO market. Additionally, manager access and selection are key determinants of investment success in private markets. There is significant dispersion between top- and bottom-quartile private managers relative to the public universe. Selection and discipline are especially important in today’s environment, where manager activity is high and the exit environment strong.

What about private credit?

Private credit strategies may also play a role in a plan’s return-seeking allocation, with investors in this asset class typically seeking equity-like returns with lower volatility and shorter lockups (6 – 8 years, for example) than traditional private equity. Private credit may also offer higher income relative to public credit, motivating some plans to consider holding allocations within their liability-hedging allocation.

Before implementing a private credit allocation, we think plans should determine their specific objectives, given the diverse range of strategies across the liquidity and risk spectrum. These include strategies focused on senior mortgage loans and senior unrated direct lending strategies, which often form the core of a private credit approach, as well as venture lending, distressed debt, CLO equity, and other niche sectors approaching more “equity-like” risk.

In summary, a thoughtful approach to liquidity management, starting with the end state in mind and working backwards, may provide plans with the flexibility to invest in targeted private market strategies in the pursuit of their return objectives.

Important Disclosures


Please refer to this important disclosure for more information.

Authored by
Amy Trainor
Amy Trainor, FSA
Multi-Asset Strategist
Cara Lafond, CFA
Multi-Asset Strategist
Jake Brown, CFA
Investment Director

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