In illiquid markets there is no such thing as a free lunch, but you can eat someone else’s!

In this piece, my second instalment in my series about "run on", I was in conversation with Matthew Searle, a professional trustee with first-hand experience of making the most of the latest "it-looks-too-good-to-be-true" trade. Read my earlier POV

The secondary market for illiquid assets in the UK has been flooded with high-quality, long-term liability-friendly assets... assets mid-way through their lifecycle and already returning profits to investors... and they are selling at material discounts. You would think that pension schemes would be buying them up... and you would be wrong. In fact, it is pension schemes selling their holdings in these assets that have created the scenario. If you have scope to buy, when others are selling, you are in the minority and it’s well worth investigating.

In order to work through the potential pitfalls and reservations, I asked Matthew a series of questions about such a deal, that he undertook recently. So if you are a pension scheme trustee, and if you agree that money-good assets trading at 10-20% reduction to fair value sounds like a good buying opportunity, this should be of interest to you.

Jordan: Why are so many schemes selling assets at such a large discount?

Matthew: With funding levels having improved significantly for many schemes, trustees are now in a position where they want to either proceed to a buyout or at least position the scheme for this. If there are enough funds to cover wind-up expenses, then as long as the sale of any illiquid assets still leaves assets sufficient for the insurance transaction, it can be in everyone’s interest to sell at a discount to the net asset value.

What is important to trustees is securing the members’ benefits and not necessarily the value realised for a specific asset within the fund. As a result, trustees are increasingly selling illiquid assets on the secondary market at a discount to the stated net asset value.

Jordan: What made you decide to do the opposite?

Matthew: I had a large scheme that was looking at the potential to reduce its exposure to a particular illiquid asset and as part of that the XPS team made us aware of a similar asset for sale using their knowledge of the secondary market. The Trustees decided not to reduce exposure on that scheme, but it did prompt me to think about schemes where a purchase could work given the discount available.

I have another scheme with a very well-mapped journey plan, with an agreed long-term funding target and a 7-8 year window to reach this. The employer was about to finish deficit reduction contributions and the Trustees were looking at cash flow management as well as ways to further improve the funding position to keep on track with the journey plan.

At first glance, the asset XPS had identified as being for sale looked like it could be a good fit for that scheme so we said why not look at buying it. After the initial thoughts, we then went through a thorough process of consideration and due diligence to validate this initial thought before formalising our position and acquiring the asset.

Jordan: Are you not concerned about being prevented from transferring to an insurance solution?

Matthew: This is the scenario that should be one of the most significant parts of the Trustees’ thinking if considering a purchase when the buyout is your end-game target.

It’s important to work with your advisers to ensure that adding any illiquid asset to your portfolio, either as a normal investment or a purchase on the secondary market, is proportionate and is part of a clear strategy towards reaching an end game. Challenge your advisers on the risk and be clear about what the exit plan is and when. Only proceed with a transaction if you are comfortable that you can realise the asset at the right value at the appropriate time.

In this case, we considered at length how the purchase met the above criteria.

Jordan: How do you plan for the illiquidity?

Matthew: As this scheme had a well-developed journey plan, cashflow visibility and collateral waterfall to support the LDI mandate, the key was to make sure that any purchase did not jeopardise any of these and, where possible, complemented these.

In this instance, we purchased a relatively mature illiquid credit fund with good visibility of distributions over the next 3 years and reasonable confidence in the timeframe to the final distributions which were consistent with our end game planning.

We mapped various scenarios with XPS to understand how the asset fitted within our investment strategy and the contribution to cash flow, expected returns and the scheme funding level. The Trustees discussed all the risks at length with XPS and explored tail risk, the asset not being fully distributed in the timeframe expected or defaults of some of the last remaining underlying assets in the fund.

The Trustees only committed to the transaction once they were fully comfortable with the risks and mitigations.

Jordan: Do you have to be running on indefinitely to access this opportunity?

Matthew: No I don’t think so. Whilst this option will likely be far more attractive to schemes that are open to future accrual or running on indefinitely it is still a strong option for some schemes with a clear plan and vision of their end game, and the timings of that, which may be more towards the mid-term.

Jordan: What were the key features of your recent deal that made it attractive?

Matthew: As this was a credit fund distributed over the next 3-4 years, it met a reasonable proportion of the benefit payments due in the mid-term so that was the first consideration.

Due to the type of asset, we were also able to gain a good level of confidence that the quoted net asset value was realistic and not overstated.

And obviously one of the key drivers of the purchase was the discount we received against the net asset value which will have made a good contribution to improving our funding level and closing a small gap we had to our target at the point of purchase.

Jordan: What advice would you give to other schemes considering purchasing illiquids?

Matthew: Do not take the first opportunity you come across because the discount looks so attractive.

If you think purchasing illiquids on the secondary market could fit your strategy, work with your advisers on the asset classes you are interested in and be clear about how this fits in your investment strategy – it is best to find assets that fit within your strategy rather than trying to fit your strategy round a specific opportunity.

Seek the sponsor’s views fairly early on, in this case, we had a very commercially minded sponsor that understood the benefits and had an appetite for the risk – don’t forget the importance of the employer covenant in any decision-making process.

Be clear about the costs of investment advice and the legal work involved when making any offer to purchase as these are not small but the transaction can still be well worthwhile. Try to fix these at the outset.

In all of this do not lose sight of your end game and only add assets that clearly move you along your journey plan with minimal risk.

Finally, don’t be afraid to swim against the tide – whilst this option won’t be right for many schemes it could be that it works very well for yours and advisers like XPS are well-placed to support and advise you in this respect.