Transcript | Illiquidity Premium and Private Asset Classes


Sarah Widmeyer

0:16 

Welcome to Conversations on wealth, a podcast dedicated to helping Canadians with your total financial picture. I'm Sarah Widmeyer, Director of Wealth strategies at Richardson Wealth, and joining me today is Romain Marguet, Vice President of Alternative Investments with Richardson Wealth. Welcome back, Romain. Thank you very much for having me again, Sarah.


Romain Marguet

0:36

Thank you very much for having me again, Sarah.


Sarah Widmeyer

0:40

So whenever our investment specialists join the podcast, we often hear the term liquidity referred to. So I want to take a stab at liquidity is the efficiency or ease with which an asset or security can be bought or sold. The most liquid asset then would be cash itself. So why would some investors be in favor of surrendering or giving up liquidity? And what opportunities could that lead to? Romain is here to shed light on these and other key considerations. So Romain, tell me about the concept of illiquidity premium, so lack of liquidity premium. And how does portfolio construction affect a client's ability to maximize opportunities with regards to that?


Romain Marguet

1:32

For sure, and this is the great dilemma, I think, in portfolio construction, currently with many high net worth portfolios, specifically in Canada. So the illiquidity premium is really the additional returns you could capture from potentially locking your money up for a longer duration than it would be if it was obviously sitting in cash or sitting in public markets, where your liquidity there is basically daily. So we're looking at asset classes, generally, that are always never traded on public markets. And that refers to private real estate. So obviously investing in either residential homes, commercial properties, industrial properties, logistics properties, private debt, which once again, is an investment in either directly making a loan in a private market to somebody whose a private company or a private citizen, or obviously investing in a manager that does that, on your behalf. Private equity is the same idea. It's investing in private markets, so companies that are not listed on stock exchanges. And venture capital is very much like private equity, but its earlier stages for those companies. So companies that are still in their ramp up stages that are not yet profitable in many cases. And the last one would really be private infrastructure. Private infrastructure is very popular and has been for decades. And that is investing in and all the infrastructure that you have around you. It could be schools, it could be hospitals, it could be highways, it could be solar fields, it could be pipelines, and you know, those are long term investments, obviously, they are not liquid. If you own a piece of a pipeline, you cannot sell that the next day or that day or even that month. These are inherently illiquid asset classes, the reason that you would look at them is because you're hoping by locking up your money to be able to get a premium on the returns that you would otherwise get in public markets.


Sarah Widmeyer

3:36

And so how long might you be holding on to these investments? Is it a year, two years?


Romain Marguet

3:43

That's a good question. There's huge variability there. It seems in the Canadian High Net Worth space, we've sort of looked at any investment that's inherently liquid would be one day. And then we still consider assets that are maybe monthly liquid or yearly liquid as being fairly liquid. Obviously, I use the example of private infrastructure and those cases, you're looking at assets when you're buying into a private infrastructure fund that are 10, 12, maybe 15 years of lockup. And in the middle there, you have private equity and venture capital and private debt, which could be anywhere from two to three years, to five or six years to 8 to 10 years. And obviously, the you know, the rationale is that, as you brought up portfolio construction theory is key here for decades, people often stuck to public markets, that's what was readily available and easy to access. And now more and more, the high net worth and ultra high net worth clients are realizing that there definitely is a spot, you know, maybe it's 5%, maybe it's 10%., maybe for some clients, it's 20% of their portfolio that can be carved off to these types of assets that are inherently more illiquid. But once again, we still always fall back properly constructing a portfolio to allow for this illiquidity, you never want to be in a situation where you need to be liquid for whatever given reason and can't be. So that scenario changes for every client and needs to be managed accordingly.


Sarah Widmeyer

5:15

Right. Okay. So what has been driving clients demand within this space?


Romain Marguet

5:22

Well, it's a few things, definitely the lower correlation of the asset classes that I brought up. A correlation means that the client is looking for an asset that doesn't behave like the public equities he already owns. So when you get a dip in the market, as you did in 2008, for example, and equities took a you know, a 40% haircut, these asset classes were supposed to give you a diversified return stream. So they were supposed to give you not necessarily the opposite, but far less of a drawdown, and in some cases, actually, they were supposed to provide you with positive returns during a down public market. So, you know, this idea of correlation is key, they realize that if you have a portfolio that behaves the same way in a downturn, you're going to lose whatever the downturn equates to. So owning private real estate, private debt, private equity, venture capital, or private infrastructure, will minimize that drawdown. And that is for sure one of the key goals, you want to mitigate your losses, you want to mitigate the volatility, so the short, everybody wants to capture as much upside with their investment. But there's always a trade off as to how much downside you're willing to withstand. And that is key. And once again, going back to portfolio construction, and the idea of correlation, it's matching that these assets are inherently less correlated to what you already hold in your portfolio. That's one major step that all investors are trying to achieve. The next one would be around yield. The fact is clients, especially elderly clients, and clients that are retired, have a demand for yield, they have a certain portfolio, and they are trying to get income from that portfolio of investments to be able to purchase assets, live their lifestyle, everybody has a different demand for yield, and yield currently, with the markets that we're in is quite low. So therefore, these assets by having this potential illiquidity premium are able to provide a higher yield than for example, public bonds, and therefore the rationale becomes, okay, well, I, I can then carve a piece out to certain assets that have that higher yield, understanding that there are other risks that come along with those such as illiquidity. And that is the way I can get from potentially, you know, a three, four yield in my portfolio to a five, six, seven yield in my portfolio. So, you know, assuming you have a million dollars in your account, and you depend on that million dollars to provide you with income. If you're solely in public markets, right now, you're depending on your risk tolerance, it'll vary between anywhere from, you know, two, three, four percent. And if you expect to get more than that, you often have to go find that yield in private markets, where once again, there is no free yield. So every time you go up, one percent, you're either giving up liquidity, or you're adding risk to the book to your portfolio by going up the risk curve and buying riskier loans in the private debt space.


Sarah Widmeyer

8:31

So I guess let's pause for a minute and talk about the risk. So one risk is that if I need the money for some cash flow issue, or some immediate shortfall, the risk is I can't get that money, that money's locked up for some period of time. So I can't just call my advisor and say, I need $20,000 today, because I've got a bill, I've got a new roof that I have to repair


Romain Marguet

8:58

For sure. Yeah.


Sarah Widmeyer

9:00

Okay, so that's one element of risk


Romain Marguet

9:02

It is one element of the risk if you are aware that what you have bought is illiquid, which you should be. And this will open the discussion around evaluating risk in these asset classes, which is inherently more difficult than in public markets, because in some cases, specifically, and you brought up private debt, in many of these cases, some of these products are marketed as being more liquid than they actually are. So you, you will be told, Oh, well, here is a mortgage fund, you're buying private mortgages, and they will tend to market that as a strategy where you can get your money out on a monthly or quarterly basis. And that is often true in good markets, but in bad markets, unfortunately, the liquidity of their underlying portfolio is not monthly or quarterly liquid. These people are issuing mortgages, and even if they're shorter mortgages than what the banks do, you're looking at mortgages that are anywhere from one to five years. So in a downturn where many people ask for their money back, these funds have the ability to do what's called gating. So therefore, they put a halt on redemptions. And redemptions will come as soon as the fund gets more money from mortgages that roll off or are paid off. And that is a major variable that is often missed by many investors. And unfortunately, it's also sold that way, so there are definitely managers that don't touch on the inherent risks around liquidity, and like for marketing purposes to focus on oh, well, I you know, this is actually pretty liquid. Sure, it's not daily liquid, but it's monthly or quarterly liquid. And, you know, if you actually read through all the documents of their structures, they will have paragraphs that say, well, this is true, but we can gate in a downturn, and unfortunately, most investors don't read these offering memorandums that are sometimes hundreds of pages long. And it should be on obviously, the manager to share these details, but I will always say and I always do, any advisor, any client who looks at these products is forced to do more work, you cannot ignore the documents that are put in front of you, you need to understand the inherent liquidity and these potential liquidity mismatches that are offered by managers. That is a key risk that we saw was very much underestimated, once again in 2020. And we saw quite a few lenders or actually also some private real estate funds were forced to gate because of an increased demand in redemptions. And they weren't able to meet that. So they gated some of them gated for you know, it took them one or two months to be able to get liquid and meet those redemptions. And in some cases, they did not, it took six months. And in some cases, we have a few lenders that are still gated, we don't own them, but you know, they're out there on the street, and other clients do own them. So it's a variable that seems, you know, marginal next year evaluating the strategy risk and evaluating the investment team and the manager as a whole and the credit risk of the manager and the market risk of the strategy. These are always the focus when you're doing due diligence for public funds, and it is also for private funds. But the additional layer that you get with private funds is definitely the structural layer. So liquidity is definitely one of them. You know, it's a focus that can't be ignored that there's additional complexities in these offering memorandums around how money is moved around, how fees are paid, all these things should be reviewed properly, but the one that is missed the most is definitely liquidity.


Sarah Widmeyer

12:45

So what I'm hearing when you're telling me all this, is one, it's a very interesting asset class, it's a diversifier. It's something that for the right investor, it should be considered to help diversify portfolio returns that non correlated asset. But the other thing that I'm hearing is, is that the importance of working with a firm such as Richardson Wealth that understands this type of investment, and understands the risk is really important. And even more so is finding an investment advisor that you are comfortable. And they are well knowledgeable in this area, there's a couple of elements. So great thing to consider for diversification. But also, there's a higher level of what we call due diligence research and understanding that's required to put this type of asset class into your portfolio.


Romain Marguet

13:44

Absolutely, all of these asset classes require more due diligence, period, it is that simple. And they also require more ongoing due diligence. You can't simply, you know, go on your computer and go on Morningstar and look up at the value of the fund. These things are, are not public, these assets that you hold in these funds are also not made public on funds like Morningstar. So they have to be tracked, they have to be monitored. We have a team here at Richardson that's established to do just that. It's our focus. It's what we do every day. It's the only thing I do every day and it can't be overlooked. There are changes that are not public changes, and it is up to you to be able to find those changes, and then it is the job of our team and our advisors to communicate that to the end client. That's a service that we have to provide if we are going to be able to approach these asset classes. We've taken a stance for as long as I've been here to try to give access to, especially in private real estate and venture capital, and private infrastructure where inherently we are one of the only IIROC firms that gives our clients access to this. It comes with a whole lot of work that is required and a whole lot of education. And you cannot skip these steps if you want a lower correlation asset to improve the return profile of your portfolio, and mitigate the drawdown and potentially get more yield or get more alpha. And also, you know, a very relevant conversation piece right now is inflation, many of these asset classes protect against inflation, it's something that unfortunately, we may see over the next many years that we haven't seen for the past many years. So therefore, inflation protection is at the forefront of every discussion I have. And sure, you can get that from private infrastructure, but is private infrastructure an asset class that is good for everyone? It is not, some clients can withstand to have a fund that they purchase and is illiquid for ten to twelve years, and some clients cannot, and there is no skipping that when you come across somebody that tells you, oh, here is a fund that mimics the return profile of infrastructure, but it's daily liquid, when something seems too good to be true, it is, it definitely is, that you cannot skip these facts. And if you want to buy into solar fields, and wind farms, there is no way to make that liquid. And that is a variable you will have to understand and be willing to live with if you are going to invest in these asset classes.


Sarah Widmeyer

16:25  

So, are these asset classes readily available to clients? And I guess what I'd like you to tell me about is, again, at Richardson Wealth, this is an area that we have gone in to with eyes wide open, we have invested in the people and the resources for this asset class. And I’m kind of thinking that we're doing something that maybe not everybody else is doing. So can you talk a little bit about that.


Romain Marguet

16:54

For sure. I've been with the firm, just over five years, and I can tell you, I've seen an incredible shift in the availability of these asset classes for high net worth and ultra high net worth investors. Five years ago, it was categorically impossible to, you know, I'll take a private infrastructure, again, to access private infrastructure. These were asset classes that were sold to our pensions, to sovereign wealth funds, to large foundations and endowments. And we're not seen as a fund that was sellable to a private client, the minimums on these funds, were often five to ten million dollars. So if you were willing to withstand the illiquidity, you still had to write a minimum of a five to ten million dollar check to be allowed to invest in the strategy. What we've seen is now many of these managers are willing to lower those minimums work with companies like us who understand the asset class, and who match investors that match the profile of investors that those managers want, because the manager on their side also does not want to have a problem with an investor that doesn't understand their product or is asking for liquidity and something where there is none. So inherently many managers have stayed away from high net worth investors for those reasons, we do an enormous amount of work and have done so for over five years to approach these managers, explain to them that we have demand from our clients, and what can we do to structure a scenario where, obviously, the minimum tickets are smaller. We don't often try to change the liquidity, the liquidity is what it is, and if it's not right for you, then you should not buy it.


Sarah Widmeyer

18:40  

And I'm sorry, Romain, when you say minimum tickets, you mean, the minimum investment?


Romain Marguet

18:46

Yeah, the minimum investment size for you to be able to buy it in your portfolio. So obviously, taking that down from, you know, five, ten million to fifty thousand to one hundred thousand, is often the case, it's educating people on both from the client side, and from the manager side that there is demand. There are many clients who need this in their portfolio from a portfolio construction standpoint. They want that protection against inflation, they want those higher yields. And for the client that is willing to give up the liquidity. It's just a matter of creating a vehicle that works for them. So we do a lot of work for that we do a lot of work to source these managers globally. Often, you know, a company like Richardson, or any of our competitors in Canada, were immediately written off, as well, you know, it's not an avenue that we should explore. So we reach out, we proactively approach these managers globally, to try to access the strategies and in many cases, these managers have, you know, it's strategies that have very high barriers to entry or even in monopolistic positions. And therefore, you know, they aren't necessarily out there looking for new investors, we're looking for them and sourcing these ideas, these strategies is key, and it's the value-add that we're trying to bring to our clients. And, you know, it took us four years to get access to private infrastructure. But we're finally there. Venture capital is definitely an enormously growing asset class for high net worth investors who want to access early stage, tech companies, early stage healthcare and medical tech companies. Private equity was further along the line, but now we're definitely seeing greater interest globally, and easier access with structures that makes sense for high net worth clients. Private debt was the one that was inherently always available, but unfortunately, it was the one that was also laden with risk due to this liquidity mismatch I explained earlier. So what we're actually doing now is finding new structures outside of Canada, new managers who aren't selling this asset class as being liquid and are selling it as what it is, which is sure, you'll be able to get seven, eight, nine percent yield, but it is not monthly or quarterly liquid, it is potentially a two, three, four, five year fund.


Sarah Widmeyer

21:21

So as we close off, I'm just wondering if I'm a client, I'm interested, what would be my next step.


Romain Marguet

21:31

The next step is definitely to reach out to your Richardson advisor and discuss this asset class. All our advisors have a team that they can also rely on to build a portfolio with any of these asset classes so that it makes sense for you that it meets not only your liquidity profile, but the risk tolerance that you have. Many advisors obviously are equipped because they've been doing this for years, to do this by themselves, it's definitely become a niche for us as a firm. And our job at the firm is to make sure that advisors always have the best products to provide to their clients. And that's the variable that's changing every month. And that's where we come in and also come in from the due diligence side to make sure that whatever it is we're providing to our clients is being monitored on, initially of course and on an ongoing basis.


Sarah Widmeyer

21:24

Awesome. Okay, Romain, thank you so much. If you have any questions about the concepts or ideas discussed in this episode, please reach out to your Richardson Wealth advisor or visit our website at richardsonwealth.com for more information. Thanks again, Romain. And remember to follow Richardson Wealth on LinkedIn for the latest in wealth strategies. Conversations on Eealth is available wherever you get your podcasts. Thank you all for listening. I look forward to the next conversation.


The opinions expressed are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson Wealth Limited or its affiliates. Past performance may not be repeated. Richardson Wealth Limited is a member of Canadian Investor Protection Fund. Richardson Wealth is a trademark of James Richardson & Sons, Limited used under license.