Lines of Defense

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As you begin your year, one of the key tasks you should think about is liquidity planning: Taking stock of what in- and outflows you plan to have in the next year and beyond, how to cover especially those outflows with means of liquidity on hand, and/or how to refill this liquidity from elsewhere in your portfolio.

Surprisingly few affluent investors  actually take the time to map out their liquidity requirements with sufficient diligence. And that is despite their higher degree of complexity - think portfolios split across different entities, ongoing outflows for cost of living, running costs for advisors and assistants, a fund portfolio in the build-up period, and a desire to make opportunistic investments in various asset classes.

Taking into account this complexity, the liquidity picture of such investors might look starkly different depending on market environment: Definitely the ‘right bet’ during good times, where a focus on return-oriented assets, including illiquid ones, pays off. But perhaps not the right one in more turbulent times, where funds keep on drawing capital, but when your source of liquidity (most often, 100% equities) is down substantially, and perhaps already reaching its limits in terms of collateral for margin loans or otherwise.

So let’s make sure that you don’t run into these issues. Today, let us talk about what I like to call Lines of Defense for your liquidity planning.

The Basics: Proper Liquidity Planning

It might seem surprisingly simple, but the best start to your liquidity planning is simply knowing what liquidity needs you have. To paraphrase from last week’s article, where I emphasized the importance of beginning-of-year tasks, including liquidity planning:

First, make sure you have an overview of capital requirements in your investment portfolio. That includes contractually required investments, such as a fund commitment, and the adjacent expenses like management fees. But you should also account for liquidity needs that are not contractual but still firmly planned - such as a certain amount that you want to invest in start-ups every year.

Secondly, and often underestimated, are capital requirements for private matters. That is ongoing costs such as cost of living, or a mortgage (surprisingly, often forgotten, despite the significant magnitude). There might also be one-off private expenses, i.e. the purchase of a car or residence, or intended charitable giving. 

How far into the future you want to plan your liquidity forecast depends on your personal preferences. In my experience, chances are that even over the next six months, the plan will likely deviate from reality. But nevertheless, I think it makes sense to forecast as long might be realistic - i.e. if you just started building a private equity fund program, that program will likely take 5-7 years to be fully invested, and it might thus make sense to also try to forecast over that timeframe. Especially when you’re just getting started and are still ‘finding your groove’.

In both of these matters, don’t forget the impact of taxes. There’s your annual tax bill from matters such as exits or rebalancing. But there is also the tax impact of creating liquidity, such as selling an ETF or bond with a gain. Selling off 100K€ of an ETF might actually just be 90K€ after taxes - be mindful.

A final remark: The intention for such a plan isn’t for this to be perfect. Nobody has a crystal ball to accurately predict the future, and spending too much time on building a perfect forecast is likely a unproductive use of your valuable time. Instead, just take the time to find all expected liquidity requirements, and map their amounts in a simple table, along with the expected timing - and compare that to your “Lines of Defense” below.

Now we know how much liquidity we need. But how should that look like?

Line of Defense #1: Cash (and Equivalents)

Perhaps the most simple form of liquidity is holding cash or cash equivalents in order to fulfill any short-term liquidity needs. There’s a few questions to ask ourselves.

First, how much of our liquidity reserve should be invested in cash - as opposed to other ‘Lines of Defense’ like bonds or term deposits. I’ve personally fared well with a reserve of 3-6 months. Over that timeframe, I know I have cash on hand as needed, without being too operationally involved (i.e. requiring to sell of assets on a monthly basis). I also believe that the six-month mark (and perhaps even longer) is a timeframe over which it makes little sense to really optimize for returns (more on that in Line of Defense #2).

In the end, this depends heavily on your personal risk tolerance. Some affluent investors that have almost no cash at all and instead stay fully invested in their diversified portfolio, and/or aggressively use margin loans. Others hold cash reserves of 12-18 months or longer. It is also worth mentioning that cash for liquidity reserves should, in our view, be separate from your emergency reserve (Notgroschen) in the Safety Bucket. (Practically this might also be the case as your emergency reserve might be at the private level as opposed to liquidity invested at the level of a holding company.)

Second, how exactly this cash buffer should look like. A few remarks:

• Make sure that your cash receives interest according to the applicable rates, i.e. the ECB or Fed rates. Also make sure that this is not diminished by any outsized fees - I’ve seen cases where banks proudly offer that they pay the prevailing rates but then have some sort of ‘premium cash account fee’ of 10-20 bps. The same applies to ‘cash equivalents’ like money market funds, where you need to be mindful of the expected interest after all fees, and not the other way around.
  

• Hold the cash in the currency in which you need it. If you need EUR, hold it in EUR - not in USD, even if you’d get a higher interest rate. The currency risk is simply not worth it, as you might’ve seen in your own portfolio in 2025.
  

• Hold the cash where you need it. Once again optimizing for operational efficiency - if you need that cash on a regular basis (i.e. at least weekly), I’d recommend not to push for the last few basis points. Instead, hold it with the bank from which you make the outgoing wires, and use that time saving to create better returns elsewhere to offset any marginal disadvantages.

Once again, this is not the place to overoptimize - I’d recommend a ‘set and forget’ approach. Any optimization you can make here will always be minor, but often create risk where there was none before (i.e. from bank deposit to something with mark-to-market-risk).

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Line of Defense #2: Short-Dated, Defensive Investments

So you have 3-6 months of expenses in cash and equivalents. So what should you do with the next 6-24 months? It’s where you might want to start thinking about some sort of ‘return enhancement’.

In the context of banking products, there is the simple term deposit. Depending on which bank you work with, chances are that they might offer you a term deposit with a relevant premium to the current prevailing interest rate, reflective of the bank’s credit profile - i.e. 2,25% for 3 months as opposed to the 2,00% deposit rate set by the ECB. Be mindful that term deposits are typically illiquid until their maturity date, so make sure that you don’t put all of your cash into them. Additionally, for longer terms (i.e. the 6-24 months), make sure that you feel like you get a fair ‘illiquidity premium’ - more often than not, you might be able to get the (almost same) interest rate from other bonds with a similar maturity, which have mark-to-market risk but can be sold at any time.

And then there’s the wonderful world of fixed income instruments. You could go as simple as a government bond, or of course get more creative in areas such as investment-grade (yet more volatile) CLOs. No matter what you do, make sure that the worst-case volatility doesn’t affect your outcomes - i.e. if you always need to have at least 100K€ even in a drawdown, and your bond investment might realistically see a drawdown (i.e. due to credit spreads widening or an interest rate increase) of 10%, put aside a bit more cash (i.e. 100€/(1-10%)= ~110€).

In this regard, perhaps the most important remark in this entire article: Your liquidity reserve is not where you should be trying to create returns. I often see affluent investors put money into (allegedly) safe, short-term investments such as bridge financings for real estate projects. They offer very attractive returns, often in the double digits, and apparent safety through a first lien on a property. But more often than not, that project goes sideways - and all of a sudden, the investor doesn’t only have to scramble to get back their money, but also needs to tap other sources of funding to fill their liquidity gap.

If you want to make such (shorter-dated) investments, make them in a part of your portfolio where you can bear losses and illiquidity - but your cash reserve is not the place for it.

Line of Defense #3: Diversified Portfolios of Liquid Assets

So let’s assume you mapped out that you need a certain amount every year for the next five years. One fifth you keep in cash. One fifth you keep in term deposits and a safe bond fund. What do you do with the remainder for years 3 to 5?

Admittedly, investing more aggressively - i.e. more in public equities rather than bonds, despite higher interest rates compared to prior years -, was the better choice the last couple of years. But of course, we never know what the future might bring, and I always try to assume the worst-case. So this is where we try to move away from our ‘thinking in silos’ to a more holistic approach. Or in other words, how can I add some degree of ‘safer assets’ into my diversified portfolio without impeding returns?

As also said before on this newsletter, we try not to focus only on what return a client wants to achieve (as high as possible, of course!), but on what return they actually need. This ‘need’ is typically their desire never to have to work again - which translates into a stable, defensive portfolio from which they can draw regular distribution to pay for their lifestyle. 

And in our view, exactly such a well-diversified, defensive portfolio can fill that gap for year 3-5. For example, if your cash requirement in year 3-5 is 600K€, you could consider designing a larger diversified portfolio (think ~1-2M€) to have a bond allocation that somewhat corresponds to to this amount - i.e. for a 1.5M€ portfolio, a 40% allocation to bonds, paired with other well-combined asset classes like equities or commodities. The emphasis is on well-combined: You don’t need to put everything into super-safe government bonds, but can also consider more return-oriented types of bonds (like emerging markets bonds or structured credit), which on its own might’ve been too risky but offers an acceptable risk-return profile in a portfolio across many different building blocks in different asset classes.

To emphasize again: If you want to tap your diversified portfolio as a potential source of liquidity, make sure that it can fulfill that purpose every market environment. That means not just 100% equities, which realistically could correct by 30% or 50% in a market correction, and would thus mean that you have to sell assets at a massive loss to close your liquidity gap. Optimize not for the highest expected return, but the highest risk-adjusted return.

Line of Defense #4: Margin Loans

A margin loan is a form of loan typically secured by a client’s liquid investment portfolio. Such loans are typically very flexible (can be taken and repaid on a daily basis) and comparably cost-effective (80-100 bps above the relevant interest rate). In practice, many of the affluent investors we work with use them, also for liquidity management purposes. And I think they can make sense as a Line of Defense - but in my view, only as the ‘last line’. 

For example, assume drawing on a margin loan to pay your cost of living. In doing so, you simply postpone the timing of said payment, hoping that your portfolio will generate a return in excess of the loan’s interest as well as related cost (i.e. transaction cost or realized taxable gains of the sale). Yes, the risk of such a loan might be limited for a reasonable LTV (think 20-30%, for a diversified portfolio - once again not just 100% equities!). And yes, your decision not to sell might indeed pay off. However, there are also numerous nuances that speak against such a loan use - such as tax issues (most notably the non-deductability of a privately used margin loan, meaning you don’t just pay taxes on the ‘spread’ between interest and return) or non-linearity of returns (the long-term return of an asset class is likely higher than your interest cost, but might fluctuate substantially, which could be not in your favor).

Most importantly, however: We think that investors should think of a margin loan, and leverage in general, as a strategic, long-term component, and not a short-term liquidity solution. There are exception to this, of course, such as using a margin loan to ‘bridge’ over short periods of time, i.e. drawing on the loan and repaying it every quarter or so. But more often, we see investors who decide to not sell of their portfolio, instead using this margin loan for short-term expenses in hope of making use of the spread which (as mentioned above regarding non-linearity) is fundamentally a long-term bet. I will admit that this ‘bet’ has paid off over recent years with equities rallying, but there’s no guarantee for it. And especially for those investors who’ve used their credit lines aggressively (think 50%+ LTV), we’d be worried that there might a rude awakening during a market correction one day which requires those investors to pay off their loan by selling assets exactly when you don’t want to sell them.

Margin loans deserve a newsletter of their own sometime this year - but for now, heed my warning: Use them for short-term purposes, but otherwise, use them as a strategic instrument, such as ‘levering up’ your portfolio. Or rather don’t use them at all.

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