Liquidity Management for Fund Portfolios

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This and last week, we are tackling the art of capital call management: The field covering topics ranging from single-fund cash flow planning (Part 1), to portfolio-level cash flow planning (Part 2), and lastly, today’s topic, liquidity management.

Liquidity management is one of the areas on which I receive the most questions in my day-to-day work with affluent individuals and family offices. As I mentioned in the final part of last week’s newsletter, liquidity management is especially challenging for fund portfolios. Step 1 in dealing with this challenge is a proper model and stress test, as we tried to build last week. As a result, we were able to quantify our liquidity needs both in a regular and in adverse scenarios.

After such an analysis, you know how much liquidity you should earmark. But how should you invest this liquidity to optimize your return without taking excessive risk? 

Let’s tackle that question today - ending with my personal views and preferences on the matter.

Parameters for Liquidity Management

Before we think about specific investments, we should first think about the parameters by which we will evaluate the various asset classes that can underlie our liquidity management strategy.

First, Return. Ideally, we want our earmarked capital to be invested in a way in which it generates a positive return. Even better would be a return akin to our desired asset class exposure - so if we want to invest into private equity, perhaps we should invest our earmarked capital in public equity in the meantime.

But of course, that is easier said than done, because we face Drawdown Risk. Public equity is one of the most volatile asset classes and might incur drawdowns of 50% or more. Of course that risk applies to other asset classes as well. Ideally, we want to invest our earmarked capital in assets that are not or less exposed to loss of capital. 

Another factor to consider is Liquidity. For capital that is earmarked for liabilities later in the future, you might consider investing your capital in semi-liquid or fully illiquid assets. Often, that reason is an expected higher return, but also a perceived and/or real improvement in risk profile. When things go well, you have a higher return and/or lower drawdown risk - but in the worst case, your investment might not be liquid when your capital calls are due.

And lastly, Complexity. Complex investments might offer benefits that traditional, simple investments don’t offer, such as uncorrelated return or lower drawdowns in market downturns. In return, they might expose you to non-traditional risks (see The Search for Structural Alpha). They might also be high in maintenance, especially when they don’t go as planned.

The Asset-Class View

With those parameters in mind, let’s take a look at a few asset classes that we might consider as options for our liquidity management. Some alternative investments like hedge funds or private credit might also be theoretically relevant. However, given that they are themselves illiquid, I don’t think that they should play a significant role in a liquidity management strategy, and hence, chose to not cover them further in today’s article. (Maybe in the future. 😉)

Cash & Cash Equivalents

Cash & Cash Equivalent, most traditionally, is any cash that you keep in your bank account. In today’s day and age, investors typically benefit from positive interest on their bank balances. Cash has the benefit of not being exposed to any downside risk while still usually offering a positive, albeit low, return. It is also the most liquid option, even more liquid than some super-safe investments. 

Of course, this safety comes at a price. Interest might just be in line or below inflation, often significantly below the desired (equity) benchmark, or as I mentioned, even below the respective fed fund rate. While not exposed to mark-to-market risk, cash is subject to the bank’s well-being and can theoretically be impaired if the bank goes bankrupt. Some investors avoid this by dividing their balances across many banks according to the respective deposit insurance, which can be complex to manage.

Money Market Funds, Term Deposits, Short-Term Bonds

In this category, I include financial instruments that have a (blended) maturity of less than a year. They typically offer a yield pick-up over cash, but (with the exception of term deposits) are subject to mark-to-market fluctuations. However, assuming that the underlying credit risk is low, those fluctuations should be limited. Investors should be more mindful of any fee-related impact, i.e. transaction fees, which might cut into the yield pick-up.

Some of cash’s drawdowns remain: Interest (especially after fees) might be just slightly or even below inflation. Returns are also typically lower than equity. Lastly, unlike cash (and term deposits), there is a default risk that needs to be considered. 

Fixed Income (Investment Grade, High Yield)

This category includes liquid debt instruments with a maturity of longer than a year. That might include both investment grade bonds as well as high-yield bonds, across the global opportunity set. Depending on duration, fixed income might bring notable yield pick-ups over cash while also keeping risks to a bearable minimum. High-quality fixed income has historically also offered very low default rates, especially for investors using diversified approaches such as a bond portfolio or a bond ETF.

However, as duration increases from one to three or even five years, investors become more exposed to interest rate risks - which can result in substantial mark-to-market swings, even for the highest-quality instruments such as US treasuries or German Bundesanleihen. For lower-rated (i.e. high yield) instruments, yields might almost be equity-like, but also be subject to higher risk (both in defaults and volatility).

Public Equities

Public equity is the counterpart to private equity: It is all equity investments in publicly traded companies, whether through individual stocks, stock portfolios, an actively managed fund or a passive ETF. Public equity offers the highest expected return of our various asset classes. However, in return, it also offers the highest drawdown risk, which might crystallize in low to mid-double digit drawdowns in times of turmoil. However, as the name says, public equity is typically the benchmark to our private equity investments, and thus, might come closest to our desired asset class and its return.

Outside of niche and/or concentrated investments, public equities are very liquid (but subject to the aforementioned drawdown risk). Their complexity can be higher, especially when using derivative structures, but I would personally deem them less complex than fixed income investments. 

Personal Views in Liquidity Management

Talking about these asset classes individually helps us structure our thoughts. But in the end, the main question is how to reflect your preferences about the aforementioned parameters in your portfolio - which typically results in a combination of those assets. Today, I want to share my personal views on the matter.

(As always, note that it is my personal view. While some affluent individuals that I advise agree with my view, or are even more conservative, some also think that my approach is too careful. In the end, it depends on your risk tolerance. I’ve outlined my personal view in Liquidity and Illiquidity.)

For short-term capital calls (the next 6-12 months), I think cash and term deposits are a perfectly fine option. From my personal experience, short-term capital calls are hard to forecast. Sometimes they come at the expected, quarterly pace, sometimes you have a quarter equal to three months of your plan. On this ‘short end’, I think it’s not worth over-optimizing - make sure you get fair interest on your cash and your short-term term deposit, and avoid mark-to-market risk and complexity.

For medium-term capital calls (12-24 months), I would still be cautious. Once again, I would optimize for simplicity: Pick well-diversified, low-cost fixed income investments that offer you a bit of yield uptick on cash but don’t expose yourself to significant downside risk. ‘Riskier’ fixed income such as high yield or emerging markets fixed income can start to play a role here, but only as a small portion of an overall low-risk fixed income portfolio.

For longer-term capital (24+ months), things depend on your risk appetite, and your asset allocation. Fundamentally, I understand the urge of some investors to focus more on returns than significant downside protection for such a time horizon. However, as I have mentioned before, overemphasizing short-term returns brings the risk of ‘striking out’ (i.e. being unable to serve your capital calls and/or to keep on committing to new funds) before benefitting from the long-term returns of an illiquid fund portfolio. 

I personally believe that compartmentalization (like the ‘Buckets’ in the end Aspirational Investor Framework) makes it more likely for investors to achieve their goals. If you know you have 500.000€ in expected capital calls, I find it easiest to just put that exact amount aside into lower-yielding but lower-risk, liquid investments. That way, your liabilities are covered no matter what happens, even though your (expected) returns are lower.

If you are more return-oriented, you might require a different approach. In this case, the ‘asset-liability-matching’ is more difficult, as return-oriented investments bring the risk of incurring a loss that brings their value below your outstanding commitment. There are two options that I frequently see - but I would advise against them:

One, you can ‘overallocate’ to a more aggressive portfolio. Assuming public equities yield 7-8% per year but face a 50% drawdown in a worst-case scenario, you could theoretically put 1.000.000€ into that asset class. In the worst-case of a 50% drawdown on Day 1, you would theoretically avoid the issue of being unable to service your capital calls. But avoiding ‘insolvency’ means you’d sell those equities at a massive loss - and it means that your fund portfolio would subsequently need to generate a 2x return just to break even. In such a case, parking your earmarked liquidity a lower-yielding and lower-risk asset is likely to achieve a better overall return.

Two, you can borrow against your (liquid) portfolio. Many private banks offer margin loans that allow you to borrow against your liquid portfolio of stocks and bonds, often at considerable LTVs (50-70%). In a drawdown, assuming you have a sufficiently large portfolio, you might still have sufficient LTV to fund your capital calls - for example, if you start with 2.000.000€ in equities and see a 50% drawdown, your remaining 1.000.000€ in market value might theoretically be enough collateral to borrow 500.000€. 

But that seems less risky than it actually is. Remember that you’d borrow against a liquid asset to make an illiquid investment. Practically, that means that the money can over the short-term only go out (into the fund), but not back in (to repay the loan), unless you find liquidity elsewhere. Thus, the margin loan just changes the timing of when you need to actually liquidate an asset to pay for the liability you now covered with the loan. 

If you have a very large, well-diversified portfolio, things might look different - but often, 

portfolios are neither large (i.e. highly levered) nor well-diversified (Mag 7 stocks). Just because the asset that you borrowed against has always gone up in the past does not mean that it will go up again in the future.

Final Remarks

To close out this series, there’s a number of final remarks that I want to make, but that didn’t fit in anywhere else (yet) in this series.

First, make sure that your asset currency matches your liability currency. If you commit to a fund in Euro, make sure your assets are in Euro. From personal experience, any (perceived) uptick due to interest rate differentials (i.e. higher interest on USD and EUR) is almost certainly offset by an adverse currency fluctuation. If you wonder when to buy a foreign currency for capital commitments in that currency, I’d advise just to do it immediately and not worry about whether a later time might have been a better time.

Second, don’t use your earmarked liquidity for short-term, high-yielding loans. It might be a personal loan to another investor, a real estate mezzanine financing or an asset-backed loan to a company: Double-digit interest for six months and 200% collateral might be a great investment, but it is not an investment appropriate for earmarked liquidity. 

Once again from personal experience, the investment will either blow up entirely (you lose interest and principal, and you don’t have liquidity for your capital calls), not repay on time (you don’t lose money, but you don’t have liquidity for your capital calls), or it will default, but you get the collateral (you lose your chance to get the borrower to pay you back in cash, you now have to figure out how to sell a 50% stake in a plot of land in a Berlin suburb, and you don’t have liquidity for your capital calls).

Third, and by far the most important: Never lose sight of your long-term goal. I might sound like a broken record, but remember that you’re thinking about optimizing your liquidity management so you can capitalize on the higher expected long-term returns of your fund portfolio. Any measure that attempts to increase your returns on short-term liquidity and/or tries to reduce the amount you need to earmark creates or increases the risk of running into a problem along the way - which might result in you not being able to invest into funds over the long term. If you want to make short-term high-yielding investments, feel free to do so - but don’t do it in your earmarked liquidity. 

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