Institutions’ growing appetite for private investments is increasing the potential for a cash crunch.
According to a new paper from PGIM, institutions often have a chief risk officer to help manage investment volatility, but few have created a dedicated role to aid in managing liquidity, which can pose even more threatening risks. PGIM, the asset management arm of Prudential Financial, thinks they should consider one.
“For long-term institutional investors such as pension funds, sovereign wealth funds, and defined contribution plans, volatility risk is rarely life-threatening,” wrote Michelle (Yu) Teng, vice president and co-head of PGIM’s IAS private assets research program. “Volatility comes and goes.”
But according to PGIM, any number of factors — from capital calls to risk rebalancing on the investment side, or payments to beneficiaries and pension risk transfers on the benefits side — could put a strain on an institution’s reserves.
“A CIO unable to meet their cash obligations (e.g., benefit payments, variation margin calls, or GP capital calls) is faced immediately with an unavoidable and usually distasteful task: Portfolio assets must be sold, and willing buyers must be found,” the paper said.
Unlike volatility events, liquidity crunches like these would require a chief investment officer to raise cash immediately. What’s more, these liquidity crunches can cascade. The United Kingdom pension liquidity crisis is just one example of what could happen.
A similar situation affected Australian superannuation funds during the March 2020 Covid crisis. An external event — the pandemic — resulted in capital calls from general partners and fewer cash contributions from members. At the same time, the Australian government allowed pensioners to take early distributions of some of their promised retirement savings.
Both unexpected situations resulted in losses for the funds — ones that potentially could have been avoided with the right management tools.
“To avoid deadweight losses from liquidity risk, it may be necessary to bring liquidity management to the fore under a dedicated person or team,” the paper said.
That would be the job of a chief liquidity officer. This person would identify the potential liquidity risks outlined by PGIM. They would determine and perhaps even engage external liquidity facilities such as secondary market sales, collateralized portfolio liquidity lines, repurchase agreements, and futures programs, the paper said.
Implementing such a role isn’t a perfect solution, however. According to PGIM, it could create cumbersome organizational overlaps and generate confusion within a fund team.
Nevertheless, the paper said that the long-term benefits are probably worth the effort and the stress. As Teng put it, “Ultimately, it is the fund’s decision whether now is the time to either appoint a chief liquidity officer, beef up expertise and analytics, or confirm and validate that the existing investment and risk management teams can adequately analyze, monitor and manage overall fund liquidity.”
