25 May 2023
How can funds find their way out of the liquidity conundrum?
With a number of factors impacting the fund financing landscape we ask what can funds do to bolster their resilience in a market environment of thinning liquidity and costlier capital?
Recently, having flourished through an extended period of easy liquidity, alternative investment funds have been hit by the desiccating effect of high interest rates and high inflation, a reduced supply of financing, and unsettling geopolitical events including Russia’s invasion of Ukraine, and civil war in Sudan. According to the IMF, economic volatility has caused liquidity to dry up across all asset classes over the last six months.
Key takeaways:
- Fund sector and lifecycle will affect the need for liquidity.
- Adaptability is key: Funds need to learn to live with the new normal of rising interest rates.
- Other investment criteria will become more prevalent, as funds emphasise non-financial performance markers. ESG and conscious investing will be at the centre of this approach.
- To foster stability and profitability in the future, fund managers will have to evaluate their efficiency.
No “one-size-fits-all” solution
Nonetheless, says Anna Layard-Liesching, Head of Liability Sales, Institutional Banking at RBS International, some sectors will find it easier to navigate the current climate than others, depending on their resources. The need for liquidity also depends on the lifecycle of a fund.
“If they’re early stage and looking at fundraising, there’s an implication in how much appetite there is from the investor community to allocate capital,” says Anna.
Mid-stage funds, she explains, will need to examine the performance of underlying assets to assess what help is needed in terms of liquidity. Late-stage funds looking at realising their assets, meanwhile, may be either forced to sell at a lower than desirable return because they’re end of life or having to plan alternative exit strategies.
“There’s a strong feeling currently that if you’ve got well-performing assets, why would you sell them just because it’s near the end of your fund lifecycle? Hence we’ve seen continuation funds growing in popularity recently.”
Anna Layard-Liesching, Head of Liability Sales, Institutional Banking at RBS International
Fund managers may be hoping to apply historic solutions to today’s liquidity conundrum. The problem, says Anna, is that the current situation is unique. “We’ve never been in this exact type of environment. And even if you could identify a similar situation, it was either before these funds existed, or if they did exist, they were in a very different form. The exposures they had were entirely different. The last time we were in a similar interest rate environment, for instance, the Central Bank was cutting rapidly rather than hiking. This all makes it very difficult to take any lessons from history.”
Rising interest rates: adaptability is key
Rising interest rates are impacting on fund liquidity, returns and investment decisions. With no meaningful drop in sight, funds need to learn to live with the new normal. “We’ve had over a decade of ridiculously low interest rate levels, where all borrowers have benefitted from really cheap funding,” says Anna. “Although it’s been over a year since interest rates started hiking, it’s taking a while to adjust.”
Eventually Central Banks will settle on a longer-term terminal rate, sitting lower than today’s. “Riding that transition is more about how you flex and adapt through this change than knowing how things will land at the end,” she advises. “Expect a big period of change without exponential growth from this sector as all these factors come into play.”
Liquidity is also drying up for some funds as they face a supply versus demand deficit for financing. The excess dry powder coupled with low interest rates that we saw at the start of the pandemic has gone; now borrowing costs are rising with interest rates, while availability of funding decreases. “It’s a perfect storm for funds because the cost of capital’s gone up and there is constraint in the market in terms of bank’s willingness to continue printing facilities,” points out Anna.
Diversification and ESG can help rebalance risk and reward in a volatile market
These financing conditions have consequences for both pricing and investor returns, causing investors to favour tried and tested funds rather than looking to diversify to mitigate low returns.
“When you’re in a very low yield environment, people usually look for alternative investments, seeking outperformance. There’s always going to be a strong need to diversify exposures, but the benefit is possibly not as great as it used to be when looking at alternatives as Bank deposits are higher yielding now,” suggests Anna.
In the current environment, other investment criteria will become more prevalent, as funds emphasise non-financial performance markers. ESG and conscious investing will be at the centre of this approach. “Anything with an ESG element is a huge theme, and you can apply an ESG lens to any type of asset class,” says Anna. “One issue will be whether the green transition is quick enough for funds to be able to hit environmental targets.”
If they’re citing ESG performance, she adds, funds need to measure transparently against science-based targets. “If IRRs are not where they used to be other credentials become more important, you need to be able to track performance in those more qualitative factors.”
When the dust settles, fund efficiency will be an important differentiator
The impact of economic volatility and reduced liquidity on the future of fund financing has a number of possible outcomes. One is that if funds are unable to differentiate themselves via returns they will promote other USPs. Another is a changed approach to longevity, where longer fund life becomes the norm as convention accepts it takes more time to realise assets’ value.
Funds might see an overall drop off in investor demand, or more likely, a shift favouring larger, better-established funds which don’t have to rely on successively larger rounds of fundraising to grow. “As a sector overall, maybe it’s capping out that level of growth. Maybe you’re not going to get a $5bn fund growing into a $15bn fund because there isn’t support from banks to lend or investors to invest progressively more. So perhaps more funds will plateau because previous growth can’t be maintained, not that this is necessarily a bad thing rather a change in the way the market behaves” argues Anna.
To foster stability and profitability in the future, fund managers will have to evaluate their efficiency.
“When things start to plateau and liquidity is constrained, you have to step back and say, ‘what can we change to make things more efficient? Have we allocated our cash in the most efficient manner? Have we negotiated the best terms that we can in all of our facilities? Are we pushing down on our assets to make sure that they’re performing as efficiently as they could be?” concludes Anna. “It isn’t easy because efficiency comes in a number of different guises, but it needs to become a major focus for fund managers.”
Over the following the weeks we will deep dive in to some of the current challenges facing alternative funds. Look out for our next update on how the fund liquidity gap will be met.
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