Super Funds & Master Trusts in a World of Member Switching, Early Release Schemes & Climate Calamities
Quantifying the “hidden” performance cost of early access to retirement funds helps CIOs and regulators make more informed decisions.
Changes in reported private equity (PE) valuations often lag those in public asset valuations, especially during periods of market turmoil. These periods often cause portfolio asset allocations to deviate from target allocations – something known as the “denominator effect.” CIOs evaluating their portfolios against target allocations now face a rebalancing conundrum – if and how to rebalance and whether there is sufficient liquidity to do so.
Rebalancing requirements relative to target hinge on the PE valuation methodology. We explore three PE valuation approaches with different sensitivities to contemporaneous public market performance: the “lifespan G” valuation approach currently employed in OASISTM; an alternative “periodic Gt” approach that is tied to both lagged and contemporaneous public market returns; and a “proxy” market value (PMV) approach that is strictly tied to contemporaneous public returns. While this third approach is intuitively appealing, unlike the first two approaches it does not permit the generation of a consistent cash flow profile to measure portfolio liquidity risk. Figure 1 compares the three PE valuation approaches.
The decision on which PE valuation approach to follow may rest on the investor type, their objective of investing in private assets and their portfolio liquidity constraints. For sovereign wealth managers without explicit interim cash flow obligations, they can ride out the distressed economic periods without attempting to “mark-to-market” private equity. However, PE allocations within a defined contribution plan subject to participant withdrawals make a lifespan G or periodic Gt valuation approach infeasible as a public market downturn could motivate immediate participant withdrawal requests. If the PE investments are non-tradeable (and assuming side-car arrangements or in-kind withdrawals are not permitted), then these plans will sell other plan assets to meet redemption requests that leave the remaining plan participants with outsized (and potentially overvalued) PE allocations. For these plans, a PMV approach may give the remaining participants an opportunity to gain any potential counter-cyclical trading advantage as a compensation for providing liquidity for those participants who withdraw.
To illustrate the impact on portfolio allocation and rebalancing decisions following different valuation approaches, we examine a stressed market scenario – a sharp public market decline (-30%) followed by a V-shaped recovery. We assume at the beginning of the period, the portfolio’s baseline (i.e., target) asset allocation consists of $20 debt, $40 public equity, and $40 PE NAV.
Efforts to rebalance between PE and public assets may prove unnecessary as public market declines are often reversed quickly in succeeding periods. Irrespective of the PE valuation approach, when the PE allocation deviates from target, investors need to decide if they prefer immediately bringing PE back to target or gradually rebalancing by adopting a rebalancing strategy that avoids active trading of PE.
Since rebalancing PE is difficult, investors may consider grouping PE and public equity together as a single “growth asset,” and rebalance between debt and the growth asset. Since public equity and PE have some common risk exposures, investors commonly pass any PE net cash outflows through public equity. If PE is non-tradeable, then any rebalancing required for the growth asset is borne by the public equity portion of the growth asset allocation (if possible).
Figure 2 shows trades needed to rebalance back to the 20% – 80% (i.e., debt – growth asset) target and the post-rebalancing allocations. With the PMV approach, more debt allocation ($4.8 vs. $1.6) needs to move to public equity to rebalance back to the target. With both approaches, the overall debt – growth asset allocation matches the 20% – 80% target.
Investors can define those rebalancing trades that raise concerns (i.e., rebalancing failures). For example, investors who have large allocations to active debt strategies may wish to avoid large debt rebalancing sales. If so, a CIO could consider the $4.8 move from debt to public equity (under PMV) as a rebalancing failure and flag such an event. In general, OASIS can flag the timing and frequency of all such events and the investor can then use this information to consider redefining their rebalancing strategies or overall asset allocation.