As a rule of thumb, there should be a ratio of post-stress liquid assets to annual cash needs of at least 3x (Figure 1)<\/span> 1<\/a><\/sup> . This ratio is based on a somewhat draconian scenario, but by being conservative, investors can ensure there is headroom to rebalance and add to beaten-up allocations in times of stress. If the ratio is below 3x, investors should consider ways to increase liquidity in advance of any potential market turmoil, as forced action during volatile times will likely prove harmful. A greater level of portfolio liquidity need not alter a portfolio\u2019s risk profile and asset allocation framework. However, changes to the portfolio\u2019s implementation should be considered. For example, a hedge fund<\/a> allocation might be overly concentrated in managers with substantial gates<\/span> 2<\/a><\/sup> and a public equity allocation could consist of more liquid vehicles. Only in extreme scenarios will investors need to revisit the size of their private investments (PI) programme and planned commitment pacing.<\/p>\n As is often the case in investing, it is critical when performing liquidity analyses to challenge any assumptions \u2013 both explicit and implicit \u2013 that may be inherent in the portfolio\u2019s construction. Has the impact of a large currency movement been considered? Or the potential for a changing cash-flow pattern of private investments?<\/p>\n Liquidity can influence portfolio management for family investors<\/a> in many ways. Some of the most common channels include illiquid investments, spending needs, and currency considerations.<\/p>\n A deep understanding of the current and future liquidity profile of a PI programme is essential to helping families avoid rash decisions during crisis periods, which can result in lost opportunities and, in a worst-case scenario, impair long-term performance through actions such as distressed sales via secondaries. Such an understanding can also help families reap the rewards of sticking to their planned commitment pacing throughout market downturns, as these periods have historically produced some of the most attractive vintage years.<\/p>\n Over recent years, many family investors have increased their allocations to illiquid investments as they have sought to take advantage of their long-term time horizons and capture the associated benefits.<\/p>\n Commitment modelling is a key step that can help families gain a clearer understanding of their PI liquidity. These models aid in determining an appropriate commitment pace to reach the target allocation, as well as clarifying expectations of future cash flows from capital calls and distributions. In addition to modelling, simply tracking unfunded commitments can be helpful in quantifying potential future liquidity demands.<\/p>\n For families building allocations to private investments<\/a>, modelling can be particularly valuable, as the allocation will likely be a drain on portfolio liquidity for several years. Once fully developed, a programme\u2019s cashflows can become more predictable and potentially even self-funding over time.<\/p>\n Alongside the maturity and composition of an allocation, the external market environment can also meaningfully impact cash flows of private investments. For example, in a weakening market, as the possibility of general partner exits diminish, the ratio of distributions to contributions will likely decline (Figure 2)<\/span> 3<\/a><\/sup> . Investors should consider the impact of a changing distribution\/contribution ratio on their total portfolio liquidity, particularly during periods of heightened volatility and uncertainty.<\/p>\n Portfolio spending for families can be more flexible than for other large investors, such as pensions or endowments. While this flexibility can be beneficial at times, the focus when stress testing liquidity should be on the possibility of unexpectedly elevated withdrawals in times of stress. When performing the stress test, family investors should include a higher level of spending than has historically occurred or is deemed feasible. Scenarios where the investment portfolio supports an operating business or other direct investments should also be considered.<\/p>\n Family investors with an operating business that serves as a source of portfolio liquidity, through dividends or otherwise, should also consider how business performance correlates to broader macroeconomic conditions. For example, an operating business may see its profitability and dividend payments decline during an economic slowdown at the very same time as the family\u2019s investment portfolio experiences a decline in liquidity. This consideration is particularly pertinent if the funding of private investments is dependent on this external liquidity source.<\/p>\n Family investors can preemptively manage liquidity risk related to spending through imposing guardrails on their spending rate within their investment policy statement \u2013 a document that clearly establishes the objectives, investment policies, and goals of a portfolio. Some family investors include a maximum withdrawal rate in any given year, while others employ a more complex approach that seeks to smooth real notional spending over time while preserving the real value of the portfolio. Such guardrails can provide a Ulysses Pact<\/span> 4<\/a><\/sup> for a family and help families avoid being pulled off course in times of stress in the future. A line of credit can also be maintained to help meet short-term liquidity needs and avoid disrupting long-term investment plans through the unexpected liquidation of investments. While the benefits of a credit line are clear, it is important to consider the cost, as access will come at a price, especially in a higher interest rate environment.<\/p>\n The various channels through which currency can impact liquidity also deserve attention. This is especially important for families with a base currency other than the US dollar, given the lion\u2019s share of today\u2019s global investment universe \u2013 especially within private markets \u2013 is dollar denominated. Indeed, the US dollar\u2019s surge in 2021\u201322 was a reminder of how extreme and prolonged currency movements can be. In fact, for many families, this episode shone a bright light on how currency can adversely impact a portfolio\u2019s liquidity.<\/p>\n For family investors with large private allocations, carefully tracking the size of unfunded private commitments outside of their base currency is a simple, yet valuable, task. A meaningful appreciation in a foreign currency can see unfunded commitments swell, as families outside of the United States saw in 2022. On top of tracking this unfunded commitment exposure, family investors can model the impact of a large, but conceivable, currency move \u2013 say 2 standard deviations<\/span> 5<\/a><\/sup> \u2013 on its size (Figure 3).<\/p>\n Strategic currency hedging programmes can also create liquidity stress through larger-than-usual margin calls when dramatic currency movements occur. Once again, European family investors that hedge US dollar exposure may have seen this occur in 2022. Moreover, the 2022 UK pension liability-driven investment crisis also gifted the investment world with an insight into how margin calls related to a hedging programme can cause havoc. Fortunately, currency hedging for families does not suffer from the same self-fulfilling \u2018doom loop\u2019 that UK pension schemes faced. Families can smooth the impact of margin calls from currency hedging through a thoughtful and institutional-quality approach to their hedging programme. For example, an investor might use a series of overlapping six-month forward contracts to smooth potential cash flows.<\/p>\n Through an awareness of currency considerations, global family investors can better understand and manage the potential variability in their annual cash needs and avoid being caught out when another sharp currency move inevitably occurs.<\/p>\n Consistently revisiting potential liquidity risk is important work for family investors, as many of these risks can lay silent for prolonged periods and become easy to overlook. In fact, unexpected liquidity demands can undo a lot of hard work and, in a worst-case scenario, force a fire sale of assets. By carrying out regular liquidity risk analyses and remaining mindful of the liquidity demands of PI allocations, spending, and any additional currency fluctuations, family investors will be better prepared to navigate short-term disruptions related to liquidity and stay on track to deliver on their long-term objectives.<\/p>\n Adam Barber, Senior Investment Director, Private Client Practice<\/strong><\/a><\/p>\n![\"\"](\"https:\/\/publishedresearch.cambridgeassociates.com\/wp-content\/uploads\/2023\/07\/2023-07-Liquidity-Hazard-01.png\")
<\/a><\/p>\nBest Practices for Family Investors<\/h3>\n
Private Investments<\/h4>\n
![\"\"](\"https:\/\/publishedresearch.cambridgeassociates.com\/wp-content\/uploads\/2023\/07\/2023-07-Liquidity-Hazard-02.png\")
<\/a><\/p>\nSpending Needs<\/h3>\n
Currency Considerations<\/h3>\n
![\"\"](\"https:\/\/publishedresearch.cambridgeassociates.com\/wp-content\/uploads\/2023\/07\/2023-07-Liquidity-Hazard-03.png\")
<\/a><\/p>\nConclusion<\/h3>\n
\nFootnotes<\/h2>