Solving liquidity for the unpredictable year ahead
“Imagine a structure in which asset managers could build on today’s auction process and create digitized, completely fungible versions of the assets in their fund.”
Volatility has recently defined our capital markets, and institutional investors face a landscape that only looks more unstable for the year ahead. There is uncertainty in public and private markets, which coincides with increased liquidity demands. On the private markets side, the estimated $550 billion in secondary holdings as of 1Q 2023 is only a small fraction of the $10 trillion in private market holdings overall, and this market remains inaccessible for many investors, with the top 10 buyers accounting for the majority of deal activity since 2021, according to data from Evercore and Preqin. If this sounds like a perennial issue, it’s because it essentially is one. By tracing the evolution of liquidity in private markets, we uncover the persistent lack of true liquidity, but also a roadmap for sustainable improvements. The clearest path is one in which paper-based and manual processes are replaced by technological advancements that can finally provide efficient solutions.
To understand today’s private market liquidity issues, it’s instructive to start at the beginning. It wasn’t until the late 1980s that the first private funds holding illiquid assets offered limited liquidity. These funds were typically structured as registered investment companies and offered limited liquidity, generally 5% per quarter through a tender offer process. The true test for these funds occurred with the 2008 financial crisis. Investors, overweight in their alternative asset allocations, submitted redemption requests to these funds in droves. Many had to prorate redemptions; some had to suspend redemptions altogether as they unwound. Providing liquidity in alternative assets lost its luster.
The first rudimentary secondary markets for illiquid funds began to gain traction around this time. The first ones specialized in matching buyers and sellers of illiquid hedge fund and FoHF interests. Buyers and sellers were matched using a mostly manual process, and the transfer of interests from seller to buyer typically required manual paperwork (e.g., transfer forms) reviewed and approved by the fund’s GP.
Today’s bulletin board auctions and exchanges provide valuable mechanisms for offering liquidity to LPs through a transfer process, but these transfers are largely still paper-based transactions: transfer forms, new subscription documents, and manual AML / KYC checks.
It took nearly a decade for the next real innovations: alternative funds geared towards the retail investor. While there were a small handful of early adopters – e.g., Bluerock launched a real estate interval fund in 2014, and Black Creek’s non-traded REIT dates back to 2012 – it wasn’t until Blackstone’s BREIT in 2017 that this market exploded. The catalyst was the desire to reach the broader investor market – the so-called “democratization of alternatives.”
Following the initial success of BREIT, a proliferation of registered products ensued – tender offer funds, interval funds, non-traded REITS, BDCs and most recently, the holding company model most notably used by KKR. While these new products were innovative and offered terms friendly to retail investors, such as upfront capital calls and 1099 tax reporting, notably, there was no evolution in liquidity terms. Over thirty years later, it has generally remained at 5% per quarter.
Through the entirety of this evolution, and with the addition of these notable market participants, the central question remains unanswered: How do we advance a solution so asset managers can provide true liquidity in private markets?
The answer is likely a combination of utilizing the above developments and leveraging technology solutions now made possible by the emerging digital asset world.
Imagine a structure in which asset managers could build on today’s auction process and create digitized, completely fungible versions of the assets in their fund.
LPs could periodically bid in an auction for additional exposure to specific desired assets on an individual basis. The winning bidders would pay a premium that would be distributed to the other LPs in the fund as compensation for their reduction in exposure to those assets. Fund investors holding the digitized assets could then trade them amongst each other and potentially with other third parties utilizing a secondary exchange. Digitized asset transfers could be executed via smart contracts, automating the existing paper-based processes, including a more automated AML/ KYC process.
Through this digitized approach, bidders could create a price signal over time by pulling specific assets out of the pool and putting those individual assets up for auction. By creating an exchange mechanism for individual assets in a pool, the asset manager can fundamentally enhance the provision of liquidity in illiquid assets by improving their price transparency.
While regulatory clarity will be required for digital, integrated private fund platforms, one thing is certain: markets, in all forms, are moving to digital assets in multiple ways. Investor demand for liquidity in illiquid assets will continue to increase, especially given today’s rising market volatility and high interest rate environment. The best way to provide investors with true liquidity requires a convergence of the investment fund and digital asset worlds. It is the next stage in the evolution of liquidity, and a required one in 2024 and years beyond, to meet investor demand.
Jacqueline Dentner is Managing Director of Private Market Products at the financial technology company Pontoro.
The subject matter and the content of this article are solely the views of the author. FinanceFeeds does not bear any legal responsibility for the content of this article and they do not reflect the viewpoint of FinanceFeeds or its editorial staff.