Tickling the Dragon’s Tail

The systemic impact of increased illiquid asset holdings in times of market stress is a sleeping dragon that, once awoken, could create havoc on liquid and illiquid portfolios. Trevor Lavin, head of Allspring’s Institutional Client Group in the Western region, discusses this with Kevin Kneafsey, senior investment strategist with the Multi-Asset Solutions team.


Announcer: Welcome to the Allspring Global Investments podcast where we explore what’s happening in the markets and discuss our outlook for the ever-changing investment landscape. Thought leaders provide their views on the latest global trends in sustainability, technology, emerging markets, and more. Join us as we take you down the road of investing elevated.

Trevor Lavin: I’m Trevor Lavin, head of Allspring’s Institutional Client Group in the Western region, and you’re listening to On the Trading Desk®. Today we’re discussing our recently published research paper, entitled Tickling the Dragon’s Tail, which takes a look at the systemic impact of increased illiquid asset holdings in times of market stress. We take you through the research, the conclusions, but perhaps most importantly, tell you why, as investors, you need to care about this. Quite simply, there’s a sleeping dragon that, once awoken, could create havoc in portfolios, both liquid and illiquid, with knock-on impacts on solvency conditions for investors. Joining us is Kevin Kneafsey, senior investment strategist with the Multi-Asset Solutions group. Thanks for being here, Kevin.

Kevin Kneafsey: Happy to be here.

Trevor: Why should people care, Kevin? Why is this even important to our listeners and to investors?

Kevin: Well, Trevor, larger illiquid asset holdings by some investors make the entire market more fragile. Now fragile in the sense that any significant market shock like we’re seeing right now has the potential to cause a significant asset selling, both liquid and illiquid, to meet cash flow needs. And that selling further depresses asset prices. Falling prices reduce liquid assets available to meet cash flow needs. And at some point, investors are forced to sell illiquid assets. This liquidity-driven selling, it’s going to impact every investor whether they hold illiquid assets or not.

Trevor: That’s a lot to take in there, Kevin. No one’s even talking about this. And besides, aren’t we coming off an amazing 12-year bull market? How can it potentially go so badly so quickly here?

Kevin: I managed a portfolio that had an illiquid asset in it through the global financial crisis, which I’ll refer to as the GFC. And I witnessed the complete loss of control of the asset allocation. And assets were redeemed from that. So, they needed to be sold to meet those cash flow needs. And it’s a perfect parallel to what we’re seeing today. So, it got me really concerned as I saw illiquid asset balances grow. The 12-year bull market that you referenced, that’s part of the stage that set up what’s happening today. The GFC, the monetary and fiscal policy response to it, and the tremendous performance of risky assets over the last 12 years set up this huge liquidity crisis we potentially are about to experience. I mean, since the GFC, the monetary response in driving interest rates to zero forced investors to look for return and they looked in riskier and less liquid assets. Since the end of 2008 through the end of 2021, private market investing, private equity buyouts ventures, private credit, real estate, and so on, it’s grown from just over $2 trillion to over $10 trillion. Over this period, investors’ portfolios have become less liquid, but all cash flow needs will have to be first serviced from the liquid part of the portfolio.

Trevor: Yes, the global financial crisis has left these markets more vulnerable. Talk to us about what the consequences of that might be.

Kevin: First is there’s a secondhand smoke effect. You don’t need to be invested in illiquid assets to be impacted by people investing in illiquid assets. In fact, because liquid assets will be the first thing sold to meet cash flow needs, they will be impacted first and potentially the most. And that’s a concern, especially as markets are down 20%. The second conclusion, though, is that there’s a tipping point. And holders of very illiquid portfolios at that point will be hurt the most because they will be forced to sell those illiquid assets and at prices far below the value of those assets.

Trevor: You mentioned there, there’s a tipping point, Kevin. Talk a little bit more about that. How is it determined exactly, and what are the possible outcomes if and when it actually is triggered?

Kevin: The tipping point is driven by two main things. One is the size of the market shock. The bigger the shock, the more likely it is that we breach a tipping point. The second is how fragile the market is and that, in turn, is driven by two things. One is the natural cash flow needs that investors have. So, think of this as pension funds making payments and endowments and foundations making the 5% payout that they typically do. The larger those cash flows, the more fragile the market. The second part of that is the size of the illiquid allocation. And this matters for two reasons. One, every dollar you take out of the liquid assets and put in the illiquid, you have less liquid assets to fund cash flow needs. The second is those larger illiquid balances, those are in private market assets, those have capital commitments and capital will be called and that exacerbates the cash flow needs. To make that more real, think about where we are today. We’re at roughly a 1.5 to 2 standard deviation event in equity markets and even a bigger one in bond markets. If you’re an entity paying out, say, 3% of assets each year, and you’ve got a 45% illiquid asset allocation, there’s about a 50% chance your liquid assets will fall below 20% of your total assets. So, that means 80% of your assets are illiquid and only 20% liquid. That’s the tipping point. The tipping point is really when you’re forced to sell illiquid assets and at a huge discount.

Trevor: With all this information then, what recommendations do you have for investors?

Kevin: For all investors, protecting liquid capital becomes really important. That could be explicit protection. It could be hedging. It could be diversification. But you seriously need to consider how do you protect the liquid capital that you’ve got? For investors with small illiquid allocations, there’s a chance you can benefit by providing liquidity and buy assets at extremely depressed prices. You can do that in the public markets. You could do that in the private markets. For investors with large illiquid holdings, there’s a risk they run, potentially, becoming insolvent. And, so, it’s really important for them to assess that early because it provides the largest choice-set to prevent becoming insolvent and have an impact on the portfolio that is small.

Trevor: Thank you for those. Any parting thoughts for our listeners?

Kevin: If you put it simply, we can’t ignore this. The title of the paper, Tickling the Dragon’s Tail, was very deliberate. And the idea is, as you said at the beginning, nobody’s talking about this. People aren’t concerned about this. Most of these aren’t going to have liquidity problems in 2023 or 2024. When you start getting beyond that, that’s when we’re seeing a lot of problems. So, it’s this huge growth in illiquid assets that’s made the market more fragile and less able to withstand the shocks that we’re currently seeing. The implication is investors with liquid assets are going to be hurt because those are the first things sold to make cash flow needs. That’s the secondhand smoke effect. Another feature of large illiquid asset holdings is there’s a tipping point where too much becomes too much. In the paper, we solve for that tipping point in different scenarios. And it depends primarily on two things. One, the size of the market shock, and two, the market fragility. The more fragile the markets, the more cash flow people need to pay out. The more illiquid assets they hold, the more susceptible they are to any size market shock. We started this work over two years ago and we worried how would we convince people that this is going to be a problem. As we’re watching what’s happening in the markets today, we’re actually worried maybe we’re too late.

Trevor: That’s a great point, Kevin. I really appreciate that. And thank you for being with us today and sharing all those insights.

Kevin: Thanks, Trevor. It was really fun.

Trevor: That wraps up this episode of On the Trading Desk®. If you’d like to read more market insights and investment perspectives from Allspring Global Investments, you can find them at our firm’s website, allspringglobal.com. To stay connected to On the Trading Desk® and listen to past and future episodes of this program, you can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you get your podcasts. Until next time, I’m Trevor Lavin and thanks for listening.


Leave a Reply

Your email address will not be published. Required fields are marked *

You might also like: