Hi, everyone, my name is Kim Uy. I'm an institutional portfolio manager at PH&N Institutional, and today we will be talking about the illiquidity premium puzzle – maximizing returns without losing sleep. I know many of you watching probably love puzzles, and love your sleep as well, so the goal of this presentation is to solve this illiquidity premium puzzle. And to achieve this, we will need to first find the right balance between trying to capture this illiquidity premium, but just as important is, how do we manage the liquidity risk thoughtfully? And why are we speaking to you about this today?

Well, we do view this liquidity risk premium as an attractive source of return. And many of you already allocate to this area of the market within your portfolios via private market investments, for example. But over the past year or two, we've seen many instances of unexpected liquidity challenges that have become headline news, and we think there are some useful learning opportunities that we want to share with you.

So, our objective today will be to, first we're going to start with the fundamentals. What are the characteristics that define whether an asset is liquid or not. Then we'll examine what's been influencing the recent liquidity challenges and provide you some good and important questions that you can ask your private asset managers as part of your due diligence process.

And then from there, we'll give you some ideas on how to assess your portfolio's overall liquidity profile and ways that you can determine your appropriate tolerance for illiquidity. So with that, let's dive right in.

And I mentioned that we do view the liquidity risk premium as an attractive source of return. And we're not alone in this view. Institutional investors also believe this. Within Canadian institutional investment portfolios, allocations to private assets on average have increased significantly over the past decade, growing from 18% in 2012 to 44% today. And then with that growth, the trade-off is that your average institutional portfolio today has less liquidity, especially if you factor in other dynamics, like the increased use of leverage and lower allocations to government bonds, for example.

At the same time, we're seeing institutional investors needing more liquidity in their portfolios for various reasons, like higher pension payments as plans have more retirees, higher operating expenses, lower contributions into the plan, etc. And these challenges, they do vary by investor. And that's why we think that it's really important to assess how much liquidity you need in order to know how much risk you can take, and we are here to help.

So, what is liquidity anyways? If you think we're talking about water or plumbing, this is the wrong presentation. I don't know anything about plumbing, unfortunately. What we really mean when we say liquidity is really, the ability to quickly turn an asset into cash without significantly impacting the price of the asset. So you can think of it as the difference between selling Apple stocks and selling a private credit investment. One takes seconds and the other one could take years.

Now, there are some key characteristics that determine how easily you can cash out of an asset. And let's take a look at those in more detail.

So first off, liquidity is really a spectrum, it's not binary. But there are some common features that we can use to evaluate whether an asset has low liquidity or high liquidity.

And let's start with high liquidity first. If an asset is easily interchangeable or fungible, then it will generally have a higher amount of liquidity as investors will have less preference for one or the other. And if the price is easily observable, then it becomes easier to transact. And a good example is stock quotes. That's very easily observable versus, imagine how slow the grocery line up would be if every individual needed to determine a fair price for all the items in the grocery cart.

And then somewhat related to observable pricing is frequent transactions. So, the higher trading volume, it does validate price. And lastly, a centralized exchange. It also helps increase liquidity as it brings buyers and sellers together rather quickly. This is not an exhaustive list by any means, but we have included some examples at the bottom.

On the flip side, assets with low liquidity, they have the opposite characteristics. They're unique, they don't have an observable price so you have to use a complex valuation method to come up with a price, and they don't transact frequently, if at all. And of course, there's no centralized exchange as well, but that's just to name a few.

And you can think of your private market investments as an example – some of your private market investments, they could have low liquidity or no liquidity at all. But I do want to make it clear that investing in lower liquid assets is not a bad thing, as long as you manage that risk appropriately, because you do get paid to take that risk. And let's explore that bit here.

When investing in public market assets versus private market assets, there are different levels of risk premiums you earn that contribute to that total return of the asset. And so when it comes to private markets, they do offer a higher liquidity risk premium, which is that dark blue shading there. And what that is, it's essentially compensation to you as an investor for accepting lower liquidity in that asset. And there's also other benefits of private market investments, for example, lower volatility of returns, lower correlation to public markets and importantly, just access to a wider investment opportunity set that's not necessarily available in public markets.

And then just lastly private market investments, they are less efficient, which allows for active management to add value. And therefore, picking the right manager is very important. All that said, again, the liquidity risk premium is very attractive. But you just need to manage that risk appropriately, and you don't want to be surprised like how some investors have been more recently.

So, over the past year or two liquidity surprises, they have become headline news. For example, you would have read that some private market asset managers, they've limited investor withdrawals or even halted redemptions altogether. And some of the reasons are market related, like the higher interest rate environment or geopolitical risk that's negatively impacted investor sentiment. And some of the reasons for the halt is fund-construction related.

So, for example, a private fund could have been using excessive leverage, perhaps there's a high investor concentration in the fund, and a large investor is trying to get out and they can't. And that's just to name a few. And we think that conducting a proper due diligence and continuously asking questions of your private asset manager, it can help you avoid these issues or at least avoid being surprised by these issues.

And so with that, we've prepared a three-part checklist of questions that you can ask your current or prospective private asset manager. And these questions are more for open-ended private market funds, but they're still useful when thinking about closed-ended funds. And so the first category of the three-part checklist is fund ownership. The questions here focus on the investor base.

So, is the investor base diverse enough or is the ownership of the fund concentrated? This is to really help identify how aligned the investors are within the fund with respect to their expectations of any fund liquidity. You could also ask questions like, what has been the historical redemption pattern of the fund? Were there any lumpy redemptions?

This will be helpful for setting expectations to avoid future surprises. And then the second set of questions is under redemption policy. The focus here is to identify realistic liquidity expectations during redemptions. You can ask questions like, what's the redemption frequency? Are there caps on the redemption amounts? How are all investors ensured equitable treatments during redemptions? And we feel that it's very important that a manager has a clear policy in place when it comes to redemptions and equitable treatment of all investors.

And then lastly, the third set of questions is under liquidity management. And the focus here is, how does a manager manage liquidity within the fund. So asking questions like, has the fund ever delayed or halted redemptions? When and why? Do you use leverage, has this leverage impacted the liquidity of the fund? So there's a lot of questions that you can ask. And this list is by no means an exhaustive list, but we feel that it is a good framework to help investors gain a strong understanding of the risk and reward associated with your private market investments.

Okay, so now with this fundamental knowledge, we will explore illiquidity in theory. So how do we model illiquid investments, and what are some of the challenges behind that modelling? Earlier we already spoke about why illiquid investments are attractive, so I won't go through all those reasons again, and we've listed some of those reasons here on the left-hand side.

But overall illiquid investments they model pretty well in a long-term asset mix model. And of course, this wouldn't be a PH&N seminar without an efficient frontier. But I promise this is the only one in this presentation. And you can see that on the right-hand side, that light blue line is a traditional portfolio of just stocks and bonds. And then when you add illiquid assets to that portfolio, like private investments, theoretically you can improve the efficient frontier. And then you get to that dark blue line. So what this really means is that you can achieve higher returns with similar levels of volatility when you add those illiquid investments.

So overall, again illiquid investments they make the total portfolio look pretty attractive, but it's not as straightforward as that. And there are some challenges to modelling illiquid investments that we want you to keep in mind, and so we're going to explore that a bit here.

So a fundamental challenge in modelling illiquid investments is that building robust assumptions is a lot less straightforward, especially when compared to public equities and public bonds, which are more well defined. Some of the challenges that all financial models face with illiquid assets are –we've listed some of those here – one of them is the representative indices for those private assets, they're un-investable. So your actual returns could very well look different than the returns of the index.

There's also limited long-term or even consistent data, which results in a potentially skewed picture across a market cycle. And of course, using old valuations or even stale transaction data can mask the true volatility of those illiquid assets. And then just lastly, our last point here is that without a transparent or consistent valuation mechanism, identical assets can be priced differently across investment managers.

And we're going to take a look at a specific example of this using private credit. So, private credit is a rapidly growing asset class, and it's characterized by illiquid loans. And when it comes to how these loans are valued, the self-pricing or self-valuation mechanism can create significant discrepancies in how these different private credit managers value the same loan. And this chart illustrates this. You can see the stark pricing discrepancies between the highest price versus the lowest price for the same loan.

So, for example, on the far right, we have a private loan where one manager has priced it at $77 and another manager has priced the same loan at $50. That's a huge difference of $27. So, you know, if that loan had a par value of 100 million, that's a price difference of $27 million just for one loan.

And then you could see all the way on the far left, we have a private loan that has a price difference of $7, but even that is significant. You would never find a $7 pricing difference in the price of a Government of Canada bond, for example. So, this is just a, you know, small insight into how private asset valuations can be inherently opaque.

So really the key takeaway in this section – illiquidity in theory – is that while the modelling of illiquid assets does make the total portfolio appear very compelling, the model is designed to provide guidelines to help you with your long-term asset allocation. So it provides a strategic framework, and it doesn't necessarily consider your liquidity needs.

But, this next section – illiquidity in practice – will give you some practical advice that you can use for your portfolio when it comes to these illiquid investments. So first off, let's start with, how do we determine how much liquidity your portfolio requires and how much you need to set aside? And that's unique to each and every investor depending on your risk and return objective. There's no there's no one-size-fits-all answer, but we're going to walk through five categories to help you think through how much liquidity you need to set aside in your portfolio.

So number one, payment obligations. What are your recurrent cash needs? This could include things like pension payments, operating expenses, or other outflows.

Number two, capital calls. Do you need to set aside liquidity for capital calls to fund your private market investments? And the challenge with capital calls is that they are often irregular and they could come at inopportune times as well.

Number three, rebalancing. Can you rebalance your portfolio without forced asset sales, or trying to liquidate your illiquid investments at unfavorable prices?

And number four, derivatives. Derivatives do introduce an additional layer of liquidity demands. And so if you are using derivatives within your portfolio, you should have enough liquidity to be able to satisfy margin calls or mark to market losses or collateral posting, for example.

And just lastly, tactical and opportunistic. You know, oftentimes there will be some sort of market dislocation, and during these times, do you have dry powder in your portfolio to quickly capitalize on these opportunities? And we know that these opportunities they come and go very quickly.

So these are just some of the things to consider when you're assessing your portfolio's liquidity needs. And it is key to the overall risk management of your portfolio. Now let's examine a cautionary tale.

This is the famous Harvard University Endowment Fund. And we're going to take a look at this endowment fund during two periods of acute stress. So, the first period being right after the financial crisis, you can see here that Harvard's endowment portfolio is comprised of 80% illiquid assets. Yet, the university depends on distributions from this endowment to fund a third of their operating budget.

So after the financial crisis, what happened was that the endowment had shrunk by 30% in market value. And so with minimal liquid assets and not being able to generate the cash they needed, they took some drastic measures. They had severe layoffs, they had operational cutbacks, they halted projects. So, you know, not a good time for Harvard.

And then when you fast forward to 2025, so last year, the U.S. government, they implemented a lot of policy changes. And one of the changes resulted in billions of funding cuts. So Harvard was yet again in a liquidity crunch. And to generate the cash they needed in April of 2025, Harvard went to the capital markets and issued $750 million worth of bonds.

And then the next month, in May, Harvard sold about $1 billion in private equity stakes to ensure that they had the appropriate level of cash available. And so, you know, while this is an extreme but real example, the key takeaway here is really to just understand what your liquidity scenarios could look like, especially during times of stress, because during periods of stress is when you will need liquidity the most.

Okay, so just shifting gears a little bit, one area of the capital markets that create that extra complexity is when you invest in private assets that use a capital commitment structure. And what that means is that investors commit a fixed dollar amount, and the managers call in that capital during the investment period. And as the managers call in that capital, it can be predictable or it can be lumpy, and the managers retain the flexibility to call the entire commitment at any time.

So you can see that there's a lot of uncertainty there. What this graph shows is an investor's commitment to private market investments across three different funds – funds one, two, and three. And this is a cumulative capital call graph. The middle line represents current day, and past capital calls fall to the left of that line. And those capital costs have already occurred. And to the right of the line is the manager's best guess at what those future capital calls could look like. And then of course, that that's still highly uncertain. And just to help you read this graph a little bit better. Fund 3 in the light blue shaded region, that carries the most uncertainty because it just started calling capital and almost all of its life span is into the future. In practice, what we see is that during times of market stress managers face tighter financing conditions, so they will respond by calling in capital from their investors sooner than expected. There's actually a 2021 study conducted by a consulting firm that found that during market stress, investors should anticipate three to four times the normal amount of capital calls.

And so really just understanding these dynamics and potential liquidity needs in your portfolio, especially during times of stress is critical to liquidity management. And then conversely, in normal markets when things are good, managers often return capital faster than anticipated. And this can leave you under-allocated to a desired asset class or even a potential cash drag as well. So it's important to know in advance where you're going to redeploy that cash.

Okay, so now we're going to bring it back and talk about the bigger picture at the total portfolio level in terms of asset mix rebalancing.

Rebalancing is an area that can be viewed in the context of liquidity risk. And so we're going to look at a sample portfolio during the global financial crisis of 2008. During that period, investors faced simultaneous pressures. Equity markets were down significantly, there was increased capital calls, widespread gating of hedge funds and private vehicles. This is all in addition to the investors routine cash needs.

So that's sort of the lay of the land back in 2008. And in terms of rebalancing, investors occasionally make rebalancing decisions before the end of the year. And often there are small shifts within the portfolio. But in this scenario, the asset mix, has drifted quite significantly, and the investor in this case needs to contemplate whether they're going to rebalance before the end of the year.

So this is where policy design really matters. So within your investment policy, if you have a min/max band of ±5%, you would have to rebalance in this scenario because you would be out of compliance. And if that's the case, does the policy require a rebalance to back to target, or is there discretion to rebalance back to just within the bands? And if you're rebalancing back to just within the bands, that provides just a bit more room to make smaller trades and avoid some of those forced asset sales. This is all to say that review your rebalancing policy and understand how you're going to execute it, especially during times of market stress.

And so we've seen that there are market and non-market related shocks that that can create pretty unpredictable liquidity pressures within portfolios. And we think that a practical exercise to help you manage uncertainty and an exercise that any investor can apply to their own portfolio, is looking at the time to cash, or how quickly can you convert your portfolio to cash?

So what we've shown here is just a sample portfolio with various asset classes, and what you can do with your own portfolio is run through your investments line by line, and fill in the time-to-cash boxes under a normal market environment and under a stressed market environment. You will see that we've assigned color coding for the different liquidity categories. Green for good, you can liquidate right away. Yellow for not so good. And orange, not good – you can't liquidate for years to come. And so when you're assigning the color coding, this would also involve asking questions of your investment managers about their expectations for liquidity and what their experiences have been during times of market stress. And they'll be the best people to help you fill out this table here.

As you're assigning each investment strategy a liquidity category, you know, once you're done that, you can sum up the amounts and see what the changes are between a normal market environment versus a stressed market environment. And we've done that here in our scenario. You can see in the bottom right-hand table we have about 13% of the portfolio move from moderate liquidity to a low liquidity bucket, and we've highlighted that in red there.

So we think that conducting this exercise frequently can help you better understand your portfolio's liquidity profile, and really make it an active part of your risk management framework.

Okay. So now we'll go through two case studies to just bring all of this to life. So our first example is a foundation with $100 million in assets and with a moderate risk profile. So this foundation, they require to disburse 5% of their total assets annually, and they need portfolio growth to exceed that payout, plus inflation – otherwise their capital just erodes over time. So this foundation needs a total target return of 7%. We have here three portfolios – portfolios A, B and C – and their initial portfolio, Portfolio A, is comprised of just stocks and bonds.

And you can see that Portfolio A falls short of the target return at just 5.5% there. You might think that a potential solution could be to increase their equity allocation, but that will likely result in higher volatility and downside risk as well. So to help mitigate this problem, we suggested incorporating some alternative investments. So you'll see that Portfolio B incorporates a little bit of private market investment. And the result is that Portfolio B has a higher return of 6%, and it comes with a lower level of risk.

And then moving to Portfolio C, we've added just a bit more private market investment, and we've added a bit of hedge funds as well. And this portfolio achieves that 7% target return, and importantly, it maintains that same risk reduction that we saw in the previous portfolio.

And so in this situation as the foundation, they're moving from Portfolio A to Portfolio C, the liquidity profile of their portfolio does decrease. And we've highlighted that in the orange box there. But this foundation, they're well aware of that and they do have the flexibility to accept this trade-off to achieve that higher return objective of 7%. And also, at the end of the day, it also improves their overall risk-adjusted return.

Now we'll walk through another case study. This one will be using a pension plan portfolio that has a bit more complex cash needs. So this pension plan, they have monthly benefit payments. And we're going to keep it pretty simple here because in reality it could get quite complex – for example, is a pension plan open or closed, what's the age of the plan, what’s the funded status – so lots of things to consider, and so we're going to set that aside for now. This pension plan also has a target return of 7%. And you'll see in the pie, the plan's asset mix is comprised of 40% fixed income, 30% equities, and 30% private market investments.

And then what makes this portfolio more complex is that it uses derivatives. And you'll see in the table on the right-hand side, the plan has a derivatives overlay component to hedge some of their liability duration. So essentially the portfolio is levered by 20% or 1.2 times. And then in addition, they have foreign currency exposure, so they're using FX hedging. And then just lastly the portfolio is also weighting on capital calls for its private market investments, and those are pretty irregular. So lots of additional things to consider and to take into account when thinking about liquidity requirements. And so where we stand right now is that the portfolio has about 60 to 70% in liquid investments.

So what we're going to do now, is we're going to stress test this portfolio and see what happens in a stressed market environment and what happens to its liquidity profile. A good test is to revisit 2022, very high inflation. This period was actually not too long ago, and some of you may have already forgotten, but it was not a good year for financial markets.

And so recall in 2022, inflation peaked at 8.1%, the Bank of Canada hiked policy rates very aggressively by almost five percentage points, and the impact on financial markets was almost negative across the board, which you can see here. Bonds posted one of their worst years on record, and this is alongside very negative performance from equities as well.

And then private market assets, they did okay depending on what you were invested in. And then lastly the Canadian dollar did depreciate against the U.S. dollar at that time. And so broadly, a very tough year for investment portfolios. And now let's take a look at the impact on our pension plan.

So the portfolio market value, it is down because of those negative market returns. And so now, the portfolio has to raise cash to fund the losses on those derivatives. And so recall that the plan uses leverage, so now the plan has to raise cash to fund the mark-to-market losses on that leverage. There's also losses on the FX hedges, so you have to raise cash to meet margin calls.

And as all of this is happening, of course you're going to have capital calls for your private market investments. So the result of all of this is that this portfolio is left with less liquidity. I won't bore you with all the calculations, but you can see the result in the table on the right-hand side.

The asset mix at the end of 2022 after a full year, it’s very different from where it began the year. And you'll notice that the private market allocation makes up a much larger component of the total portfolio now. And then lastly, the portfolio has about 10% less liquidity. The good news is, this portfolio, as complex as it may have sounded, was structured in a way that ensured it would have sufficient liquidity to meet all of its cash requirements.

So this pension plan was fine at the end. But if it if they did start with 20% lower liquidity, then you know, perhaps it might be a different story.

And then we also want to spend a few minutes on governance. We saw that at the start of the presentation, your average institutional portfolio has evolved quite meaningfully over time. So we think that your governance framework should evolve as well. And to help with that, we've listed a handful of key considerations that we believe will lead to good governance.

Number one, earlier we provided a list of questions to ask your private asset managers. Make sure you do ask those hard questions. And number two, we also saw that conducting stress testing and scenario analysis on your portfolio, it's very important, and it's one of the ways to ensure that your portfolio will have sufficient liquidity even in adverse market conditions.

And number three, from these tests, they can help you set appropriate asset mix bands – less liquid investments, they do warrant wider bands so consider building that into your policy. And number four, the reality is that, you know, as much as we try to prepare for all of this, sometimes these thresholds and bands, they can be breached. So having a clear breach protocol policy in place ensures everyone involved knows who needs to come together quickly to make quick decisions if needed.

And then just lastly, our last point here is that choosing the right manager is very important, as we know that the dispersion of returns amongst managers is quite wide. And so choosing the right manager is important and particularly in private markets. And then make sure you also stay on top of your managers because that ongoing due diligence is also as important.

So really the bottom line is having a strong robust governance structure in place. It will help you avoid liquidity surprises – you really don't want to be like our cactus friend here who's well aware of its hot desert environment but still did not set aside enough liquidity. Shame on Mr. Cactus here.

Okay. So that brings us to the end of our presentation. And I do want to provide a few key takeaways to summarize what we've discussed. And that is, illiquid assets do offer very attractive risk premiums and portfolio benefits, but only if you manage the liquidity risk appropriately. So know your liquidity needs before you invest, stress test your portfolio regularly, and having a strong governance framework in place and all of the above will help you prevent liquidity surprises.

So hopefully we've helped you solve this illiquidity premium puzzle. Thank you.