In the first article of this series, I considered a pension plan’s total fund liquidity needs. The second article looked at the use of a liquidity buffer for managing the liquidity risk of an open fund invested in a non-tradable asset class (the buffer method). This article will look at using the queue method for managing the liquidity risk of an open fund.
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What’s the queue method?
The queue method involves a hypothetical line or sequence in which each investor’s cash is placed, both for investment and divestment purposes. The investor commits new investment funds and the fund manager calls on those funds when the need for fund liquidity arises (e.g. when a property is purchased in the case of a real estate fund).
The funds are drawn either in order of commitment of the funds or by a pro rata method. In either case, total funds drawn will be based on the total number of funds required by the manager for the new investment.
The opposite is true in the case of a divestment, where funds can be sourced from cash on hand, from income produced by an underlying portfolio investment or from the sale of investments. As in the case of the investment process, funds can either be distributed through a “first come first serve” method or on a pro rata basis.
The primary requirement for using the queue method is an effective cash flow model for the fund. In general, investments in the private domain (e.g. real estate) may require additional investment such as capital expenditures to maintain or upgrade the investment.
Other uses of cash include interest payments on debt, taxes, management fees and drawdowns on investments under construction. Sources of cash must also be taken into consideration and generally comprise lease payments in the case of real estate, or contracted cash flows from concession or power purchase agreements in the case of infrastructure.
Once the internal dynamics of sources and uses of cash for the investments are considered, the investment manager must then consider the market dynamics: what investments might be worth selling or buying in the market and how this can be achieved in the context of either committed funds (net investments) or funds queued for withdrawal (net divestments).
In order to effectively execute the queue methodology for managing liquidity risk, the fund manager must have a robust cash flow model and allow for transparency to investors, with respect to anticipated timelines of investment and withdrawal based on said model.
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Benefits
There are several benefits of investing in a fund that uses the queue method. The primary benefit is consistency of product; there are no blurred lines in terms of investments in other asset classes, as was the case in using cash or equity equivalents for the buffer method. Therefore, an asset-liability study can use a pure product rather than attempting to model one, which involves a hybrid of asset classes with weights in the buffer component that may fluctuate over time.
The buffer method allows weight in the proxy asset class to vary depending on the liquidity needs of clients so that the actual investment in the private asset class will be inconsistently applied over time, while the queue method remains 100% invested in the private asset class at all times.
Disadvantages
The main drawback of the queue method is the lack of liquidity. There is no proxy asset that can be utilized to provide temporary liquidity for those requiring cash in the case of a request for divestment. However, with a sophisticated cash flow model, the investment manager can apprise clients of expected timelines for liquidity. The queue method can enhance the communication between client and fund manager, such that liquidity needs can be projected by the institutional client and communicated to the manager to ensure cash needs can be modeled appropriately.
Fund size can impact the ability to source liquidity: as the fund grows, income produced by the assets increases, which becomes a formidable source of liquidity for distribution of cash to clients divesting or reducing investment in the fund.
In contrast to the queue method, the buffer method appears to have liquidity through the proxy asset; however, this liquidity can be tenuous when the size of a single client withdrawal exceeds the value of the proxy asset or in times of stress when many clients expect to liquidate assets simultaneously.
The ability to meet liquidity needs for clients of the queue method appear to be inferior relative to the buffer method. Nevertheless, it is important to understand the limitations of potential liquidity sources, rather than assume the liquidity to be available when needed.
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The queue method is an excellent method for managing fund liquidity when the fund manager uses a sophisticated cash flow model for projecting sources and uses of cash, and maintains strong communication ties with clients to understand their future liquidity needs.
Fund managers approach the issue of liquidity in perpetual private asset funds by utilizing either the buffer or queue method. Clients can benefit from being aware of the strengths and weaknesses of each method and by understanding the selected approach and implementation structure the manager uses.