Illiquidity for a weak-covenant scheme: chasing 250bp
Thornbury Engineers Pension Scheme has assets of £900m and liabilities of £1.15bn (funding level 78%), a deficit recovery plan of £12m a year over twelve years, and net cash outflows of £23m a year after contributions and investment income. Liability duration is 19 years and the sponsor's covenant is weak: two profit warnings in twelve months and interest cover of 2.1x. The investment sub-committee proposes raising private credit from 5% to 15% and property from 8% to 12%, funded from gilts and corporate bonds, arguing that a 250bp illiquidity premium will 'close the deficit without extra sponsor cash'. Current assets: 20% growth, 47% bonds, 13% LDI collateral and gilts, 13% alternatives. The private credit fund has a five-year lock-up extendable by two years, no secondary market, and commitments drawn over three years. The last internal property valuation was six months ago.
1. Evaluate the proposal: quantify the expected benefit, assess it against the scheme's liquidity position and covenant, and identify the risks the sub-committee has underweighted.
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Quantification The move is +10% private credit and +4% property, i.e. £126m, taking illiquid holdings to about 27% of assets (£243m). At 250bp the gross premium is about £6.1m a year. Incremental fees against gilts and credit (say 1.2%) cost roughly £2.9m, leaving about £3.2m a year - roughly 1.3% of the £250m deficit. It is not a solution to the deficit, and it is not free money.
Liquidity Net outflows are £23m a year, so the scheme needs around £115m of liquid assets over five years before any collateral call, plus a buffer for LDI. Funding the £126m from gilts and bonds strips liquidity from exactly the assets that generate cash and back the LDI. The private credit fund also carries undrawn commitments: £90m of commitments drawn over three years means a further £60m of calls on a scheme already paying out cash. Property is suspended-prone: in 2008 and 2022 funds suspended dealing while the scheme still needed cash.
Covenant The illiquidity premium is compensation for risk that is correlated with the sponsor's weakness. A weak sponsor means deficit contributions may be at risk precisely when illiquid assets are hardest to sell. The scheme cannot afford to be the forced seller.
Underweighted risks
- Stale valuation. The property valuation is six months old; reported funding will understate true volatility, and the reported 78% may be optimistic.
- Buy-out. An insurer will not pay full NAV for illiquid assets and will want them sold or retained outside the transaction; the illiquidity premium may not translate into a lower buy-out cost.
- Pacing risk. Committing capital over three years into a rising or falling market without a view is a strategy in itself.
- Manager and leverage risk in private credit, including covenant-lite lending and floating-rate exposure that is not a rate hedge.
2. Recommend an alternative implementation plan and the governance, monitoring and reporting that should accompany it.
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Implementation
- Cap illiquid assets at 20–25% of the £900m, say £180m–£225m; the proposal takes them to £243m, which is too high for this covenant and cash-flow profile.
- Phase the build over three years, funded only from maturing bonds and investment income, with no sale of gilts held as LDI collateral.
- Hold a liquidity reserve of at least three years' net outflows (about £70m) in short gilts and cash, on top of the collateral buffer - not the same assets counted twice.
- Maintain a commitment schedule showing undrawn commitments, expected drawdowns and expected distributions quarter by quarter, and stress it for a two-year period of no distributions.
- Prefer open-ended or semi-liquid property and shorter-lock private credit for the first tranche; avoid a five-plus-two lock-up where the scheme is already cash-negative.
- Consider using part of the improved funding position for a buy-in of a tranche of liabilities rather than reaching for return.
Governance and monitoring
- Set a formal liquidity coverage ratio in the statement of investment principles and a liquidity waterfall with delegated authority.
- Require quarterly independent valuations, an annual external valuation of property and a look-through of private credit underlying exposures.
- Run a 1-in-20 stress combining a 200bp yield rise (LDI collateral), a 20% NAV fall and a suspension of dealing, and report the result to every meeting.
- Report performance net of fees against a benchmark that reflects the illiquidity, and show the illiquidity premium actually earned versus the 250bp assumed.
- Document the advice taken and the reasons for departing from the 250bp case, given the trustees' duty to act in members' interests and the regulator's focus on liquidity risk management for schemes with weak covenants.