Endowment Illiquidity, Denominators and Capital Calls
A UK grant-making charity holds a £260m endowment and applies a spending rule of 4.5% of the three-year average market value, plus 0.6% investment costs. Its objective is CPI plus 5% over rolling ten-year periods. The current allocation is 55% global equities, 25% government and corporate bonds, 10% UK property and 10% cash. The investment committee proposes committing £45m to private credit and £35m to infrastructure over three years, funded from equities and bonds. Of the £80m, £52m will be drawn over the first 24 months, with the balance over the following three years; unfunded commitments will peak at about £34m. Annual spending is approximately £11.7m, paid quarterly. The charity also holds a £10m overdraft facility. In the committee's stress test, a 25% equity fall and a 15% bond fall occur in the same year, and capital calls accelerate.
1. Assess whether the endowment can support the proposed illiquid allocation, considering liquidity and the denominator effect.
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The proposal takes illiquids to 30.8% of the endowment (£80m of £260m) at full drawdown, before any market move. Two stresses matter.
Denominator effect. A 25% equity fall and a 15% bond fall reduce liquid assets by roughly £45m (0.25 x £143m plus 0.15 x £65m), while private assets are marked with a lag. Illiquids would then be about 37-40% of the fund, above the likely policy limit, and the charity could not rebalance without selling at depressed prices.
Liquidity. Annual outflows are about £13.3m (spending £11.7m plus costs £1.6m), paid quarterly, before capital calls. Peak unfunded commitments of £34m coincide with the drawdown period. A prudent reserve is 18-24 months of spending plus peak unfunded commitments, approximately £54-61m, against cash of £26m and bonds of £65m.
Conclusion: the endowment can support the allocation only if (a) the illiquid cap is set at about 30% with a hard trigger, and (b) a dedicated liquidity reserve is carved out and not counted as rebalancing capital. The £10m overdraft is a timing tool, not a liquidity reserve, and should not be relied on in the stress.
2. Recommend a rebalancing and commitment-pacing policy.
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Policies to recommend:
- Commitment pacing. Commit no more than annual net inflow plus a planned drawdown from liquid assets; spread commitments so that no single vintage exceeds about one third of the programme. If £52m is drawn in 24 months, that is about £2.2m a month, which should be pre-funded from maturing bonds and dividends rather than by selling equities.
- Liquidity reserve. Hold 18 months of spending plus peak unfunded commitments in cash and short gilts, reviewed monthly.
- Rebalancing. Use cashflows first, then rebalance on bands of plus or minus 5% around target rather than by calendar; do not rebalance into illiquids when the denominator is falling.
- Denominator policy. Pre-agree that if illiquids exceed the cap, new commitments pause and distributions are not reinvested until the ratio is back within range.
- Borrowing facility. Use the £10m overdraft only for settlement timing, and disclose it as a contingent source rather than as liquidity.
- Spending rule. The 4.5% rule based on a three-year average already smooths spending, but in a severe drawdown the committee should consider a temporary cap to protect the capital base and the intergenerational equity of the endowment.
The overall principle is that illiquidity should be sized by the worst-case liquidity need, not by the expected return. Doing so preserves the ability to rebalance and to keep paying grants through a stress.