Oxford SWF Project

Ashby Monk

Gillian Tett’s article in the FT today on the changing perceptions of liquidity risk among SWFs has me captivated; I’ve already caught myself, deep in thought, staring out various windows at least five times. What’s got my thoughts so provoked? Well, Tett appears to be privy to an internal process of evaluation taking place within the Government Investment Corporation of Singapore that could see some dramatic changes to the way it manages its money. Specifically, she portends a shift from external (co-mingled) management of assets to in-house management.

The article’s peg is the realization within GIC that the “Yale Model” isn’t a panacea for long-term investors. This is sensible enough. However, it seems to me that the GIC’s concern is more nuanced than this; the fund is less worried about widespread diversification of assets (which is espoused by Yale Modelers) than it is about some (recently unearthed) liquidity risks embedded in their supposedly “long-term” investments. As Tett notes,

“…in the past two years, sovereign funds discovered that the long-term mantra provides far less protection than previously thought. For by investing in private equity and hedge funds, the GIC (and others) ended up being exposed to the vagaries of their co-investors – and some of those had short-term horizons, or mark-to-market triggers. Thus what hurt groups such as the GIC was not just the issue of asset correlation, but a contagion of investor style as well.”

So, the GIC’s problem is apparently not with highly diversified, long-term investments—it, instead, has a problem with the investment vehicles through which it undertakes these investments; namely private equity and hedge funds.

Tett seems to imply that the GIC was forced into some “asset fire sales or unseemly investment exits” due to the “mark-to-market triggers” of its co-investors (i.e. the other limited partners) in the private equity or hedge funds. This, Tett suggests, has some within the GIC hot and bothered, as they now recognize they are taking on the liquidity risks of their fellow LPs!

I’ll be honest. I’m confused by this whole thing. As a former employee of a private equity fund (…yes, I was once seduced by the power of the dark side of the Force…), I was under the impression that limited partnerships had explicit lock-up periods that, in effect, precluded any “co-investors” (i.e. LPs) from bailing out. This is crucial for seeing any investments through to a profitable exit! In fact, I thought LPs usually had  no right to demand that sales be made at all! So, I have to say it, the whole premise of the GIC’s internal deliberations strikes me as being somewhat off …

Nonetheless, it’s been a while since I’ve seen the inside of an LP contract. So I acknowledge that the rules of the game may have changed. Indeed, when talking about hedge funds and private equity, Tett keeps using the term “co-investor” instead of “limited partner”, so maybe GIC had signed itself up to some other types of private equity or hedge fund investments? In any case, let’s play along with this for a moment. Tett then asks:

“That raises some big questions about how the GIC (and others) should conduct themselves. Should they only co-invest with similar investors in the future? Could they now demand detailed lists of their co-investors (even if they hate providing such data themselves)? Could they ask to be paid for assuming illiquidity risk? Or should they dump external managers altogether, and bring that activity “in-house”?”

More to the point, investors need to understand the nature of the co-investment (i.e. LP) contracts they are signing; if they have explicit lock-up periods that prevent the type of “stop loss” or “trigger” sales that Tett refers to, then this shouldn’t really be a problem at all. However, in cases where a co-investment has no lock-up period, then you better understand your co-investors’ liquidity constraints. Otherwise, their problems will become your problems.

In short, I think the GIC is fretting needlessly over the liquidity risks associated with PE or HF investments. This should simply be addressed as part of the due diligence process associated with the original investment in the fund. In fact, when it comes to these type of investments, one of the major concerns among investors is not being able to get at their money if they really need it…the GIC appears to be worried about just the opposite outcome.