Illiquid assets

Unwrapping alternative returns Global Investor, 01/2015 Credit Suisse

Unwrapping alternative returns
Global Investor, 01/2015
Credit Suisse


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Global Investor 1.15, May 2015

Expert know-how for Credit Suisse investment clients


Illiquid assets

Unwrapping alternative returns

Roger Ibbotson Are investors rewarded or penalized for holding illiquid stocks?

Sven-Christian Kindt Exploring the upside of new illiquid alternatives.

Alexander Ineichen Hedge funds overcome recent challenges.

Carol Franklin Trees represent a growth opportunity for the patient investor.

Important information and disclosures are found in the Disclosure appendix

Credit Suisse does and seeks to do business with companies covered in its

research reports. As a result, investors should be aware that Credit Suisse may

have a conflict of interest that could affect the objectivity of this report.

Investors should consider this report as only a single factor in making their investment

decision. For a discussion of the risks of investing in the securities mentioned in

this report, please refer to the following Internet link:



Photos: Martin Stollenwerk, Gerry Amstutz

Responsible for coordinating the focus

themes in this issue:

Oliver Adler is Head of Economic

Research at Credit Suisse Private Banking

and Wealth Management. He has a

Bachelor’s degree from the London

School of Economics, as well as a Master

in International Affairs and a PhD in

Economics from Columbia University

in New York.

Markus Stierli is Head of Fundamental

Micro Themes Research at Credit Suisse

Private Banking and Wealth Management.

His team focuses on long-term investment

strategies, including sustainable

investment and global megatrends. Before

joining the bank in 2010, he taught at

the University of Zurich. He previously

worked at UBS Investment Bank. He

holds a PhD in International Relations

from the University of Zurich.

Standard financial theory tells investors to carefully assess the tradeoff

between return and risk. Liquidity is a third key consideration. This

Global Investor (GI) is about the liquidity and illiquidity of individual

assets and overall financial markets. Just as risk and return are uncertain

before the fact, so is liquidity. Some assets may appear highly

liquid, only for their liquidity to suddenly vanish. Moreover, changes

in liquidity often correlate with shifts in risk. As our article on fixed

income (page 62) points out, some more exotic bonds become very

hard to sell just as their perceived risk increases, and when less liquid

assets are pooled in typical (open-end) funds, such difficulties can

be amplified (see page 24).

This does not imply at all that we would advise against investing

in illiquid assets. In fact, assets that eventually generate high returns

are very often highly illiquid. Those who invested in Apple, Google

or Microsoft when they were small (unlisted!) ventures run out of

“garages” garnered huge returns. Apart from private equity, this GI

covers a broad range of other more or less illiquid assets – ranging

from forests to farmland to infrastructure, and from real estate, the

most common of illiquid assets, to the most exotic “passion” investments.

We also look at the pros and cons of investing in hedge funds,

which are not necessarily particularly illiquid, but where the sources

of return are often harder to identify than those of other more visible

illiquid assets.

Adrian Orr, CEO of the New Zealand Superannuation Fund, known

for its innovative investment philosophy, points out (page 26) that

even investors with long horizons should gauge the liquidity of their

overall portfolio carefully: investments in illiquid assets should be

balanced by some that can be easily sold. This rule is of even greater

importance for private investors whose investment horizon is

typically shorter and where the potential for a drastic change in

personal circumstance (and thus need for liquidity) is that much more

pronounced. The temptation of abandoning such caution seems particularly

high at a time when both nominal and real expected returns

on the most liquid of assets are so meager. Conversely, investors

should avoid overpaying for liquidity: Professor Ibbotson (page 10)

argues that investors tend to overrate (and thus overpay for) the

benefits of owning large cap stocks. The fact that these assets can

be traded in almost any circumstance may not only render them

more expensive but also prone to excessive price gyrations. In sum:

make sure that the analysis of risk and return is complemented with

a careful review and “stress test” of the liquidity of assets and

investment vehicles.

Giles Keating, Head of Research and Deputy Global CIO





TEXT MARKUS STIERLI Head of Fundamental Micro Themes Research


What do we know

about liquidity?

A particular focus of this Global

Investor is on market liquidity.

By this we mean the presence –

or absence – of the ability to

sell (liquidate) an asset quickly,

without impacting the market

price significantly, and without

institutional constraints.

Measuring market


For many asset classes, bid-ask spreads are

a convenient and straightforward way to measure

market liquidity, with declining (tightening)

spreads indicating greater liquidity, and

vice versa. The spread is simply the cost that

you would incur if you were to sell an asset

on the market and immediately purchase it

back. But, as we will discuss throughout this

Global Investor, the concept of market liquidity

is more complex than that. To start with,

the bid-ask spread is not easy to measure for

many assets, such as real estate. Moreover,

market liquidity typically varies dramatically

across the cycle. Some assets

are highly liquid in

the upswing or the top of the

cycle, but become less liquid

in a downswing. Lastly, instruments

matter. For example,

closed-end funds can deviate

from the value of the underlying

assets, which is bad in some ways,

but may also help protect long-term

investors. Some vehicles, such as private

equity funds and hedge funds, may impose

so-called “gates” on their investors to limit



has many


In the wake of the financial

crisis, the liquidity of the

financial system became

synonymous with its “lifeblood.”

Large injections of

liquidity by central banks (the

ultimate creators of liquidity)

were necessary to save those who “bled”;

the provision of liquidity to safeguard the

economy has remained paramount ever since.

In this context, macroeconomic liquidity does


Investors and firms share a common problem:

liquidity risk premiums are hard to gauge, both

across different types of assets and over time.

Liquidity does not manifest itself in standard

measures of risk, such as price volatility. In

fact, in normal times, illiquid investments are

not necessarily more volatile than liquid ones.

Of course, price volatility may simply be hidden

because illiquid investments are priced

at lower intervals – turnover is itself a definition

of liquidity. However, even in equity markets,

as we learn from Yale’s Roger

Ibbotson (see page 10), lower turnover

stocks actually proved more resilient

(and less volatile) during the financial

crisis in 2008 than their highly liquid peers.

Bringing it all together

not really refer to

the availability of cash

in the economy, but rather

to the smooth functioning of financial markets

and thus the economy as a whole. To a financial

firm, liquidity refers to the ability to meet

its debt obligations without becoming insolvent.

While cash holdings (a liquid balance

sheet) provide a buffer against losses, the

ability to convert assets into cash to meet

current and future cash flows – its funding

liquidity – can prove critical for survival in the

event of stress. Therefore, funding liquidity is

now a key regulatory imperative. Nevertheless,

central banks ultimately will always need

to act as a backstop to commercial banks; as

the role of commercial banks is typically to

invest clients’ liquidity (deposits) in less liquid

assets, they would structurally not have sufficient

liquidity to withstand a bank run.

On premiums and risk

While the different concepts of liquidity are

often treated in isolation, it is essential to try

to understand how they interact. We know

that liquidity black holes wiped out entire

markets, such as the junk bond market in

the mid-1990s, and the subprime mortgage

market more recently. We understand that the

deterioration of balance sheets forced banks

to cease lending, resulting in a vicious liquidity

squeeze that required significant policy

intervention to restore confidence so that the

financial system could fulfill its most basic

purpose. The most challenging part of the

liquidity discussion is that it depends heavily

on circumstances. The financial crisis was

such a profound event that it still has a significant

impact on investors’ attitudes toward

illiquid investments. Consequently, entire asset

classes are being shunned, sometimes

unjustifiably, and genuine opportunities will

be exited prematurely or missed altogether.

In other cases, investors may actually end up

paying too much for liquidity. If history has

taught us one thing about liquidity, it is that it

is often self-fulfilling, and at times a mirage.






Global Investor 1.15


Psychology and (il)liquidity

Liquidity has its price. But, says Roger

Ibbotson, with equities the popular choice

has a premium that may be too high.


Liquidity trends in illiquid


Amid rising interest in less liquid alternatives,

Sven-Christian Kindt points out the

reward for sacrificing unneeded liquidity.


On doing your homework

If you’ve first done your research, says

Alexander Ineichen, hedge funds may

bring higher end returns with less volatility.


Liquidity – a key to hedge fund


It’s a key factor. Marina Stoop examines

the role that liquidity plays in hedge funds

and for their investors.


Open-end versus closed-end funds

The right investment, say Giles Keating

and Lars Kalbreier, is a function of the

underlying asset type and the kind of fund.


Attractively consistent

At the helm of the New Zealand Superannuation

Fund, Adrian Orr talks about

patience, opportunity and very long horizons.


Talking teak

She has branched out. Carol Franklin has

a diverse background including language,

insurance and plantation ownership.


Institutional investment

in timberland

It’s not easy going green. Gregory Fleming

explains why institutional investors

see timberland as a growth opportunity.


Farmland – a fertile investment

With dairy farming interests, and over 20

years in asset management, Griff Williams

knows plenty about farmland investment.


Ins and outs of real estate

It’s an illiquid asset, but real estate is

attracting growing interest. Philippe

Kaufmann offers his insights and advice.


Infrastructure on the rise

Institutional investors are flocking toward

infrastructure. Robert Parker explains why

building for the future is a big deal today.


Looking beyond liquidity

Felix Baumgartner and Patrick Schwyzer

reflect on client perspectives of the illiquid

asset landscape.


In passion we trust

Art, antiques and collectibles: Art Market

Research and Development looks at

a different kind of alternative investment.


From illiquid assets to profitable


The European Central Bank is working

to restore the European securitization

market, report Christine Schmid and

Carla Antunes da Silva.


No exit?

There’s lower and more volatile liquidity in

the corporate bond markets. Jan Hannappel

outlines the causes and the implications.

Disclaimer > Page 65


Photos: Robert Falcetti

Roger Ibbotson, founder, chairman and CIO of Zebra Capital Management.


Liquidity premium


and (il)liquidity

Maintaining a certain amount of liquidity in a portfolio is fully justified, but investors tend

to pay up too much for it while underestimating the extra returns from holding illiquid assets.

The overpricing of liquidity seems to be greater in equities than in bonds, in part because

in equities the price is strongly influenced by “stories,” whereas in bonds it is dry mathematics.


SID BROWNE CIO and Head of Research Liquid Alternatives

Sid Browne: Economic theory states that

there should be a premium available for

accepting illiquidity. You’ve studied premiums

– and associated risks – attached to

both illiquid and liquid assets. What can you

tell us about your findings in general within

a portfolio context? How should institutional

and private investors invest?

Roger Ibbotson: Let me start off by

saying that the stocks that I study are actually

publicly traded stocks. They may be less

liquid than the most liquid stocks, but they’re

all liquid stocks. There’s a strong theoretical

reason why you’d expect less liquid stocks,

in fact less liquid assets of any type, to be

lower valued. People want liquidity, and

they’re willing to pay for it. They pay a higher

price for the most liquid assets, and therefore

the less liquid assets sell at a discount.

That discount means that, for the same

cash flows, you pay a lower price and

sub sequently you get higher returns. Now,

what’s especially interesting in liquid markets

is that giving up a little bit of liquid -

ity actually can have a surprisingly big

impact – by buying stocks that trade every

hour, say, as opposed to every minute.

José Antonio Blanco: From an investor’s

perspective, could you call the effect you’ve

just described a risk premium, or is it

instead the result of market inefficiency in

the sense that investors focus on certain

companies and disregard the rest?

Roger Ibbotson: It could be both.

You can create a risk factor from a liquidity

premium. But I am rather thinking of

something I call a “popularity” premium,

which I’ve expanded on in recent papers.

The stocks that trade the most are the

most popular. And those are the ones

where there is mispricing because they get

to be “too” popular, as measured for example

by their heavy trading. Interestingly, our

measures of stocks that trade less show

lower volatility. So these stocks don’t really

seem more risky. Therefore I don’t really

like calling the extra return a risk premium.

Sid Browne: What about in the event of a

squeeze, when all of a sudden you want

liquidity and rush to sell your illiquid stocks?

Isn’t there that flight-to-quality risk?

Roger Ibbotson: There could be the risk

of having to sell quickly. In actual experience,

though, for example in 2008 when you had

a kind of a liquidity crisis, it was the most

liquid stocks that were sold and dropped the

most. So even in a financial crisis, the less

liquid stocks do relatively well compared to

the more liquid stocks. Now it is true that it

is more difficult to sell the less liquid, and


people chose not to sell them. But it is still

a fact that their prices fell much less than

those of more liquid stocks.

Sid Browne: So would it make sense to

have a very large exposure in your portfolio

to these types of stocks?

Roger Ibbotson: If you’re a day trader,

you don’t want to buy these kinds of stocks

because they’re going to have higher trading

costs. It really depends on your horizon.

If you have a longer horizon, then buying

less liquid stocks can make sense.

Oliver Adler: Could you discuss the parallels

in the bond market, or segments of the

bond market, in terms of what those

liquidity or illiquidity premiums would look

like there?

Roger Ibbotson: Well, first of all, bond

markets are in the fortunate position of

having yields to maturity that you can actually

see. You know that if the bond doesn’t

default, you’re going to get a specific return

in that particular currency. And you know

it in advance.

In the equity market, you can’t see the

forward returns in the same way. You only

see the result. And since returns themselves

are very volatile, it’s hard to discern

what the result really is. Moreover, the return

measures differ strongly over different

periods. That’s why we can debate which

of these premiums really exist and how high

they are. This is quite different in bond

markets where maturities are normally fixed.

Oliver Adler: Would you say that the stock

market gives rise to more irrational behavior

in some sense than the bond market?

Roger Ibbotson: I’m sure there is irrational

behavior in the bond market, too. But

yes, there is behavior in the equity market

where essentially people are attracted to

stocks that trade a lot. And they’ll pay more

for them, just as you would do with brands

in the consumer market. Consequently,

the return structure is going to be different

among the less popular and the more popular,

and that leads to mispricing. Of course,

you’re also going to see mispricings in

the bond market, but they may be smaller

there and they’re more visible and thus

easier to take advantage of.

Sid Browne: You’re saying that something

could be more popular in the equity market

than it would be in the bond market.

So Apple stock, for example, could go

“hot” and very, very liquid, but the debt,

because it’s traded less and because

it is a discounted flow of more certain



interesting in

liquid markets

is that giving

up a little

bit of liquidity


can have a


big impact.”

Roger Ibbotson

cash payments, would actually not be

impacted by this popularity phenomenon.

Roger Ibbotson: It could be affected,

but it would not be affected by as much

because you can see the pricing exactly in

a yield spread. And so you know exactly

what you’re paying for.

José Antonio Blanco: Are you saying that

we have more serious information issues

in the equity than in the bond market?

If you compare two bonds, it’s relatively

easy to find the one that is paying too

much, or too little. Whereas, for a stock,

you might look at the past, but the future

is much more difficult to assert. So, as

an investor, you tend to grab things that are

a bit easier to recognize, like brand names,

along the lines “if something is popular,

it’s probably better.”

Roger Ibbotson: Yes. In the equity

markets, you can tell stories about

the stock. And the stories can be very interesting.

And you can pay a lot for stories.

That’s why, for example, value tends to

have higher returns than growth. Growth

gets highly priced because growth

companies have much more interesting

stories than value companies. In the bond

market, all these same phenomena may

exist, but there is more information.

It’s much more mathematical. The spreads

are visible.

Oliver Adler: How about areas like private

equity, or hedge funds, where you need

a lot of knowledge and can’t easily

tell stories? Might it therefore be fair to

say that mispricing phenomena occur

less frequently here?

Roger Ibbotson: Well, mispricing can

be pretty frequent in private equity as well

because there’s actually less information

for the buyer. You need more specialized

expertise to understand the specific stocks.

Also, in private equity, the presumption is

that the private equity manager not only

identifies undervalued stocks, but actually

changes the company in some way to make

it more valuable, perhaps by getting tax

benefits, restructuring management or

altering incentives. So there are potentially

more possibilities for profit if you’re really

good at doing that.

Hedge funds typically buy publically

traded equities or bonds – more or

less liquid securities. When you invest in

a hedge fund, you are essentially buying

the manager who is buying liquid


continued on page 14 >


How Moody’s


liquidity stress

In periods of market stress, investor scrutiny

often moves onto lower-rated financial

instruments that have been issued

with a premium yield level attached.

Concerns about the ability of issuers to meet

ongoing cash obligations for coupon payments

can lead to investor flight from speculative

bonds, just at the moment when those issuers

most need to shore up their finances to remain

in business. Classic examples might be riskier

consumer finance companies, smaller oil and

gas firms, and heavily leveraged property

developers. If the stress period persists, such

issuers are often unable to raise suffi cient

short-term debt to maintain their trading

activities and, if undercapitalized, they may

even fail.

Defaults in this riskier zone can prove contagious,

both because of the effect on other

parties exposed to a given sector or deal, and

due to the psychological effect on the general

investing public. A vicious illiquidity circle

can develop, as occurred in real estate loans

in 2008–2009, and may require government

intervention and ultimately debt write-downs.

Liquidity, a key element of credit analysis

In order to provide additional transparency in

its existing liquidity assessment process and

arm investors willing to hold speculative- grade

debt against falling foul of rapid shifts in market

sentiment, the rating agency Moody’s

began assigning Speculative Grade Liquidity

(SGL) ratings in 2002. Loss of access to funding

remains a risk criterion in any assessment.

Defining speculative-grade liquidity

risk as “the capacity to meet obligations,”

SGLs describe an issuer’s intrinsic liquidity

posi tion on a scale of 1 (very good) to 4 (weak).

Assignment of a rating is carried out under

detailed criteria for measuring a company’s

ability to meet its cash obligations through

cash, cash flow, committed sources of external

cash, and potentially available options for

raising emergency cash through asset sales.

SGLs are a measure of issuers’ intrinsic

liquidity risk – meaning Moody’s assumes

companies do not have the ability to amend

covenants in bank facilities or raise new cash

that is not already committed. Such conditions

are not typical in normal market environments,

but can occur in periods of economic and

credit market stress when companies need

liquidity support the most to avoid default.

Because Moody’s factors market access and

the ability to amend covenants into its longterm

ratings, the assumptions utilized in analyzing

liquidity are more stringent.

One proviso that Moody’s noted from the

outset is that liquidity assessments focus on

corporate capacity to meet obligations. Willingness

to default remains a management

issue that is not factored into SGL ratings, but

is separately evaluated as part of the longterm

ratings analysis. Ratings are dynamic and

may be modified ad hoc, as with bond ratings.

To date, Moody’s assigns SGL ratings to

US and Canadian issuers alone, although

the framework is used in most other regions

as well. Moody’s maintains SGL ratings on

appro ximately 840 issuers, with USD 1.8 trillion

in rated debt.

Index summarizes the market conditions

Moody’s also created the Liquidity Stress

Index (LSI) to provide a broad indication of

speculative-grade liquidity. The LSI is the percentage

of SGL issuers with the weakest

(SGL-4) rating. Changes in corporate earnings,

borrowing costs and ease of new debt

issuance are critical drivers of changes in the

LSI over time. Credit cycles tend to lead the

economic cycle because willingness to leverage

into expanding economic activity has to

occur before the activity itself gets underway

in the real economy.

Speculative-grade companies do not have

access to the commercial paper markets, so

they are generally unable to quickly raise new

financing in crisis moments. Measuring their

riskiness essentially boils down to gauging

the free cash flow from operations, cash on

hand, and committed financing from other

sources such as revolving credit facilities (the

latter is not part of the SGL analysis.)

More than 12 years after the introduction

of SGLs, the track record now includes both

extended periods of more-than-ample liquidity

and phases of unprecedented risk and

market stress. The LSI’s long-term average

value since inception is 6.8%, with a record

high reading of 20.9% in March 2009 at the

height of the financial crisis in the US. The

lowest level reached by the index was 2.8%

in April 2013, with default and illiquidity risks

exceptionally low. At the start of 2015, the

index was still very benign at 3.7%, indicating

a below-average forecast of the default rate

of speculative-grade companies in the course

of this year. Higher risks from falling oil prices

were balanced against the steady earnings

gains from US consumer spending.

Article by

John Puchalla, Senior Vice President,

Corporate Finance Group at Moody’s


Gregory Fleming

Senior Analyst

+41 44 334 78 93



Oliver Adler: What sorts of issues come

up in terms of liquidity and premiums

with some of the more obscure asset

classes, like infrastructure, or the

not-so-obscure ones, like real estate?

Roger Ibbotson: Well, of course, something

like real estate is by its nature very

illiquid. But there are structures that you

can buy, like REITs (real estate investment

trusts), that make it more liquid. If you put

real estate into a structure that makes it

more liquid, it tends to be more highly valued.

A REIT is a more expensive way to buy

real estate, but of course it has the benefit

of being liquid. On the other hand, if by

buying real estate you actually get involved

in managing it, it’s a much more complicated

thing. That’s more like private equity.

All of these things are less liquid, and they

all should have illiquidity premiums. I suspect

that a lot of the return from real estate

comes from its illiquidity premium.

Oliver Adler: Given that the different asset

classes seem to have different characteristics,

how do you deal with the liquidity

issue when you put everything together

into a portfolio?

Roger Ibbotson: People need a certain

amount of liquidity. If you’re going to have

a lot of illiquid assets, you also need some

liquid assets to meet your liquidity needs.

On the one hand, people should not pay

for liquidity they don’t need. On the other

hand, they may need more liquidity than

they think.

There’s a danger in going into too many

illiquid assets, like real estate and infrastructure

and private equity. Some of

the universities, for example, did get into

a bit of a squeeze in the financial crisis.

They could not get very good prices for

their private equity investments. One of the

benefits of the kinds of stocks I’ve been

talking about is that they can easily be

sold in any crisis without paying much of

a discount at all.

Oliver Adler: But might it be possible

to argue that illiquid assets could help to

put a break on investors’ impulses

to sell at the wrong time and save them

from making mistakes?

Roger Ibbotson: That’s an interesting

argument. And, of course, there is evidence

that overall stock market trends go in the

opposite direction of what retail investors

do: retail tends to sell after the crash and

buy after the rise. So if retail investors were

somehow prevented from overtrading, they

might perform better. But the truth is that

people want liquidity even though it sometimes

leads them to take the wrong actions.

José Antonio Blanco: Once you know

what your liquidity needs are, is there a fair

reward for real illiquidity? Or could you

also achieve a higher return by structuring

liquid assets, for example by exploiting

anomalies or special effects, as you’ve

described (I don’t want to call it risk

premiums)? In other words, do you think the

illiquidity premium is overestimated?

Roger Ibbotson: I think one aspect

of what you are speaking about is the ability

to achieve “alpha” (a measure of outperformance

relative to some asset class or

benchmark). To get a lot of alpha, you may

need to do a lot of trading. People are

overconfident, of course, of their ability to

achieve alpha. But the more you believe you

can create alpha, the more you want liquidity

because it is the lower-cost assets that

may allow you to achieve alpha.

In contrast, if you have long horizons,

then you’re the natural type of investor

to go after illiquidity premiums. The fact is,

though, many people believe they can

create alpha – some legi timately, and others

who just think they can – and they will pay

up for it. I don’t see that going away. So,

the market will tend to pay too much for

liquidity, and conversely underestimate the

illiquidity premium.

Roger Ibbotson

The founder of Zebra Capital Management

in 2001, Roger Ibbotson is also

Professor in the Practice Emeritus

of Finance at the Yale School of

Management. He has written numerous

books and articles, including “Stocks,

Bonds, Bills and Inflation” with Rex

Sinquefield (updated annually), which

serves as a standard reference for

information on capital market returns.


Private equity

in emerging


Markus Stierli

Fundamental Micro Themes Research

+41 44 334 88 57


Nikhil Gupta

Fundamental Micro Themes Research

+91 22 6607 3707



The untapped potential

of emerging markets

Emerging markets make up:


of global output


of global stock market capitalization


of global private equity fund-raising


of global private equity investments


Global opportunity

At USD 29 billion, emerging market private equity

fund-raising has been concentrated in emerging

Asia, but growth has been the fastest in Africa.

USD 4 bn


USD 29 bn



High expectations

In the USA, private equity achieved annual returns

of around 16% over 2009–2014. Only 39% of

limited partners surveyed expect that the USA

will be able to sustain that level in 2015. 57%

of limited partners expect emerging market private

equity portfolios to achieve net returns of 16%

or greater in 2015. Historical annual returns for

emerging market private equity were around

13% over 2009–2014. Emerging market equities

only returned around 4% over the same period.

In comparison, US private equity trailed US equity

markets in terms of returns.


The promise of venture capital

Emerging market private equity investments

increased by 60% in value between 2009 and

2014. In the same period, venture capital investment

value increased sevenfold, now making up

more than 20% of total private equity investments

in emerging markets. Technology investments

have more than tripled in the same period.

Emerging market private equity by strategy, USD bn









* 2014 vs 2009

6 7

2009 2014

Buyout Growth PIPE Venture capital

Data sources used for the article: Datastream, Emerging Market Private Equity Association, Preqin

Not all markets are equal

Private equity investments expanded rapidly

in China, Brazil and Nigeria, shrank slightly in

India and collapsed dramatically in Russia

and South Africa between 2009 and 2014.

Private equity capital invested

in key emerging markets, USD bn













2009 2014






South Africa

In search of exit

Asian venture capital investments have started

to find viable exits through IPO routes. The

aggregate value of venture capital exits quadrupled

over 2013–2014 to reach USD 38 billion.

Number of Asian venture capital exits




22% 7%



83 exits

145 exits


USD 9 bn


Aggregate exit value

Trade sale IPO

Write-off Sale to GP

USD 38 bn


Moving up the value chain

African private equity is moving up the value chain,

away from extractive industries.

PE investments in 2014,

USD mn










Oil and gas



PE investments in 2009,

USD mn









in illiquid


Investors are increasingly showing appetite to commit to less-liquid alternatives. This includes

investment opportunities in areas such as private equity, private debt and real assets. According

to a recent study, shifting from liquid assets in which the primary investment return results

from the market’s (or benchmark’s) movements to less liquid investments in which the primary

source of the return is due to a fund manager’s skill at navigating an investment to a successful

outcome typically results in a median return premium of 20%–27% over a fund’s life, and

more than 3% per year. This illiquidity premium can be further enhanced by investing with the

best-performing managers. These managers typically generate top-quartile investment returns

and outperform the median performance benchmark by as much as 20 percentage points.

Despite the opportunity to enhance overall portfolio returns (while reducing exposure to daily

market volatility), individual investors tend to be under-allocated to illiquid alternatives relative to

institutional investors. One oft-cited reason is the restriction on withdrawals of ten years or

longer before fully returning capital and profits to investors. However, the recent growth of shorter

duration and yield-producing investment strategies, such as direct lending to small and mediumsized

enterprises, coupled with the emergence of a secondary market for early liquidity,

may result in greater comfort with and more appropriate allocations to illiquid alternatives.


Head Private Equity Origination & Due Diligence, Credit Suisse

Photo: Biwa Studio / Getty Images


The illiquidity premium

The term “liquidity” refers to the ease with which

an asset can be converted into cash. Assets

or securities that can be easily bought and sold,

such as bonds and publically traded stocks, are

considered liquid. Private equity, private debt

and real assets, in contrast, are said to be illiquid.

Investment returns tend to increase with the

degree of illiquidity of the asset. A recent study

of nearly 1,400 US buyout and venture capital

funds found that the aggregate performance

of these funds has consistently exceeded the

performance of the S&P 500 by 20%–27% over

a fund’s life, and more than 3% annually.

Investment returns generally

increase with illiquidity

Compound gross annual returns in %













Small equity

US fixed



High yield

Real estate

Hedge funds

1 2 3 4 5

Venture capital

Private equity

Illiquidity estimates


The manager premium

An increase in illiquidity shifts the primary source

of the investment return from movements of

the market itself (or beta) to a fund manager’s

knowledge or skill at navigating an investment to

a successful outcome. Manager skills influence

the returns of illiquid alternatives primarily

through strategic and/or operational improvements

brought to portfolio companies. For example,

a manager may be particularly able to increase

portfolio company sales, reduce operating expenses,

optimize asset utilization or exploit leverage.

The potential for upside in illiquid alternatives is

therefore driven not only by exposure to a specific

illiquid category but also by investing with the

best-performing managers. This is evident in the

graph below, which shows that the return difference

between top and bottom quartile managers

can be over 30 percentage points in private equity.

Manager dispersion

increases as illiquidity grows

Return differential vs median in %





Top decile

Median 2nd quartile

3rd quartile

–10 bottom decile


Long-only Long-only

fixed income equity





Individual investor allocation

Relative to individuals, many institutional investors

with long investment horizons, such as

pension plans (with their liabilities for retirees)

and endowments (with their ongoing operating

budgets), have built up significant allocations

to illiquid alternatives, as shown over the last

two decades. In 2013, the average US endowment

held a portfolio weight of 28% in alternative

assets, versus roughly 5% in the early 1990s.

A similar trend is evident among pension plans.

In the early 1990s, pension plans held less

than 5% of their portfolios in less liquid alternatives;

today the figure is close to 20%.

Having a long-term investment horizon may give

more patient investors an edge in harvesting

the illiquidity premium. They can be rewarded for

sacrificing liquidity that they do not need.

Allocation to alternatives

% of investment portfolio








Source: Illiquidity estimates taken from “Expected Returns” by

Antti Illmanen, 2011. 1994–2014 return data taken from Bloomberg,

Citigroup, Barclays Capital, J. P. Morgan, Bank of America Merrill Lynch,

NCREIF, Hedge Fund Research, Cambridge Associates, Russell 2000.

Source: Taken from “Patient Capital, Private Opportunity” by The

Blackstone Group, Private Wealth Management, 2013. Return data drawn

from Lipper, Morningstar, Preqin and Tass.

Source: Allocation data drawn from Cerulli Research, National

Association of College and University Business Officers 2013/14

Studies, Pensions & Investments 2013 Annual Plan Sponsor Survey.

Liquidity options

Historically, illiquid investment propositions such as venture capital and private equity funds required ten years or longer before fully returning capital

and profits to investors. However, the growth of shorter-duration and yield-producing investment strategies and a secondary market for early liquidity may

result in greater comfort with allocations to illiquid alternatives. The strategies outlined below are only a small subset of more liquid options available to

the investment community. These, and others, should make it easier for individual investors to sacrifice liquidity that they do not need in order to capture

(some of) the illiquidity premium.

Private debt strategies

The private debt market has seen strong growth since 2008, primarily

driven by direct lending funds. According to alternatives data provider Preqin,

over 200 private debt funds have raised in excess of USD 100 billion of

new capital commitments in 2013–2014. Private debt is characterized by

shorter investment duration relative to venture capital and private equity

funds, and in the case of direct lending, funds can be combined with regular

yield payouts to investors. The outlook for investing in the direct lending

space remains positive due to persistent structural factors preventing middle

market companies from accessing the broader traditional credit markets.

While credit supply remains tight, demand for middle-market credit remains

strong due to the expected deployment of committed, uninvested capital

(also referred to as “dry powder”) and the refinancing overhang of middlemarket


Secondary strategies

The secondary market in illiquid alternatives has been fueled in the recent

past by new regulations (e. g. the Volcker Rule), by record amounts of

dry powder and by improving economic conditions. A record USD 42 billion

of assets have traded on the secondary market in 2014, up from USD 9 billion

in 2009. Investors increasingly see secondaries as a viable channel to

generate liquidity before fund lockups expire. They are using the secondary

market to rebalance their illiquid portfolios, exit poorly performing investments,

reduce capital costs or comply with new regulations. In order to

increase liquidity for investors, some managers are now proactively offering

the possibility of exiting their funds early. For example, in its latest flagship

fund, a US buyout manager committed to selling fund stakes twice a

year to a preselected group of preferred buyers. Other managers have

started to provide interested sellers with a list of potential buyers.


Hedge funds

On doing your




Photo: Gerry Amstutz

Recent skeptical reports in the press about

hedge funds, and a high-profile divestment

or two, have prompted speculation that hedge

fund returns are in “structural” decline. Not

so fast, says Alexander Ineichen. For investors

willing to get off the couch, a careful study

of hedge funds shows that they actually deliver

higher-end returns than US equities do,

with less volatility.

Many seasoned investment professionals argue that liquidity

is an illusion. It is something you think you have, and

can measure in good times, but it vanishes immediately

during a perfect storm. It is a bit like your path toward

the emergency exit in a concert hall: under normal circumstances you

can run toward the exit within seconds; when fire breaks out, you

cannot. Liquidity is something everyone seems to require at the same

time. The financial crisis of 2008 is a good example. Markets literally

disappeared for a while. So-called market makers would delete their

prices on their screens and not pick up the phone, even in markets

that were considered liquid prior to the market disturbance. Another

example is the more recent decision by the Swiss National Bank to

drop its quasi-peg to the euro in January 2015. For a short time, the

foreign exchange market – considered as the most liquid market in

the world – stopped functioning properly.

Hedge funds – a “quasi-liquid,” superior return profile

Alexander Ineichen

Alexander Ineichen started his financial

career in derivatives brokerage and

origination of risk management products

at the Swiss Bank Corporation, UBS

Investment Bank and UBS Global Asset

Management. In 2009, he founded

Ineichen Research and Management

AG, a research boutique focusing

on absolute returns, risk management

and thematic investing.

In his 2000 book “Pioneering Portfolio Management”, David Swenson,

the CIO of Yale University’s endowment fund, distinguishes between

liquid and illiquid. But, for hedge funds, he creates something

in between that he calls “quasi-liquid.” This is a very elegant turn of

phrase. Hedge funds are indeed not as liquid as US large-cap stocks,

but are also not as illiquid as, say, private equity or real estate.

In the last couple of years the gloss has come off hedge funds.

Earlier, the high returns had turned a niche product into a flourishing

industry. For example, an investment of USD 100 in the S&P 500

Index at the beginning of 2000 was at USD 89 (–11%) five years later,

including full reinvestment of the dividends. The same investment of

USD 100 in an average hedge fund portfolio, after all the fees everyone

complains about, stood at USD 141 (+41%) five years later. This

is a big difference.

Hedge funds did well in the second part of the last decade too. In

the five years to December 2009, a long-only investment in the S&P

500 went from USD 100 to USD 102 (+2%), whereas an investment


of USD 100 in the average hedge fund portfolio went to USD 132

(+32%). This is still a big difference, but it had gotten smaller. In the

five years to December 2014, a USD 100 investment in US equities

more than doubled to USD 205 (+105%). However, USD 100 in the

average hedge funds portfolio “only” rose to USD 125 (+25%). As an

investor, which sequence do you prefer: –11%/+2%/+105% or

+41%/+32%/+25%? The second sequence is superior in two ways:

higher-end return with less volatility. I like to think of the first sequence

of returns as “nature.” That is what you get if you do not apply

risk management: moderate overall return with high volatility.

Hedge funds can improve this sequence with active risk management.

The second sequence does not appear in nature, it is man-made.

Hence the fees.

Challenges big and small

The biggest challenges hedge funds face today are linked to the

smaller managers. First, they find it very difficult to raise capital

because the financial crisis and the Madoff incident caused private

investors to more or less disappear. They are coming back only very

slowly. This means the main source of capital comes from institutional

investors who have a more sophisticated decision-making process.

They expect a hedge fund to have at least USD 100–150 million under

management and three years of proven real returns. Furthermore,

institutional investors conduct due diligence with their managers, because

a lack of it was one of the sources of disappointment in 2008.

Institutional investors also expect various layers of operational excellence,

adding to the cost base of hedge fund operators. This means

that the barriers for smaller, less-established managers have risen.

Finally, regulation has intensified. Large hedge funds can deal with

the added bureaucracy more efficiently than smaller managers.

But large hedge funds also face challenges, and one of them is

related to regulation. The financial crisis, and the regulation wrath

that it triggered, resulted in investment banks downsizing their trading

operations. Liquidity in many markets went down. Because of the

winner-takes-all effect that resulted in large hedge funds getting

larger and larger, these growing hedge funds see dwindling liquidity

as a challenge. A less liquid market means diminished opportunity

and is more prone to gap risk.

Are hedge funds a good/bad investment?

“Over the last decade

or so, the conceptual

arguments for investing

in hedge funds have

not changed by much.

However, the market

place has changed.”


I always recommended to everyone willing to listen that they move up

the learning curve with respect to risk management, absolute returns

and hedge funds. Knowledge beats ignorance every time. An educated

investment is better than an uneducated investment. And education

compounds. At the end of the day, an investment decision is

binary: either a position is established or it is not. This means the

various trade-offs, the pros and cons, need to be carefully weighed

against each other. This requires an effort, i.e. learning. Whether a

nice chap recommends hedge funds is not that relevant for most

investors. An investor needs to reach a level of comfort before investing,

and a conviction once acquired requires ongoing reconfirmation.

Both are a function of learning and effort.

The late Peter Bernstein, author of one of the best books on the

history of risk, once wrote that “liquidity is a function of laziness.”

What he meant is that liquidity is an inverse function of the amount

of research required to understand the characteristics of an investment.

As he put it: “The less research we are required to perform,

the more liquid the instrument.” An investment in US Treasuries requires

less research than an investment in US equities. An investment

in US equities requires less research than an investment in

hedge funds and so forth. In sum, hedge funds are not for the lazy.

Why I want hedge funds in my portfolio

Hedge funds originally marketed themselves as absolute return products

that deliver positive performance in any market environment.

Now, in the wake of the financial crisis, hedge funds focus on their

diversification benefits and risk-adjusted performance. A portfolio of

hedge funds does not obviate any alternative or “classical” way of

portfolio construction. However, hedge funds have properties that

you do not find in other areas of finance. For example, trend-following

managers have had a positive return in 17 out of 19 major corrections

in the equity market since 1980. This is unique. There is nothing

else in finance that has such favorable correlation characteristics.

Among other asset classes, measured low correlation more often than

not turns into an illusion when it is most needed, somewhat akin to

perceived liquidity.

Over the last decade or so, the conceptual arguments for investing

in hedge funds have not changed much. However, the market

place has changed. For example: hedge funds as a group are larger;

the largest funds are larger; some trades are more crowded; liquidity

in some market areas is lower due to Dodd-Frank; yields are lower

and IT is more important. But again, conceptually, an intelligently

structured portfolio comprising independent returns and cash flows

is as worth considering by every thoughtful and diligent investor as it

was in 1949, when the first hedge fund was launched. If you know

the future, invest in what goes up the most. If you do not, construct

a portfolio where the source of returns and cash flows are well balanced

and the risk is actively managed, while not forgetting that perceived

liquidity can turn into an illusion.


Hedge Funds

Liquidity –

a key to

hedge fund


Whether it’s related to an investor’s risk tolerance, or a

fund manager’s decision on the appropriate trading strategy,

the management of liquidity issues is a vital consideration

when investing in hedge funds. And while illiquidity can be a

source of risk, it can also be a source of additional returns.

Annualized returns

Liquidity is an important aspect to consider

when investing in hedge funds.

Liquidity issues have to be managed

by both investors as well as hedge fund

managers. While it is true that hedge fund

liquidity has generally improved for investors

since the global financial crisis, hedge funds

are still less liquid investments than equities.

To use Alexander Ineichen’s term, they can

be called “quasi-liquid.” In the following, we

take a closer look at the role liquidity plays

for hedge funds and their investors. A key

conclusion is that illiquidity is not only a drawback,

but also a potential source of returns,

which still has to be managed.

Illiquidity as a source of return

Hedge fund returns can be divided into three

components: (1) returns from general market

performance (also called beta factors), (2)

returns from exploiting risk premia, including

illiquidity factors (alternative beta), and (3)

returns related to manager skills (e.g. in selecting

securities and timing entry and exit

into an investment, called alpha.)

The performance of equity and fixed income

markets to which hedge funds have

exposure are typical beta drivers. The sensitivity

toward these drivers varies across hedge

fund strategies. While long/short equity strategies

(which belong to the fundamental style,

see box) have a relatively high sensitivity to

equity market performance, the influence on

managed futures (a tactical trading strategy)

or fixed income arbitrage (a relative value

strategy) may be minor.

Hedge funds provide advantages

Tactical trading 5.5%

Relative value –1.9%

Event driven –2.6%

Low liquidity


Directional investing –4.6%

Tactical trading 9.1%

Directional investing 7.4%

Event driven 7.3%

Low liquidity


Relative value 5.8%

Best trading strategy is a function of market liquidity

In periods of low liquidity, tactical trading strategies have performed best. Particularly in an environment

of low liquidity, this style stands out as the only one delivering positive returns. Source: Datastream, Credit Suisse

Directional investing 15.3%

Event driven 14.6%

Tactical trading 11.9%

Relative value 11.6%

High liquidity


Directional investing 18.5%

Event driven 17.0%

Tactical trading 13.6%

High liquidity


Relative value 9.5%

Generally, it is easy to gain exposure to traditional

beta drivers. However, alternative

sources of beta may not be as easily accessible

through commonly traded instruments.

Default risk and illiquidity premiums fall in

this type of category, and hedge funds can

be one way to access this type of return. For

example, the distressed debt strategy in -

vests in illiquid, distressed securities that are

not commonly accessible to investors. In

contrast, mutual funds have more stringent

liquidity requirements and are usually restricted

to invest at most in low-rated credit,

while their structural setup allows hedge

funds to take on such credit risk. Moreover,

distressed debt hedge funds have a longer

time horizon, which allows them to hold on

to investments for longer and to wait until the

company that issued the distressed security

gets back on track.



Glossary of liquidity provisions

Redemption notice period Minimum period for

advance notice prior to redemption.

Redemption period Frequency with which

investors can withdraw their funds.

Lock-up Time period from the initial investment

until it is possible to make a first withdrawal.

Gates A gate limits withdrawals to a certain

percentage of assets under management during

any redemption period.

Side pockets A provision that allows the manager

to keep particularly illiquid holdings in a separate

account. There is usually no liquid market for

these holdings. It may be difficult to establish the

holdings values and may be difficult to sell

them. Hence, if an investor places a redemption

request, the manager does not need to liquidate

positions in a side pocket immediately. Pro rata

proceeds of these holdings are only distributed to

investors once these holdings have been sold –

which can be long after an investor has withdrawn

his capital.

Investments in more illiquid securities on the

side of hedge fund managers have implications

for investors too. Since the forced selling

of securities can mean selling at unfavorable

prices, hedge fund managers can set up

a range of provisions to avoid losses due to

this. Liquidity provisions can take the form of

redemption restrictions, lock-ups, gates, side

pockets or a combination thereof (see glossary

at the left hand side). It is no surprise

that the strategies investing in the most liquid

assets (managed futures and global macro)

tend to be the strategies that offer the highest

liquidity for investors. As a result of the bad

experiences made during the financial crisis,

with many investors not fully aware of such

provisions, investors now desire a higher degree

of liquidity. Consequently, more liquid

strategies as well as structures like UCITS

(undertakings for the collective investment in

transferable securities), which are designed

to accommodate this desire, have attracted

more inflows.

While barriers of withdrawal can protect

investors from redeeming funds at the most

unfavorable terms, there can also be arguments

raised against such policies. Investors

may get the impression that hedge funds are

using such provisions as an excuse to earn

further fee income before their capital is eventually

returned. It is thus important that investors

are assured that long lock-up periods are

well justified – e.g. because the hedge fund

is holding illiquid investments such as overthe-counter-traded

distressed debt securities.

Generally, investors eager to benefit from illiquidity

premia should be prepared to take a

longer investment horizon and be willing to

accept more stringent liquidity provisions. In

any case, it is important that investors clearly

understand the fund terms in order to avoid

unpleasant surprises later on.

Liquidity requirements and return potential

As Alexander Ineichen points out, hedge

funds used to be known as an asset class that

delivers superior returns at lower volatility.

However, our view at this time is that lower

expected upside from traditional asset classes

(i.e. weaker beta drivers) in combination

with structural changes is likely to dampen

the return potential of hedge funds. With regard

to structural changes, the investor base

of hedge funds is increasingly made up of

institutional investors, while private investors

previously played a larger role. Tougher requirements

regarding liquidity and transparency

have made it easier for institutional investors

to include hedge funds in their

portfolios. Further, the shift toward a more

institutional investor base has increased the

focus on the role of hedge funds in a portfolio

context: low correlations with other asset

classes and more stable return patterns have

become the key differentiating feature rather

than the delivery of high returns. With tough-

Hedge Fund Barometer variables: Liquidity

Hedge funds thrive when liquidity conditions improve and are exposed to liquidity shocks

when conditions tighten. Source: Credit Suisse/IDC

Percentile rank value




Liquidity tight









Liquidity plentiful

Jan. 92

Jan. 96 Jan. 00

Jan. 04 Jan. 08 Jan. 12

Liquidity composite 13-week moving average composite


er regulatory requirements, operating costs

have risen, which in turn has left some smaller

hedge funds unprofitable. Conversely, institutional

investors have been willing to sacrifice

high returns for lower risk as long as

their needs for liquidity and transparency are

fulfilled. For these structural reasons, we

think that the return potential of hedge funds

has generally decreased.

Liquidity drives our hedge fund strategy

The Credit Suisse proprietary Hedge Fund

Barometer is our main tool to assess the

broad investment environment for hedge

funds. The tool is an early warning framework

that should help avoid unnecessary risks. Besides

volatility, the business cycle and systemic

risk, the tool also assesses liquidity

conditions. While we have observed a general

increase in risk starting in late 2014,

tightening liquidity conditions began to draw

our attention in early 2015. As the second

chart shows, liquidity conditions deteriorated

around the turn of the year. While tighter liquidity

is generally a concern for hedge funds,

some strategies are less affected and can

even thrive in such an environment (see first

chart). Given the divergences in monetary

policies between the main regions and, in

particular, the likely approach of rate hikes by

the US Fed, we do not expect liquidity conditions

to improve materially in the near future.

Therefore, we adjusted our hedge fund strategy

in early 2015 and began to focus on

strategies that are less sensitive to liquidity

conditions, e.g. tactical trading strategies. At

the same time, our outlook worsened for

relative value strategies, particularly those

that are active in fixed income investments.

These strategies typically apply higher leverage

and/or invest in more illiquid securities,

and are thus at greater risk when liquidity

conditions tighten.

In sum, when investing in hedge funds,

investors should not just take traditional market

drivers into account, but also focus on

liquidity considerations. Illiquidity can be a

source of risk, but also a source of additional

returns for investors. Careful analysis of

the role of market liquidity in an investment

strategy can help avoid unnecessary risks and

lift returns.

Marina Stoop

Cross Asset and Alternative Investments Strategist

+41 44 334 60 47


The different hedge fund styles

and how they deal with liquidity

Tactical trading strategies are resilient when liquidity is scarce

Tactical trading strategies include global macro and managed futures.

In this style, managers try to exploit trends in equity, fixed income,

currency and commodity markets. Analysis of macroeconomic variables

rather than corporate transactions or security-specific pricing discrepancies

distinguishes tactical trading from other styles.

Tactical trading strategies trade in all major markets. However, one

major difference between managed futures and global macro is that

managed futures focus on trading futures contracts, the most liquid instrument.

In contrast, global macro managers have the widest investment

universe trading a broad range of different market instruments.

Another key aspect of the tactical trading style is that some strategies

are purely model driven. Within managed futures, trend-following strategies

are probably the best-known example of this strategy. A model generates

trading signals upon which trades are executed. Human discretion and

emotions are negated, which helps explain why tactical trading strategies

are well positioned to navigate through crisis periods. While discretionary

managers may rely to some degree on models, they can use their own

judgment when making investment decisions, and may be more prone to

making irrational decisions in a tough investment environment.

Fundamental strategies have various degrees of sensitivity to liquidity

Fundamental strategies focus on individual securities, mostly in the equity

and fixed income areas. While directional strategies usually build a broader

portfolio of more liquid securities and thus deliberately take directional

market exposure, event-driven strategies often build a more concentrated

portfolio of securities depending on a specific catalyst (event). Directional

strategies tend to take positions in more liquid publicly traded securities,

while event-driven styles often engage in illiquid securities (e.g. distressed

debt, special situations and activist investors with longer holding periods).

While liquidity sensitivity depends on the underlying investments, the

leverage applied is typically lower than in the relative value segment.

Relative value strategies depend on a favorable liquidity environment

Relative value strategies include fixed income arbitrage, convertible

arbitrage and equity market neutral strategies. They aim to exploit pricing

inefficiencies between related or unrelated securities and try to avoid

directional market exposure. Forgoing returns from beta drivers, returns

of these strategies would naturally be lower (yet more stable and with very

low correlation to movements in major asset classes). Leverage is a way

to enhance returns. It can be high, particularly for fixed income strategies

where targeted pricing inefficiencies can be small. But this makes the

strategy sensitive to liquidity conditions. While these strategies tend to do

well as long as markets move in their favor, volatile markets with scarce

liquidity can mean that positions need to be sold at unfavorable prices –

or worse, cannot be sold at all. This left many investors with large losses

during the financial crisis. It is thus vital to keep an eye on market liquidity.



Open-end versus

closed-end funds


Making what turns out to be the right investment

decision can hinge upon the underlying asset


type, and understanding the fundamental


differences between open-end and

closed-end funds.

In good times

On the upward trend,

investors see the discount

narrowing noticeably for

closed-end funds as the

economy strengthens.



Index points




In times of crisis

The discount of closedend

funds mirrors the

development of the overall

market. The discount

increases as the crisis

unfolds, but is quick to

revert again as recovery

begins to take hold.

– +







Discount to NAV in %






01.05 07.05 01.06 07.06 01.07 07.07 01.08 07.08 01.09 07.09

MSCI World Average discount 3m MA (rhs)

Average discount to net asset value for US closed-end investment funds

Through the worst of the Global Financial Crisis, the average discount on closed-end funds dipped from roughly – 7% to – 11% in January 2008

before rebounding sharply, but briefly – after which it fell to –18% before recovery at the start of 2009. Source: Bloomberg, Credit Suisse


Investors have many choices when selecting

a pooled investment fund: regional

versus global, active versus passive, bonds

versus equities, famous manager versus

start-up, and so on. But one choice can be

overlooked: open-end versus closed-end

funds. On occasion, this may be the most

important issue.

As we will show, the practical difference

for investment returns may not be great under

normal market conditions, but can become

significant at times of market stress, especially

for funds investing in illiquid assets such

as real estate, small caps, or specialized credits.

In such cases, a closed-end fund may be

the better structure.

Key differences

Closed-end funds have a fixed asset pool.

This can grow (or shrink) due to good (or bad)

investment performance, but normally no extra

capital is added from investors or paid out.

An existing investor who wants to exit must

sell on the open market to another investor

who wants to put money in. In contrast, the

assets in open-end funds can change because

of shifts in market prices as well as due

to net inflows or outflows of capital from investors.

When net new money comes in, the

manager invests in extra underlying assets,

while exiting investors sell units back to the

fund manager, who disposes of underlying

investments to meet net redemptions.

Operation under normal market conditions

Investors in open-end funds buy and sell units

at a level equal to the underlying asset value

(subject to enough liquidity, see below). By

contrast, the price of closed-end funds is typically

at a premium or discount to the underlying

assets, reflecting the balance between the supply

from exiting investors versus demand from

those entering. Academic studies have argued

that a premium might reflect the skill of the

manager or the rarity of the underlying assets,

while a discount might indicate lack of confidence

in the manager. Morningstar data shows

that, over the long term, closed-end US funds

have on average traded at a slight discount.

This tends to deepen when markets go down,

while it narrows or moves to a premium when

markets go up and investors become more


Some closed-end funds buy back their

own shares to try to narrow the discount, enhancing

value for remaining investors. Sometimes,

external predators try to gain control

and liquidate the fund at the market value,

thus effectively eliminating the discount.

Despite these measures, discounts and premiums

rarely disappear completely, perhaps

because demand for most closed-end funds

is dominated by retail investors who tend to

be procyclical.

When money flows in or out of open-end

funds, the dealing costs are in many cases

spread among all investors. The impact of these

costs may be negligible in large funds with

little movement, but can be a noticeable burden

on performance in small, fast-growing funds.

Perhaps, more importantly for an open-end

fund with specialist strategies in relatively illiquid

assets like small-cap or frontier-market

stocks, a good performance in the early years

when the fund is small may be difficult to replicate

later if large amounts of new money are

attracted by the good results, but are not easily

investible in the same way. So many successful

open-end fund managers in specialist

areas close their funds for new investments to

protect existing investors as they approach

capacity limits. If a manager does not do this,

there can be style drift, making the track record

of a fund manager less relevant.

Operation in stressed markets

When markets become stressed, such as during

the financial crisis, some assets may become

illiquid, while others remain easy to sell.

When this happens with an open-end fund,

the first investors to exit will tend to receive

cash obtained by the manager from sales of

the more liquid assets. While this is good for

these faster-moving investors, slower-moving

investors are left with units in an imbalanced

fund that holds mainly illiquid assets that cannot

be readily sold and for which the theoretical

valuation may fall further than the more

balanced portfolio existing before the stress

began. Well-known examples in recent years

include some frontier-market, real estate and

credit funds. Fund managers may have some

ability to restrict (“gate”) withdrawals. If this

is done early in the stress situation, it in effect

temporarily makes the fund closed, protecting

remaining investors. But in a worst-case scenario,

this closure happens after the faster

investors have left, which leaves remaining

investors trapped with a pool of illiquid underlying

assets that may then eventually be sold

as soon as some limited liquidity reappears,

which unfortunately is likely to be near the

bottom of the market.

Clearly, this process simply cannot happen

in a closed-end fund. Faster investors who

try to exit will likely find few buyers, forcing

the fund price down to a substantial discount

to the apparent net asset value. In the middle

of the financial crisis in early 2009, the average

discount of the largest US-listed closedend

funds rose as high as 25%. But the fund

manager is not forced into selling the underlying

assets to meet withdrawals. Investors

who are prepared to hold their nerve through

the phase of stress will still own a share in

the balanced pool of assets selected by the

manager, with a good chance of recovery after

the stress has passed, and they will not

be forcibly liquidated near the bottom of the

market by the selling actions of other investors

in the fund. Indeed, after the financial crisis,

the average discount narrowed quickly as

markets recovered, providing an additional

return driver for these funds on top of the rise

in price of the underlying assets.

Conclusion: Horses for courses

The conclusion is that investors should choose

between open-end and closed-end funds

largely on the basis of the underlying asset

type. For investments in mainstream, liquid

markets like developed economy large-cap

equities, an established large open-end fund

is probably the better choice in most cases.

It avoids the fluctuating premiums/discounts

of closed-end funds and should be large

enough to avoid issues of dealing cost attribution,

although it would likely not have leverage


In contrast, closed-end funds are likely to

be the better choice for underlying assets

such as real estate, frontier markets, small

caps and low-grade credit, since these are,

or are at risk of becoming, illiquid with all the

potential issues described above (see article

on Swiss real estate funds on page 47 for

more details).

Giles Keating

Head of Research and

Deputy Global Chief Investment Officer

+41 44 332 22 33


Lars Kalbreier

Head of Mutual Funds & ETFs

+41 44 333 23 94



Liquidity issues in an institutional portfolio context



Patient, yet opportunistic. Those are two key characteristics

of the New Zealand Superannuation Fund, whose very long-term

investment horizon allows it to pursue contrarian and illiquid

strategies if the price is right, all while managing liquidity at the

whole-fund level.

INTERVIEW BY OLIVER ADLER Head of Economic Research


Oliver Adler: From the point of view of

a private client, what’s special about

the New Zealand Superannuation Fund

(NZ Super Fund), as a national

sovereign wealth vehicle?

Adrian Orr: We are a “buffer” fund.

Our aim is to smooth the increasing financial

burdens for future generations. For

that reason, we have a very long-term

investment horizon: no money will come out

of the fund until at least 2031. That provides

us great certainty around our investment

horizon and our liquidity needs. These

“endowments,” as we call them, together

with our governance and our ownership

(i.e. our control over our capital) allow us a

very high level of risk appetite and also

the ability to invest in what can be called

illiquid assets.

Oliver Adler: How do you decide

your investment strategies?

Adrian Orr: We have a number of

investment beliefs against which we continuously

test ourselves, for example, that

there is some concept of fair value for an

asset, and that prices may deviate from

fair value, but should also revert to it over

time. These beliefs give us the confidence

to pursue contrarian strategies, as well

as illiquid strategies, if we think the price is

right. All potential investments, regardless

of asset class, are measured in terms of

their attractiveness – either as a diversifier,

or as a (mispriced) opportunity – and, more

generally, their consistency with our beliefs.

Oliver Adler: Isn’t that what the vast

majority of funds do?

Adrian Orr: Most funds have specific

strategic asset allocations (SAAs) to which

they are always rebalancing, whereas

we are opportunistic: we are continuously

shifting from the least attractive to the most

attractive asset classes or assets, based

on our confidence in our strategies. We are

least invested in black-box hedge-fund-type

strategies that are purely skill-based. We

have low confidence in skill as a basis for

adding investment value because we really

struggle to be able to assess it, and we

also have low confidence in its consistency.

José Antonio Blanco: What kind of horizon

do you use to estimate the attractiveness

of an asset mispricing? How much do

you want to have in illiquid assets? And how

much in liquid ones?

Adrian Orr: We define a long-term investor

as someone who has command over

the capital. So at any point in time, we >


Photos: Jamie Bowering

Adrian Orr is CEO of the New Zealand Superannuation Fund, which has posted annualized returns between 17% and 25% over the last five years.


José Antonio Blanco

Head Global Multi Asset Class Solutions

+41 44 332 59 66


Managing portfolios –

a quest for value

Credit Suisse Private Banking follows a structured investment approach,

which starts by defining a suitable strategic asset allocation (SAA) for its

clients and then actively managing the mandate portfolio in a disciplined

way around this SAA. However, the SAA is periodically checked and

adjusted (see interview). Although financial markets in some broad sense

tend to be efficient, there are costs to finding relevant information quickly

and acting on it appropriately; so price movements in response to events

are sometimes neither instantaneous nor always correct. This opens

opportunities to improve the return and risk characteristics of portfolios

over time by deviating from the strategic allocation in various ways.

We therefore manage portfolios actively, generally in all dimensions

across asset classes, markets, currencies and individual securities.

In our quest to add value, we combine in-house insights with added

value provided by other parties as long as their investment style fits

with the logic and structure of the mandate portfolios and the requirements

of the client. Unless specifically instructed to do otherwise, discretionary

portfolios for private clients are predominantly invested in fairly liquid

assets, in the sense that we focus on assets that are easy to trade and

monitor, although we will take some limited liquidity risk by investing some

of the portfolios in asset categories (like high-yield bonds) and strategies

(hedge funds, for example) that are less readily tradable and should

therefore generate a liquidity premium on top of their other characteristics.

Our prudence with regard to illiquid assets is the result of regulatory

considerations (some asset categories cannot be offered to private

investors because they require very specialized know-how and may entail

high and unusual risks) and the fact that investments in illiquid assets

limit our ability to adapt the portfolios to the changing environment and

client needs. These types of assets are therefore best managed separately

from the liquid part of the portfolio.

should have the ability to buy or sell on our

own terms. When you apply that definition

of a long-term investor, what it means is that

we manage our liquidity at the whole-fund

level. We want to make sure that we don’t

suddenly find ourselves in a situation where

we’ve got a fund full of illiquid assets and

have to shed assets in a fire-sale. We always

want to preserve the ability to buy assets

at opportunistically favorable times, for

example, when they are poorly priced by

the markets.

Oliver Adler: How do you price liquidity?

Adrian Orr: We have an absolute level

of liquidity that we wish to maintain at

any point in time for the fund. And we have

a pricing schedule for that liquidity as we

approach that must-have level. The level

for the fund as a whole is established

through specific scenario shock analysis,

so that we are always in a position to buy

assets at the markets’ darkest moment,

as opposed to having to sell assets. Having

a moving price structure rather than a

defined target quantity of specific illiquid

assets tends to create the right incentives

within the fund.

Oliver Adler: Might it mean that, in a market

stress period, your liquidity level actually

falls? And could that also mean that

you may not be able to then invest in the

opportunities you had thought you

might want to invest in?

Adrian Orr: Well, we try to anticipate

and pre-empt exactly that. We are thinking:

what does this portfolio look like in bad

times? And that consideration sets the price

or the “hurdle rate” we are prepared to

accept for making that investment. In other

words, we have a “waterfall” of liquidity,

starting from the highest, mostliquid investments

through to the leastliquid asset

structures. We have a pricing structure

and a management structure for the whole

fund that allows us to work our way through

that waterfall. By the time you get down

to the leastliquid assets, you are in a very,

very strange world, one where liquidity

would probably be the least of your concerns.

José Antonio Blanco: A look at the

current structure of your fund shows that

the allocation to what might be called

less liquid investments is very broad and

relatively small (about 20%). Why do

you diversify broadly on the illiquid side,

while having quite significant chunks on

the more liquid side?


Adrian Orr: You have to take your

mind out of an SAA framework. We asked

ourselves, how could we achieve our purpose

in the least-cost, simplest manner?

That means going out and buying listed,

low-cost liquid assets to create what we

call our reference portfolio. It ends up being

effectively 80% equity, 20% fixed income,

globally diversified. And we think of that

reference portfolio as delivering a Treasury

bill plus 2.5% return, on average, over

20 years. We then get out of bed every

morning and say: how can we outperform

that reference portfolio? How can we

add value?

José Antonio Blanco: Adding value

means …?

Adrian Orr: Improving the Sharpe ratio,

a higher return for the same risk, or the

same return for less risk. And that is when

we start actively investing.

Oliver Adler: If you compared your actual

allocations with a typical SAA for a balanced

fund, how marked would the deviations

be, say, in the main asset classes from any

kind of starting or “reference” point?

Adrian Orr: The deviation is quite big,

and has become more visible since about

2007, when we shifted away from our

SAA (we had one once!) and got far more

active and more direct in our investment

strategies. This is also the period of

high growth in the value-add of the fund.

So I would compare our strategy style to

a growth fund’s, not a balanced fund’s.

We have performed exceptionally strongly

over the last five years or so, with

annualized returns anywhere between

17% and 25%.

Oliver Adler: What about illiquid asset

classes such as real estate, which

is probably very local? Or infrastructure,

which everyone is talking about?

Adrian Orr: Many of our illiquid assets

have entered the portfolio as diversifiers

(like timber) or because there was a

significant market mispricing, or a specific

asset mispricing (like Life Insurance Settlements).

Infrastructure has been the real

tough one. Infrastructure assets have been

very sought after; so we rarely see a

mispricing opportunity, and they aren’t as

good a diversifier as people claim unless

they are true infrastructure.

José Antonio Blanco: How do you handle

the delicate question of ethical and

sustainable investment vis-à-vis illiquid


“We then get out of

bed every morning and

say: how can we

outperform that reference

portfolio? How can

we add value?”

Adrian Orr

Adrian Orr

CEO of the New Zealand Superannuation

Fund, which he joined in February 2007,

coming from the Reserve Bank of New

Zealand where he was Deputy Governor.

He has also held the positions of

Chief Economist at Westpac Banking

Corporation, Chief Manager of the Economics

Department of the Reserve Bank

of New Zealand and Chief Economist at

The National Bank of New Zealand.

Adrian Orr: A big part of our emphasis

on consistency is related to environmental

and social governance issues. We will

not enter into an external manager contract

if we cannot get the transparency we

need and the behaviors and reporting and

performance that we expect.

Oliver Adler: Would you agree that the

set of opportunities for you has diminished

over the last few years generally, if you

look across most investable assets?

Adrian Orr: Very much so. Our big valueadd

came from being able to be a contrarian

investor. Now equity prices are broadly

at fair value, globally. There are still some

opportunities in Europe and Japan, but

that’s where we have lower confidence.

José Antonio Blanco: In principle,

does the current situation favor illiquid

assets relative to traded assets?

Adrian Orr: I would say the illiquidity

premium has declined. There’s so much

global capital chasing illiquid assets,

that we just think, why bother? Why take

on illiquidity and all of the governance

challenges that come with direct investing

when you’re not being rewarded for it?

So we can be patient and await better

opportunities over time.





Trees are a fixture of the

physical landscape, inspiring

the human imagination, and

their products are a ubiquitous

component of everyday life.

Small wonder that they also

constitute a vehicle for investment.

Teak is particularly

prized for its beauty, spiritual

associations, durability and ease

of workmanship. A teak tree

matures in about 20 years and

is fairly easy to grow, though

the locations where it thrives

pose their own challenges.

Nonetheless, in the right hands,

teak offers an interesting

pro position for the patient

in vestor.




Carol Franklin

Chairman of the Board of Forests for

Friends and of the Tree Partner Company,

she earned her PhD in English literature

before assuming a series of management

positions at Swiss Re over the course

of 20 years. She subsequently became

the Executive Director of WWF (World

Wide Fund for Nature) Switzerland.

Giselle Weiss: You describe “falling into”

the business of growing trees but finding it

interesting. Why?

Carol Franklin: Investing in trees

means you give your money away for

20 years. The concept is difficult to sell

in the sense that if you go about it properly,

it really is illiquid. Most of our competitors

say that you will get a first payout after

three to five years, and that they will

reimburse your investment if necessary,

which is absolute rubbish. They also

tell you that returns are between 9% and

15% a year, which is also rubbish. We

compare our return to what you used to

get on a savings account – so something

like 6% to 7% per annum, 85% of

which comes in after 20 years when

the trees are harvested.

How does it work?

Carol Franklin: The basic concept

is that the investor pays all the money

up front, on a shareholding basis. In other

words, we have enough money for the

20 years it takes for the trees to grow.

We buy the land, plant the trees, and maintain

them very carefully. If all goes well,

we have the first non-commercial thinning

after four to five years. Then after eight,

14, and the final harvest after 20 years.

Let’s backtrack just a bit. Why trees, as

opposed to vineyards or fancy cars or

Picassos or a nice little chemical start-up?

Carol Franklin: I personally have always

been interested in ecology. And trees are

vital for our survival. They help slow down

climate change by capturing CO 2 . They

are something that you can see and touch,

as opposed to, say, derivatives. Why teak?

After 20 years you can sell the wood.

There are a lot of beautiful and interesting

trees, but they have no international market,

whereas there is a functioning international

teak market. At the moment, we are selling

all our wood to India, which could buy

the entire worldwide harvest. Recently, the

markets of Vietnam and China have been

growing, and some of the wood is going

to these countries to make very nice

garden furniture, doors, cabinets, whatever.

It would be nice if the US and European

markets became stronger again in the

near future.

Just to be clear, we’re talking about tree

plantations, not tropical forests, right?

Carol Franklin: Yes. We plant the trees

on former cattle land. Plantations are not

ecological, although ours are all certified by

FSC (Forest Stewardship Council). What

plantations do is to take the pressure off

the primary forests, as people no longer

have to go and cut trees in the jungle.

And the reason for doing it in Panama?

Carol Franklin: Teak only grows in

tropical regions, but you probably wouldn’t

want to invest your money in many of the

countries along the equator. Panama has a

relatively reliable legal system and, due to

its narrow shape between two oceans,

there is always a port nearby. If you plant in

Brazil, for example, and people do, the

nearest port can be 3,000 kilo meters away.

Getting the timber there costs a fortune.

Unlike overland transport, sea transport is

not very expensive. Panama also has tax

incentives for reforestation.

Who should invest in a teak plantation?

Carol Franklin: It’s not about quick

money. So patient money, possibly. People

who have an affinity for trees. People who

are ecologically minded and who want

to do something to save the world. Pension

funds would be ideal because it’s a longterm

asset and pension funds have calculable

long-term liabilities. It’s well suited

to family offices: traditional families used to

have their own woods, and some still do.

We have many grand parents! They think

long-term, and teak is a shorter return than

German forests, for example. A German

oak takes 100 years to mature.

And who should not invest?

Carol Franklin: Someone who might

need the money in the next 20 years.

I’d also never invest more than 10% of my

available money in something like this.

We’re not listed, which means the investment

is even more illiquid. But this also

means we are decoupled from the financial

markets. So if everything goes down,

which it will again of course, at least your

trees will continue to grow. And if the wood

price happens to be unattractive at any

given moment, we can just let the trees

stand and wait. It’s not rice or oranges or


Could you describe the planting cycle?

Carol Franklin: You buy the land.

You prepare the land. You plant the trees.

You have to get the right soil and the right

seedlings. Over the past ten years, seedlings

have improved dramatically. Because

our plantations are ecologically certified,

you can’t use certain pesticides and herbicides,

so you have to keep the grass and

shrubs down with the machete.


“There are a

lot of beautiful

and interesting

trees, but they

have no international


whereas there

is a functioning


teak market.”

Carol Franklin

As the trees grow, you cut the branches to

avoid knots in the wood. You usually plant

between 800 and 1,100 trees per hectare,

with the trees spaced about 3 meters apart.

After four years, you thin the trees to give

them enough room and light to grow and

become tall, strong and straight trees.

And you continue to thin as the trees grow?

Carol Franklin: Yes. The next thinning

is usually after eight years. This is the

first commercial thinning and the wood is

used for doorframes, tongue-and-groove

walls, indoor floorboards or furniture. As we

now get more money than we pay for the

thinning, we can use the proceeds for

the maintenance. So in the cash plan this

is income, but we do not distribute it to

the shareholders – unlike some companies

who use this money to keep their shareholders

happy and have to look for additional

income for maintenance. There’s another

thinning at 14 years, and the final harvest

at 20, but it could be 18 or 22, depending

on the growth of the trees and the state

of the market.

Aren’t the trees vulnerable to weather

or natural enemies?

Carol Franklin: For the first four or

five years, you have to be careful about fire.

So we have fire breaks, usually roads.

And we have people living in the plantation

to watch. Panama has no hurricanes.

We do have local windhoses, and sometimes

a bunch of young trees will fall over.

But you can put them back up and they

continue to grow. There’s also a type

of fungus, but it’s fairly limited, and we

are on the lookout for it.

What should investors know or consider

before they make such an investment?

Carol Franklin: The main thing is that

they should realize that the money is out

of their portfolio for 20 to 24 years. And

they should check us out because you

invest in people and not in things. It’s like

re-insurance. It seems very technical, but

in the end, you underwrite the underwriter.

Do you worry about climate change?

Carol Franklin: Well, there are general

concerns about the unpredictability of

the rains. And, naturally, if the tropics were

to become colder, that would be an issue.

But on a day-to-day basis, I think political

risks tend to be higher than natural risks.

Panama is probably more stable than some

of the other countries in the tropics.

Do people come to see the trees?

Carol Franklin: We organize investors’

trips including visits around Panama –

to the canal, an indigenous village, the old

fortress near Colón and our sheep and goat

farm. We have quite a few people who

just want to have a look and not invest, or

who want to get a feel for who we are

before they invest. We’re happy with that.

If you were starting over, would you do

this again?

Carol Franklin: My first experience with

this type of investment was actually sitting

on the board of a company that failed. It’s

a long story. My husband and I made it our

business to rescue it – now called Forests

for Friends – which was a huge gamble and

the odds were against us. But if we hadn’t

accepted the challenge, two-and-a-half

thousand people would have lost their money.

We succeeded, and that effort, as well

as starting The Tree Partner Company, has

changed my life.






Tree Partner

Province Darién

Shareholders’ investment 2014: CHF 4,207,407

1 The Tree Partner Company comprises two teak plantations totaling 170 hectares, located within three hours driving distance of Panama City.

2, 3 Engineers periodically gather statistics on how well the trees are growing. The first commercial thinning occurs at about eight to ten years, when the tree

trunks measure 40 centimeters circumference minimum.







4 Trees cut from the first thinning will be made, for example, into door frames. 5 Panama’s proximity to ports is a huge advantage in terms of cost. 6 Harvest takes place

around 20 years after the planting, when the entire plantation is felled, or “clear-cut.” 7 The plantations provide jobs and learning opportunities to the local communities.

8 The fruit of 10 years’ labor: the wood from thinnings is collected at the entrance to the plantation, then loaded into 12-meter containers and shipped, primarily to India.





in timberland

through vehicles known as “TIMOs” – timber

investment management organizations. These

intermediate investment funds make exposure

to timberland simpler for non-specialist institutions,

but the larger pools of capital often

prefer purchasing the assets directly. Returns

for institutions that acquired undervalued

holdings have been strong, initially driven by

a lower discount rate boosting long-duration

assets like timber, and recently supported by

better wood demand.

Current market situation and outlook

Land devoted to investible timber worldwide

amounts to 165 million hectares

(408 million acres), roughly equivalent

to the land area of Alaska. Institution al

investors now own timberland in Argentina,

Australia, Brazil, Canada, Chile, New Zealand,

South Africa, the United States and Uruguay.

Just under half of these assets (by area) are

in North America. There is much less harvestable

timberland worldwide than forested land.

In Australia, only 1% of forested land is developed

as timber plantations.

Broadly defined institutions, such as the

military, universities and even royalty, have

held exclusive property rights in forests for

centuries. Interest in timber assets by purely

financial institutions developed in the 1980s

in response to both the growth of institutionally

managed retirement accounts seeking

diversification, and a wave of forest divestments

by large forest-product companies.

Institutions enter into forestry

In the first two decades of investment by institutions

outside the wood-products industry,

activity was confined to large university endowment

funds. US timber companies using

GAAP accounting had to pay tax on forest

owned – even when it was not being logged,

thus incentivizing them to sell such plantations

to US tax-free pension funds. Preferential tax

treatments for real estate investment trusts

(REITs) also encouraged corporate divestment.

During a period of strong equity market

returns and declining inflation, the motivation

for institutional investment was limited to

those with a long time horizon for returns and

an unusually broad mandate on alternative

investments, enabling direct holdings of unlisted

assets. This led the same institutions

interested in pioneering private equity to explore

the scope for investing in timberland, as

a component of natural resource portfolios.

Front-runners were the endowment managers

for Yale and Harvard Universities. Yale alone

holds three million acres of forests.

Harvard’s Head of Alternative Assets,

Andy Wiltshire, worked in the New Zealand

forests sector early in his career, and drove

the 2004 purchase of a 408,000-acre New

Zealand timber estate by the Harvard Management

Company. Kaingaroa Forest was the

largest commercial forest property on the

country’s North Island. A 30% share of this

huge forestry block was divested two years

ago to the Canadian Public Sector Pension

Investment Board with an additional stake

taken up by the New Zealand Superannuation

Fund. Broadening of interest from private institutional

to public institutional investment is

thus well underway.

Timber has appealed to observers noting

long-run real annual returns of 10%–15% on

intensively managed, short-rotation plantations.

Seeing the very positive returns from

timber and its low volatility, sovereign wealth

funds and large public pension funds have

been acquiring exposure to commercial forest

assets. Corporate pension plans now own

around 10% of the asset class.

Based on measured returns on investment,

timber is not positively correlated with

other assets. But, because the timber price

is responsive to house-building cycles, the

run-up to the credit crisis in 2008 saw timberland

prices climb and then drop sharply.

The sluggish recovery in US housing led to

a multiyear opportunity for pension funds

to acquire timberland assets at reasonable

valuations, and most have entered the market

The US housing market has traditionally led

timber demand and is now in a gradual recovery.

The Australia-New Zealand region has

enjoyed resilient building activity that is expected

to continue, driven by immigration. In

China and India, continuing urbanization and

construction means these markets are still

growing. Chinese plantations cannot meet

demand and are under some pressure to be

converted into development land.

Increasing institutional investment is a

safe prediction due to low current allocations

within alternative asset portfolios and since

wood usage follows wealth development.

Thus, there is growing orientation toward

the Southern Hemisphere. Recent surveys

indicate that investor interest in emergingmarket

forests is primarily European, and

that smaller-scale investors favor emergingmarket

timberlands. Sustainability is a critical

concern – particularly with indigenous

hardwood trees – but a wide range of tools

are at hand, including forest and manager

certification, NGO oversight and replanting


Gregory Fleming

Senior Analyst

+41 44 334 78 93


Find additional details on

our map on pages 40–41


Farming and

forestry investment

Timberland is the investment term for

harvestable forests, as is farmland for agriculture

investment. Both types of investments act

as portfolio diversifiers, satisfy investors’

desire for “real” assets and have

emotional and social resonance.

But they do require patience.

Canada exports USD 4 bn worth of l umber and wood pulp to China


China imports USD 13.3 bn worth of soybeans from the USA

EU28 exports USD 2.6 bn worth of paper and paperboard to the USA

China imports USD 2.6 bn worth of cotton from the USA


Product mix – forestry

Tree products include hardwoods

such as mahogany (used for

furniture) and softwoods such

as pine (used for building and

paper production). Woodchips

may be sourced from either,

though softwood is a cheaper

source. South-East Asia

produces 90% of the world’s

natural rubber.

Source: FAOSTAT,

Statistics Canada, Rubber Manufacturers

Association, New Forests Asset Management

worth of lumber to the USA

Canada exports USD 15.8 bn

USA Export 10%




China imports USD 3.7 bn worth of soybeans from Argentina

China imports USD 19.1 bn worth of soybeans from B razil

EU28 imports USD 2.9 bn worth of soybeans from Brazil




ASIA Export 100%





CANADA Export 87%










NEW ZEALAND Export 50%

Hardwood domestic

Softwood export

Hardwood export

Rubber export

A US TR ALIA E xport 65%

Softwood domestic


NZ timber destinations

Logs constitute New Zealand’s third-largest export

industry. New Zealand is also now the world’s

leading log exporter (as of 2012) and the biggest

supplier of softwood logs to China (as of 2013).

JAS: Standard units. Source: UN Comtrade, New Zealand MPI

NCREIF Timberland TR Index

Returns as measured by a diversified index of

timberland investments. Timber serves as a good

diversifier, remaining stable during the financial

crisis of 2008 as shown in the index.

Source: Bloomberg, Credit Suisse/IDC

Volume (million JAS)









The USA imports USD 2.9 bn worth of paper and paperboard from China










EU28 exports USD 2.6 bn

worth of paper and paperboard to Russia

03 04 05 06 07 08 09 10 11 12 13

China India Japan

Korea Taiwan Other

03.87 03.95 03.03 03.11

NCREIF Timberland TR Index


The USA exports USD 3.3 bn worth of meat to Japan



Australia exports USD 1.6 bn worth of meat to Japan

China imports USD 3.3 bn worth of dairy products from New Zealand



Investing in farmland means

investing in rural land along

with specific crop and livestock

assets. Crops may be row crops

like soybeans or permanent

fruit and nut crops.


Dairy products


Paper and paperboard



Wood pulp

Mature, intermediate

and emerging timberland

investment regions

With most US forestry assets

already in institutional ownership,

investor interest has turned

to non-US markets, e.g. Asia. In

Europe, forests are generally in

private hands.




Australia exports USD 1.7 bn worth of cotton to China

Excellent climate for

agriculture, total annual


Agricultural productivity is

greatest in the world’s temperate

zones. Nonetheless, other

regions, such as South America

and Africa, where water is still

plentiful, are drawing investor


475–4974 millimeters rain

Selected international

agri-trade flows in USD

Find more

information in

the articles

on pages

39 and 42




Harvesting yields from agriculture

Farmland –

a fertile


One doesn’t often think of institutional investors and farmland

in the same breath. Yet, global population growth and the

accompanying demands on our food supply have made agriculture

an asset class worth considering. But bridging the worlds of

farming and financial services requires rather specific expertise.


Food demand

is set to grow

by over 60%

as the world





Find additional

details on

our map on

page 40




population is


to increase by

some 50%

Gregory Fleming: Griff, you have moved

from a traditional investment career in

pensions and investment funds into advising

on and structuring of farmland

investments. What motivated this move?

Griff Williams: A desire to make agriculture

investment accessible to institutional

investors. Agriculture is an asset class that

delivers real benefits to savings and retirement

portfolios, but lamentably, it is very

difficult to access it in a pure-play format.

It is also an asset class that requires specific

expertise that generally does not reside

in the financial services sector. As a farmer

who has spent over 20 years in the asset

management sector, I am blending the two

worlds to deliver this objective.

What kind of investor considers farmland?

Griff Williams: Investors seeking exposure

to assets that benefit from long-term

secular themes such as population growth,

changing dietary habits, growing middle

classes, water and conservation management.

Farms offer a hedge against inflation,

combined with an income yield. At the

same time, investors need to be able to

trust the farm managers, or at least the

partner selecting them. No one really wants

to have to go down to the farm and

check what’s happening there in person.

Is agriculture sufficiently exposed to

the modern, services-based economy to

offer good returns?

Griff Williams: The global population

is expected to increase by 50%, to more

than nine billion in the next 40 years, while

food demand is set to grow by over 60%

as the world becomes wealthier. Shifts in

diet preferences toward protein foods are

well-attested in enriching societies, and this

will increase the demand for land resources.

So investors can potentially benefit from

value-added gains in food or crop quality,

but also from the very limited expected

increase in the world’s available arable land.

The investment time frame is important

in illiquid assets. What is the best time

frame for taking a stake in farming?

Griff Williams: Farming lacks the thrills

of daily commentaries on network television.

The farmer is almost the archetype of

a patient investor, and non-farmers also

need some patience. Much depends on the

mode of investment, but an investment

horizon of five to ten years or a longer-term,

strategic allocation is reasonable. For investors

preferring the fund route to a direct

investment, between three and five years is


the shortest time frame to see results, but

that renders the investment rather prone to

the fortunes of just a few growing or production

seasons. Capital gains on farmland

are also likely to accrue more reliably over

longer horizons.

What kind of return can investors expect?

Griff Williams: A good internal rate of

return would be around 12% to 15% per

annum. This is likely to be split between a

cash yield on the farm products of 6% to

8% and a similar appreciation in the capital

value of the farmland, as it is improved.

Would you say that any one kind of crop

or product is superior, from an investor’s

point of view?

Griff Williams: I have looked at opportunities

in dairy, livestock, cotton, sugarcane

and fruit, soya, grains, and other rotational

crops. Each has unique and demanding

characteristics that require very solid experience

on behalf of the farm managers.

Investors may have an affinity with a particular

farm product, which is legitimate, but

it shouldn’t bias the objective judgment of

their returns and risk levels across the cycle.

All the farm products benefit from intractable

global demographic trends, but within

this rising demand trend, some crops are

considerably more volatile. Alternatively,

some are more demanding – for instance,

dairying requires much more investment

and stock management than sheep farming.

What approach should investors take?

Griff Williams: Maximizing sustainable

yield and minimizing environmental risks

means that it is critical to partner with real

farm operators. The skills the investor

should try to access are centered on rural

productivity, rather than on land speculation

or investment vehicles that mainly back

trades in the agricultural futures markets.

These markets have quite distinct returns

time frames and performance drivers from

the farmland itself.

What are the special characteristics of

investing in farmland globally?

Griff Williams: The key point is that

agriculture, in many countries, remains a

politically defined investment universe.

Certain governments restrict direct farm

ownership to residents, while others link

subsidy payments to the farm’s output. A

set of agricultural economies, however, has

liberalized its farming sector to reflect global

market prices, and these countries have

seen substantial efficiency gains. New

Zealand is the classic example here, ditching

“Maximizing sustainable

yield and minimizing

environmental risks means

that it is critical to

partner with real farm


Griff Williams

Griff Williams

The New Zealand national comes from

a farming family on the North Island,

where he continues to have dairy farming

interests. At Milltrust he is responsible

for designing and co-managing the

globally diversified agricultural strategy

with special focus on Australia and

New Zealand. Prior to Milltrust, he was

Head of Europe and Interim CEO of Itaú

Asset Management.

farm subsidies virtually overnight in the

mid-1980s. The New Zealand dairy sector is

now the most efficient in the world, and few

farmers would seek a return to government

involvement in the price-setting process.

Australia has also largely cut out farm

support. Other countries, such as the USA,

have more recently and gently modified

farming subsidies. The 2014 US Farm Bill

took the positive, though modest, step of

lowering direct payments and replacing them

with crop insurance provisions. Globally,

rich-country transfer payments to the agriculture

sector have been a major obstacle

to free trade agreements. It’s important

to stress that agriculture can survive and

thrive in a high-income country, without

state price support. Finding those liberalized

land opportunities, and conducting the vital

due diligence on legal systems, security of

title, environmental and marketing systems,

does require a broad range of skills.

Have you identified some best-practice

markets, or does it vary from farm to farm?

Griff Williams: The set of undistorted

farm product opportunities is quite small, in

country terms. The best operating environments

are seen across Australasia and in

selected Latin American countries such as

Uruguay, Paraguay and Brazil. Once a

number of farmers in a given country adopt

the best technologies and practices,

the pressure on the other farmers builds up

rapidly. This is as true of yield-enhancement

techniques as it is of sustainable

farming practices. Still, there are enough

underper forming farms in countries with sufficiently

good investment conditions to provide

opportunities for a portfolio approach.


Trends in real estate investment

Ins and outs

of real estate

As an illiquid asset, real estate takes time to sell and the length of the selling period can

vary heavily. For indirect investments in particular, there may be regulatory frameworks and

the possibility of pooling properties that moderate the negative effects, but there will

still be a certain risk of illiquidity due to the inherent hetero geneous characteristic of real

estate. However, investors with a sufficiently long time horizon can cope with these

risks and are compensated by a potentially higher return compared to more liquid assets.

Photo: Gregor Schuster/Getty Images


Hints for investors

1 / Adopt a long investment

horizon. Transaction costs

are best absorbed by having a

long investment horizon.

2 / Mind the leverage. Sufficient

own funds help to avoid

fire sales as price and liquidity

cycles can be long.

3 / Know your product.

Legis lation is very different for

distinct types of real estate

funds and country-dependent.

Some setups are more

exposed to liquidity problems.

4 / Take your time. Avoid

making your decision to buy

or sell too quickly. This could

turn out to be very costly.

5 / Add real estate to your

port folio. Do not be frightened

of illiquidity. Real estate is

a good diversifier in portfolios.

01_Allocation to property in

UHNWI investment portfolios

While residential property (main residence and

any second homes) makes up almost 30% of

the total net worth of UHNWIs, real estate also

plays an important role when it comes to making

investments. On average, property accounts

for 24% of UHNWI investment portfolios.

In over 40% of all cases, this share has even

increased in recent years.

Source: Knight Frank, The Wealth Report 2014

in percent















Middle East

North America

Latin America

When talking about illiquid assets,

real estate is at the forefront as

it belongs to the most prominent

of illiquid assets. In developed

markets, real estate is the most important

wealth contributor in household portfolios and

adds up to enormous amounts of wealth. It is

not surprising that regulators and central

banks pay a lot of attention to real estate

markets. Residential real estate accounts

for almost 30% of net worth in portfolios of

ultrahigh-net-worth individuals (UHNWIs) (see

Figure 1), and pension funds also have a substantial

share of their allocation in real estate

(see Figure 2).

Causes of illiquidity of real estate assets

The illiquidity feature of real estate results

from a combination of several characteristics.

To begin with, real estate assets are always

tied to a certain location. The combination of

a particular location and a specific object

quality creates a unique tangible asset. Consequently,

every building requires a one-off

analysis and, on a microlevel, prices can even

differ heavily on the basis of, for example,

exposure to noise or view. All this is reflected

in the valuation of a property: there is no true

02_Asset allocation of

Swiss pension funds as

of September 2014

Swiss pension funds traditionally have a substantial

allocation to real estate. As of September

2014, almost 20% of their funds were invested

in real estate. This number typically decreases to

some degree when equity markets are doing

particularly well and therefore make up a larger

part of the asset allocation.

Source: Credit Suisse Swiss Pension Fund Index, Q3 2014





Liquidity Bonds Equities

Alternative investments Real estate

Mortgages Rest




or objective price. Target prices depend on the

type of valuation model used and on investorspecific

preferences. Finding a price becomes

even more difficult when there is only limited

data available on similar transactions and if

assets have rare characteristics. This often

makes price negotiations time-consuming, and

adds to illiquidity. Determining a fair price is

especially important when one considers the

large size of the transaction.

Several other real estate characteristics

contribute to illiquidity, mostly from a cost

perspective. For example, the design and, to

some degree, the location of a building predetermine

its suitability for certain activities.

The conversion of a big department store

into many small retail units is relatively costly,

and regulation must also be taken into account.

Changing the use of a property from

a legal point of view, such as the conversion

of apartments into shops and vice versa, may

be difficult or even impossible. Investors must

bear this in mind and should therefore have a

clear strategy when investing in real estate.

Other costs include legal expenses and taxes

at the transaction stage. In total, there are

five steps in the acquisition of a commercial

building (see Figure 3). At each step, different

types of costs occur. Purchasing a commercial

real estate building typically needs a

negotiation time of about three months, plus

several months to conclude the transaction.

One last reason for the illiquidity of real estate

is simply the state of the market, which can

dry up quickly in periods of excess demand

(when nobody wants to sell a property) or,

more seriously, in a situation of weak demand.

Investors are facing difficult decisions

The main question for investors is whether it

is worth accepting this disadvantage from

a risk-return perspective. This depends on

the time horizon. As high transaction costs

associated with illiquidity are fixed costs,

it makes sense to hold such an asset for a

longer period. Therefore, pension funds and

other institutional or private investors with

a long time horizon are typical real estate investors.

In addition, these investors need to

accept that their real estate positions may not

be 100% liquid at any time. For wealthy investors,

these constraints are easier to cope with

(a fact that is reflected in the higher real estate

allocations of UHNWIs, see Figure 1). For

these investors, it makes sense to accept the

illiquidity and be compensated for it. For example,

the historical average premium to the

intrinsic net asset value (NAV) for listed >


03_Real estate transaction process

A typical transaction process for commercial real estate consists of five steps and may last up to

six months. Expenses, such as search or transaction costs, may incur at each step. Steps 2, 3 and 4

could run simultaneously. Due diligence thus makes up most of the time and costs.

Source: Credit Suisse


– Search costs

– 2–4 weeks

Swiss real estate funds has been 7% since

January 1990. Direct real estate investors

can avoid this premium. In addition, although

direct real estate cannot be traded on a daily

basis, this may be a good thing from a behavioral

finance perspective. Most investors tend

to underestimate transaction costs and in turn

reduce their performance by trading too often.

Since the real estate transaction process

takes time, investors are automatically prevented

from excessive trading.

Preliminary check and

non-binding offer

– Agency costs

– 1–2 weeks

Negotiation and final offer

– Negotiation costs

– 2–4 weeks

Due diligence

– Market, legal, tax, technical

and environmental due diligence

– 1–3 months


– Additional costs

(transfer taxes)

– 1–2 weeks

Implications of illiquidity on markets

In the case of illiquid assets, the problem

is that investor interests do not necessarily

align with market conditions. While it may be

highly rational for an investor to buy or sell a

property, too many investors acting in the

same manner at the same time can reduce

the liquidity of the whole market. In the end,

investors behave in a pro-cyclical manner because

they take more extreme positions and

trade more often when liquidity is high and

revise their ideas if liquidity drops. From a

long-term perspective – and this is the horizon

of most direct real estate investors – this is

irrational. Theoretically, there should be a

similar number of transactions in each stage

of the cycle. But this is clearly not the case.

Between the peak in Q1 2007 and Q1 2009,

quarterly commercial real estate transactions

in the USA fell by 91% in terms of volume,

and they increased by 691% by Q3 2014.

Illiquidity is often amplified in abnormal

market situations. Moreover, not all real estate

segments are affected by illiquidity in the

same way. Down markets trigger a flightto-quality

effect. Most investors will focus on

core properties in prime locations of favored

cities such as London or New York – if they

are still buying real estate assets at all.

Negative consequences are not a given


0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29

Investment solutions to meet the illiquidity

challenge are very different from country to

country, but generally adhere to the same

simple idea: pool some properties, securitize

them and distribute the shares. Then create

a market for these shares. This can be a stock

exchange or not. In either case, the shares

can be traded more or less continuously

and the properties are thus effectively more

liquid. Sometimes, a market maker is needed

to make the market fully liquid. This not only

applies to properties but also to mortgages

that are backed by properties. The legal structure

of such transactions can be very differ -

ent depending on the number of owners and


properties. For all these structures, trust is of

key importance, which implies a certain degree

of transparency when it comes to valuation

for instance.

Sometimes illiquidity conflicts with certain

investment goals. For example, one concept

is to reduce liquidity slightly by increasing

transaction costs in order to curb speculation.

This may help to lock out investors that have

a very short time horizon and are prone to

selling assets when the first headwinds occur.

Limits to liquidity

Even if liquidity is enhanced by pooling properties,

there is still no guarantee that this

will work all the time. Sometimes pooling

properties only results in “pseudoliquidity,”

which works when markets are rising (see

also “Open-end versus closed-end funds”,

page 24). In contrast, in times of falling markets,

the number of potential sellers surpasses

the number of potential buyers. This can

also happen for complex real estate-related

financial instruments such as residential and

commercial mortgage-backed securities

(RMBS /CMBS) as investors learned in the

aftermath of the financial crisis. Confidence

could not be restored on short notice. The

risk of moving from a liquid to an illiquid market

environment depends on the legal framework,

as seen in the case of German openend

real estate funds. The announcement of

possible regulatory changes to the corresponding

legal framework triggered massive

redemptions by investors who wanted to retrieve

their capital before the new regulation

was introduced. In contrast, listed fund structures

with a fixed capital base such as in

Switzerland are less exposed to such risks.

Selling real estate may become easier

As long as properties are tied to specific locations,

real estate will face liquidity issues. But

we believe that real estate properties will become

a priority for investors in the coming

decades. First, real estate still does not have

the appropriate or optimal weight in many asset

allocations. Second, interest rates may

stay at low levels for an extended period of

time, which makes real estate returns attractive

and should help to improve liquidity from

the seller’s perspective.

Beat Schwab

Head Real Estate Investment Management Switzerland

+41 44 333 92 42


Swiss real estate funds:

Liquidity and diversification

Real estate funds are an interesting alternative to investing into physical

real estate as they typically offer investors access to diversified real estate

portfolios that are managed by experienced real estate professionals.

However, the way the product structure deals with in- and outflows

of investor liquidity can impact the funds’ returns. Generally, one can

distinguish between open-end and closed-end funds. As described in the

article by Giles Keating and Lars Kalbreier (see page 24 for more details),

these two contrasting structures have both advantages and disadvantages

in times of market stress.

Swiss real estate funds aim to create a structure that captures

advantages from both types, while limiting the disadvantages by having

a semi-open-ended structure. This means that funds are opened up to

investors during periods of capital-raising activity, but that shares of the

funds are otherwise exchanged between investors on secondary markets

(with the majority of funds being listed on the SIX Swiss Exchange).

Whenever there is strong investor appetite for real estate funds, any

excess demand on the secondary market leads to an increase in unit prices

and vice versa. However, this excess liquidity does not flow directly

into the product and, as such, can neither impact the underlying portfolio

nor potentially affect operations, as it is fully absorbed by supply and

demand on the secondary market. Typically, this often leads to fund units

either trading above (agio) or below (disagio) par to the net asset value

of the underlying real estate portfolios. If true investment opportunities

arise in target markets, the funds can be reopened for subscription

of fresh capital for newly issued units, which can then be put to work.

This structure thus enables controlled and healthy organic growth, while

also providing a certain degree of liquidity to investors.

We also advise real estate investors to diversify internationally.

Since real estate market cycles tend to vary between different countries,

adding international real estate to a domestic portfolio can significantly

enhance the risk-return profile of a real estate portfolio. There are

several Swiss real estate funds with an international focus. While such

products are denominated in Swiss francs and foreign currencies are

mainly hedged, we believe the approach of globally diversified real estate

portfolios offers value to investors beyond Switzerland.

Philippe Kaufmann

Head of Global Real Estate Research

+41 44 334 32 89



Taking a long-term view


on the rise

Source: Preqin

Transport sectors Telecommunications Energy Social infrastructure

and technology


and waste


USD 94 bn of

infrastructure assets


USD 282 bn of

infrastructure assets


of surveyed investors plan

to invest at least USD 50 mn

each over the year 2015


of surveyed investors plan

to invest over USD 400 mn

each over the year 2015

Illustration: -VICTOR-/Getty Images


Largely due to the current low interest rate

environment, institutional investors such

as insurers and pension funds are increasingly

moving toward allocation into longer-term

illiquid assets, in particular into infrastructure

as an asset class. This trend has been a

significant one. In fact, global infrastructure

assets under management have seen a

300% increase over the past seven years.

Investors are increasingly putting their money

into the transport, tele communications,

technology, energy and resources sectors,

and backing the large-scale construction

projects these sectors require. While not

without risk, such investment is supported by

governments and supranationals alike.

There is clear evidence that insurers and pension funds

with long maturity liabilities are increasing their asset allocation

to infrastructure as an asset class. Other categories

of investors are larger family offices and sovereign wealth

funds. The investment case is that infrastructure projects or businesses

offer long-term yields that are theoretically fairly stable

and normally can provide inflation protection. Typically, investors

are taking a seven- to ten-year view on the risk / reward of investing

in infrastructure assets, but frequently the time horizons can be

considerably longer. According to Preqin, global infrastructure

assets under management in unlisted funds are at a record high of

USD 282 billion, having increased threefold since 2007. Of the investors

surveyed by Preqin, 25% plan to invest over USD 400 million

each over the next year in infrastructure, and 90% plan to invest at

least USD 50 million. Preqin estimates that “dry powder”, i. e. uncalled

capital already committed, could be USD 107 billion, while insurance

companies are planning to increase their asset allocation to infrastructure

to 3%.

Infrastructure: The different components

Infrastructure covers a range of differing assets, but can be broadly

disaggregated into the transport sectors, telecommunications and

technology, energy, social infrastructure, and resources and waste

management. Examples in the transport sector will include the

construction of new railways / mass transit systems and trains, ports

and shipping, airports, roads, bridges and tunnels. Telecommunications

and technology investments range from relatively simple, such

as mobile phone masts and fiber-optic cable, to complex projects,

such as server or other tech cluster farms. The energy sector is very

broad, but will include conventional assets such as pipelines, storage

facilities, refineries, support infrastructure for oil and gas fields, the

nuclear sector, energy transmission systems and alternative energy

assets. There has been significant investment in alternatives such as

on- and offshore wind farms, hydroelectric systems, solar and biomass

plants. Social investments are typically defined as the construction

and maintenance of schools, universities, hospitals and prisons.

Although there is some overlap with the energy sector, resources

and waste management infrastructure includes water management

systems, sewerage, waste collection and the recycling sector.

Typical infrastructure investment vehicles

In an unlisted fund, it is normal for the general partners to manage the

infrastructure assets and to appoint management teams as relevant

to the day-to-day management of individual assets or projects. Limited

partners will have made an initial capital commitment, and capital

will be called as and when funds are invested. There is typically an

initial investment period, and if the general partner has not invested

funds prior to the maturity of this investment period, then capital

commitments are waived or the limited partners can vote on granting

an extension. There will be clear guidelines on the fund’s turnover,

on investment concentration, leverage, planned repayments to limited

partners, and how, if necessary, the limited partners can vote on

a change in asset manager or general partner. Leverage has to be

carefully monitored since funding can be at the fund level or more

normally embedded in the actual projects or assets being invested

in. Leverage levels will typically be higher than what is normally found

in the private equity industry on the assumption that cash flows have

a lower degree of volatility than that in private equity. Sources of >


performance will be cash flows from projects, the improvement or

upgrading in infrastructure assets with new management, leverage

and over the long term the disposal of assets to new investors.


Investor demand: Existing assets versus greenfield projects

The infrastructure industry is dominated by investment in existing

infrastructure with a focus by general partners to improve the cash

flows from existing assets, to improve the financing structures,

to upgrade assets and to sell on what were originally purchased

as undervalued assets. In some cases, publicly listed infrastructure

companies will be taken private with a view that management change

can be more easily effected in a private structure. One key problem

is that although 70% of infrastructure requirements are estimated

to be in greenfield projects, investor demand is primarily for existing

assets. The rationale for this reluctance lies in the fact that investors

do not want to carry the initial construction period risk where cash

flows will be negative, and where investors have limited direct control

over issues such as cost overruns, construction failures, environmental

risks, supplier failures, etc. Greenfield project risks are typically

carried out by companies with a long history of involvement in

the construction of infrastructure, and they may be supported by

government, bank or supranational institution guarantees. In emerging

economies, many projects have only taken place backed by, for

example, guarantees from the Asian Development or the Inter-

American Development Bank. In Europe, the European Investment

Bank has played a key role, not just in financing projects, but by

providing guarantees.



Financing can be divided into a variety of constituent elements –

including equity – typically with pension funds and insurance companies

acting as limited partners in unlisted funds, companies involved

in the infrastructure sectors providing equity, bank financing, the

developing infrastructure bond market and the provision of guarantees

from banks, governments or supranational institutions. Given the

long-term and illiquid nature of the assets, it is generally agreed that

it is inappropriate to have infrastructure assets in mutual funds where

short-term liquidity is provided to investors. If retail investors want

to access the infrastructure industry, the most appropriate route is

to purchase the equity or bonds of infrastructure construction and

maintenance companies.


Infrastructure bonds

Apart from equity investing on the part of long-term investors, there

is a clear recognition among investors that the infrastructure bond

market requires further development. Historically, infrastructure was

financed either by bank lending or by bond issues made by supranational

institutions, governments, or companies involved in the construction

or maintenance of projects. Investor risk was limited to a direct

credit risk on the issuer without any recourse to the project assets.

With banks deleveraging and reducing maturity mismatch risk by

focusing on floating-rate rather than fixed-rate assets and reducing

proprietary positions, bank financing for infrastructure will decrease

on trend, and therefore lead to greater reliance on access to funding

from investors and the bond markets. Since investors are reluctant

to act as equity providers in greenfield projects, they likewise will not

be providers of longer-term financing for new projects. They will, however,

be active participants in bond issues made by existing infrastruc-

1 Workers laying railway track in northwest

China. 2 Pipeline pipes at the ready with

oil rig in background. 3 Bales of paper ready

for recycling.


Photos: Imaginechina, Lowell Georgia, Anna Clopet/Corbis

ture management companies such as train operators, pipeline managers,

etc., while they will also purchase bonds where there are credit

guarantees either by government, supranational institutions or banks.


While the current low interest rate environment encourages increased

allocation into longer-term illiquid assets such as infrastructure, it is

important to focus on the risk factors in the industry and highlight

some examples where investor losses have been generated. For

new projects, the obvious key risk is that projects are either not completed

or have serious delays and / or cost overruns. Recent examples

include escalating costs of building new nuclear plants, projected

overruns in high-speed train lines and toll road tunneling projects.

Political risk has to be carefully assessed; there have been a number

of instances, notably in mining projects in higher-risk emerging markets,

where a change of government has led to contracts / concessions

being cancelled and assets sequestered. Another example of political

risk is the possible change in government subsidies and / or support.

A number of alternative energy projects and notably wind farms have

faced deteriorating economics as government subsidies have been

withdrawn, and likewise social infrastructure projects, which might be

in the form of a public / private partnership, can suffer from reduced

government funding. Environmental issues are critical, notably in the

transport, energy and waste management sectors. Examples of problems

have been the imposition of environmental fines on projects and

infrastructure assets and projected cash flows being delayed because

of disputes over environmental issues. Certainty of cash flows is

obviously important, but in a number of cases, cash flow projections

have been too optimistic. One example has been in toll roads where

they have competed with toll-free roads and traffic has not switched

to the toll roads, with a mediocre outcome for revenues and cash

flows. Another risk is the threat from new technology. For example,

in telecommunications, the future viability of mobile masts has to be

questioned, while initially the excessive installation of fiber-optic

cabling led to major losses. Market price movements can change the

economic viability of infrastructure. At present, the sharp decline in

oil prices is challenging a number of alternative energies, and investment

in oil and gas fracking is becoming less attractive.

Financial risks involve the threat of higher interest rates and / or

wider credit spreads. Increased financing costs will challenge the

economics of infrastructure, make alternative asset classes more

attractive and could delay projects if refinancing needs are not met.

Other market-related risks can be changes in foreign exchange rates

where hedging longer-term assets can be problematic, shifts in

yield curves (which might affect swap pricing where swaps have been

used to hedge borrowing risks) and the use of excessive leverage.

In 2008–09, a number of infrastructure funds had to be restructured

since reduced cash flows could not meet increased borrowing costs

and / or refinancing could not be successfully achieved. The final risk

is that, in “easy” markets backed by quantitative easing, valuations

may become stretched and there is some initial evidence of this occurring

with current transactions in the ports and trains sectors being

effected at values significantly higher than those that took place over

the last five years.

Government policies

In the recent G20 communiques, the G20 stated “we are working

to facilitate long-term financing from institutional investors and to

encourage market sources of finance, including transparent securitization,

particularly for small and medium enterprises and we endorse

the multiyear program to lift quality public and private infrastructure

investment.” It is obvious that at the level of individual governments

and also the IMF, OECD and EU, accelerating infrastructure projects

is a clear macropolicy objective. S & P has estimated that infra structure

financing needs worldwide could total USD 3.4 trillion annually until

2030. For governments, infrastructure investment is clearly attractive

given the initial positive impact on employment and the longer-term

multiplier effect on the economy.


There are a number of clear trends in the infrastructure sector. First,

new investment from investors such as pension funds that need

long-term assets and do not need liquidity will increase significantly.

Second, investment in infrastructure will have the support of governments

and supranational institutions given the strong economic

multiplier effects. Third, the environment for investing in greenfield

projects / start-ups will remain challenging and will require project and

credit support. Fourth, investors will focus on areas where there is

inflation protection, minimal systemic risk, and where leverage and

financial risk is intelligently managed. Finally, the flow of equity capital

will be matched by the development of the infrastructure bond

market as an alternative to bank financing.

Robert Parker

Senior Advisor

+44 20 7883 9864



Advising on illiquid assets




Global Investor asked two Credit Suisse wealth managers

to describe the illiquid asset landscape from the point of

view of investors. Do clients feel it is worth trading liquidity

for additional returns? How much of their portfolios do clients

allocate to illiquid assets? Are some assets more popular

than others? And how does culture affect asset choices?

INTERVIEW BY MANUEL MOSER Senior Financial Editor, Credit Suisse

Manuel Moser: What does a typical client’s

portfolio allocation look like?

Felix Baumgartner: My perception

is that “this” client is invested approximately

40% to 50% in equities and 30% in cash.

The cash tends to come from fixed income.

In other words, when a bond expires, the

money goes into the cash portion of the

account owing to the lack of opportunities

in fixed income. Now, clients are a bit

worried about staying in cash, and consequently

they’re looking for other opportunities,

including illiquid assets.

Are some investors more open

to illiquid assets than others?

Patrick Schwyzer: There are different

ways of characterizing investor preferences:

by geography, by what stage investors are

in in their lifecycle, by their background

and by the country they live in. For example,

the USA is certainly more open to illiquid

asset investment. Switzerland not so much.

There are a number of reasons for the difference,

one of which could be that in the

USA, people have to administer their own

pension money. That means thinking through

the range of investments for the best yield

and return, whereas in Switzerland we

still delegate the entire business of pensions

to outside parties or the companies’

pension scheme.

What about preferences for various kinds

of illiquid assets, such as real estate or

hedge funds?

Felix Baumgartner: The order of

pre ference that we observe is: real estate,

then hedge funds, followed by private equity.

Traditional Swiss investors, in particular,

look for real estate in Switzerland. But there

is not much left here. It’s all been bought

up. Some traditional investors still like gold,

which is not an illiquid asset, of course,

but still very volatile.

How satisfied are clients with the

returns on their investments in illiquid


Felix Baumgartner: I’d say they’re

satisfied with real estate, and with hedge

funds. Private equity could be the next

boom in the coming years because it offers

a long-term investment, diversification and

good returns. But clients are too little invested

in it at present to reap the benefits.

For Swiss-based investors, I would estimate

that private equity currently represents

only about 1% or 2% of their portfolio.

Patrick Schwyzer: I would say it’s more

like 0.5%!


Photos: Luca Zanetti

Patrick Schwyzer (left) and Felix Baumgartner from Private Banking & Wealth Management, Credit Suisse, take a moment to exchange viewpoints.


What additional return would a client

typically expect in private equity versus

traded equity, after fees?

Patrick Schwyzer: It’s difficult to price

the illiquidity premium. Research shows that

private equity does create a positive outperformance

over the classic equity market in

the long run. For example in a traditional

buyout private equity fund, a client would be

looking for annual double-digit returns over

the lifetime of the fund.

How realistic are those returns?

Patrick Schwyzer: What’s key in

private equity is to invest in what we call

top- quartile performers. So you tend to

go with managers who have proven that

they can achieve the double-digit return in

any particular strategy. Needless to say

that expertise and knowledge of the private

equity universe are key in identifying

such managers.

Where would you rank expectations for

hedge funds compared with cash, bonds,

equity or private equity?

Patrick Schwyzer: Again, it’s difficult

because hedge funds are not a homogeneous

asset class. We group hedge funds

into four different styles, so to speak.

And every style has its own risk/return

profile. For an equity long-short manager,

for example, a rule of thumb is that you

participate in two-thirds of the upside and

one-third of the downside compared

to traditional equity. There’s no such thing

as a free lunch, as you know. There are

other styles, e.g. managed futures, strategies

that tend to be uncorrelated to an

equity market. Keep in mind that any broad

hedge fund index is just the amalgamation

of all these different styles.

Nobody assumes that hedge funds are fully

liquid. But what about bonds? The financial

industry is reporting big rushes into high

yields and very high-risk bonds. Do you see

a risk that clients may have bought things

that they thought were liquid, but that may

end up not being liquid?

Patrick Schwyzer: Education is key.

Absolutely key. This is one of the lessons of

the financial crisis of 2008. Sometimes

a product behaves just like it is designed

to, but a different perception was linked to

the product and therefore caused irritation

with clients. An explanatory discussion with

a specialist typically helps in such situations.

Also, secondary market liquidity can be

provided for alternative solutions. While this

generates liquidity, it is not inherent in the

“What I see in most

discussions is that clients

want to understand

the thought process and

how we do things.”

Patrick Schwyzer

Patrick Schwyzer

is a Managing Director of Credit Suisse

in the Private Banking & Wealth

Management division, Zurich, and Head

of Alternative Investments for Private

Banking clients Switzerland and EMEA.

He was previously with GAM Global

Asset Management London. He graduated

from the University of St. Gallen

with a special focus on Finance and

Capital Markets.

Felix Baumgartner

is a Managing Director of Credit Suisse

in the Private Banking & Wealth

Management Division, Zurich, and

Co-Head Premium Clients Switzerland.

He was previously a Director at Credit

Suisse First Boston in Global Foreign

Exchange (GFX) and a member of the

GFX management team. He is a graduate

of the Zurich and the London Business



product, and the liquidity provider will

typically buy at a discount to the actual net

asset value of the product.

Are entrepreneurs more likely than other

investors to favor illiquid assets?

Felix Baumgartner: It’s a good question.

As owners of their own company, they’re

more open to illiquid investments. They

probably have 80% of their total wealth invested

in the company, and they’re comfortable

with that because they know what

is going on with it. Of course, if they already

have 80% invested in their company, it

makes no sense to put the rest in illiquid

assets as well. So we would tend to advise

them to maybe put 5% in private equity,

if they really want that, and keep the rest

in cash or in liquid assets.

How much do clients want to know before

they decide on an illiquid investment?

Patrick Schwyzer: What I see in most

discussions is that clients want to understand

the thought process and how we

do things. They want to understand how

we come to the selection of a particular

manager, be it in the private equity or the

hedge fund space. They don’t really want

to receive the full package on the due diligence

report and go through it themselves.

That’s exactly why they come to us.

In terms of cycles, is it fair to say that

investor appetite is back where it was

before the financial crisis?

Felix Baumgartner: Absolutely. Investors

are looking for opportunities. Clients,

and especially Swiss clients, often want to

leverage their portfolio, also the illiquid

parts. It’s analogous to taking out a mortgage

on real estate. And banks are increasingly

amenable to offering credit (assessed

on the basis of loan to value, or LTV) on

illiquid assets. We clearly limit the risk in the

interests of both the client and the bank.

Patrick Schwyzer: Another cycle- related

example: before the 2008 financial crisis,

there was a lot of movement into the socalled

fund of hedge funds space, particularly

in Switzerland. After the crisis, those

private investors left that space. And now

we see them coming back, as providers

begin to offer a selection of carefully vetted

single-manager hedge fund products or

advisory services.

Has the rise of family offices played

a big role in increasing the allocation

to illiquid assets?

Patrick Schwyzer: It depends on the

type of family office. The smaller ones that

literally are a family of two or three people

have one investment specialist who needs

to cover everything from bonds to alternatives.

In that case, they’re looking to us to

help them put together their own portfolio of

hedge funds. Bigger family offices typically

employ their own private equity specialist

or hedge fund specialist, but like to talk to

us as a “sparring partner.”

Felix Baumgartner: Investment behavior

and interest can also change dramatically.

We’ve seen that over the last one or

two years. Some family offices that previously

invested only in traded equities with no

allocation in private equity because of

worries over illiquidity, decided to go into it

within the space of three or six months.

Are fees an issue for clients?

Patrick Schwyzer: Certainly, pre-2008,

the predominant means of investing in

hedge funds for the private sector was fund

of hedge funds. And there you had a double

layer of fees: the underlying managers

who on average were going to charge you

a 2% management fee and a 20% performance

fee; and the additional level on

the fund of hedge funds where the manager

would pick and choose those funds. We

have seen a clear trend toward single funds,

which has removed one of the fee layers.

The second layer is also under pressure.

It comes down to performance. Good

performance is clearly needed to justify the

fee levels.

“The order of preference that

we observe is: real estate,

then hedge funds, followed

by private equity.”

Felix Baumgartner


AMRD 2003 = 1000



Market overview

Indexes compare each sector’s

growth over a ten-year period,

using the central 80% of

data and a 14-month moving

average (14MMA).

Chinese Contemporary Art

AMRD Contemporary 100


Classic Cars






05 06 07 08 09 10 11 12 13 14

In passion

we trust

The idea of objects of desire as investments of passion took off in the UK in the late 1970s

with the publication of “Alternative Investment.” As an investment analyst in the City of London,

the late Robin Duthy noticed that, while conventional investments were intensely studied for

past performance and future potential, no systematic analysis of the markets for art, antiques

and collectibles had been undertaken. Working with the late Sir Roy Allen at the London School

of Economics, he devised a sophisticated methodology of trimming and smoothing mechanisms,

which eliminated seasonal and other distortions. It is important to remember that when the

media reports eye-catching prices for collectibles sold at auction, the prices paid by the buyer

will be substantially higher than the cash received by the seller; transaction costs in these

markets (e. g. auctioneers’ or agents’ commissions) can be sobering, reflecting the price paid

to overcome the illiquidity inherent in trading high-value idiosyncratic items.


Photo: malerapaso / Getty Images Sources: Art Market Research & Development (AMRD)


“All successful

buying must

be based on confidence,


in a dealer or

in oneself, and

the only basis

for confidence

in oneself

is knowledge.”

Robin Duthy “Alternative Investment” –

Founder of Art Market Research

Drawing attention: The rise of

Chinese contemporary art

In 2007, art collector Howard Farber sold Wang

Guangyi’s “Great Criticism: Coca-Cola (1993)”

for USD 1.59 million at Philips, having claimed to

have paid just USD 25,000 ten years earlier.

The painting was sold in late 2007 as the market

neared its peak for 63 times the reported acquisition

cost. After 2005, the auction market for

Chinese contemporary art entered a phase of rapid

development. Two years later, Charles Saatchi

was noted for selling off some of his younger

German artists collection in order to fund his

interest in Chinese contemporary art. The painting

“1998.8.30” by Lijun sold at Sotheby’s Hong

Kong in 2010 for over USD 1.2 million. Last year,

his “Publication 2 No. 4” sold for over USD 7.6

million. AMRD’s methodology enables comparison

with other art sectors, for example, as represented

by the AMRD Contemporary 100, a leading

benchmark. Set against an overview of sales of

contemporary artists across the globe, the index

reveals that sales of top Chinese contemporary

artists have been outperforming the competition

for the last five years.

Chinese Contemporary Art

versus Contemporary 100

The index, calculated on a 14MMA basis, shows

that the Chinese contemporary sector has grown

29% in the last 14 months and is back to where it

was in early 2007.







01.05 01.08 01.11 01.14

Chinese Contemporary Art top 25%

AMRD Contemporary 100 top 25%

Chinese Contemporary Art bottom 25%

AMRD Contemporary 100 bottom 25%

Investment vehicles:

Italian classics in pole position

Most of us past a certain age are likely to have

owned and subsequently lost a prized possession

that has gone on to become a valued collectible.

It seems that a combination of rekindling one’s

youth and the empty nester’s disposable income

enables enthusiasts to purchase rare items,

and this is nowhere more obvious than in the

classic car market. Prices for some classic cars

are going through the roof, and it is the Italians

that continue to lead the market. Ferrari’s

1959–1982 models have seen a 1,350% increase

in the last ten years. Maseratis produced between

1958 and 1982 have also seen some action in

the last six months, having increased in value by

over 23%. The 1946–1977 era British Triumphs

have almost flatlined in comparison, but have

continued to rise slowly, with a compound growth

rate of 3.9% over the last ten years.

Classic Cars

Ten years of market growth on a 14MMA basis

shows Ferrari outperforming Maserati by 55%

and Triumph by 84%. The Classic Car Index was

rebalanced to 1000 in 2003.










01.04 01.06 01.08 01.10 01.12 01.14

Ferrari 1959–1982 Maserati 1958–1982

Triumph 1946–1977


Growth by brand from January 2004 to December

2014 using the central 80% of data from the

AMRD Watch Index, calculated on a 14MMA basis.

The index was rebalanced to 1000 in 2003.








01.04 01.06 01.08 01.10 01.12

Patek Philippe Cartier Rolex


Some watches ticking upward

Luxury items tend to be one of the first things

to suffer during tough economic times. The last

financial crisis was no exception, with the highend

watch market taking a steep plunge. The Swiss

watch market is especially sensitive to economic

depressions, regularly having to target new money.

High-end wrist watches are generally a poor

economic investment. People buy them for their

beauty, but not because they think the watches

will hold or increase their value. Yet Patek Philippe,

Rolex and some Cartier watches can be exceptions,

as they have shown solid value retention.

A person buying a new Rolex or Patek Philippe

watch today has a reasonable chance of losing

little or no money on selling it in a few years.

There is a healthy auction market for vintage Rolex

and Patek Philippe watches, and a few rare models

do fetch very high prices at auction, such as the

sale of a Patek Philippe 1933 “Henry Graves

Jr. Supercomplication” pocket watch, which sold in

2014 at Sotheby’s in Geneva for CHF 23.2 million

(USD 24 million). This set a new record for any

timepiece ever sold at auction.

Pearls are a girl’s best friend

Jewelry has performed extremely well in recent

years, with the emphasis being on signed pieces,

colored gemstones, and pearls in particular. Names

like Cartier, Van Cleef & Arpels or Boucheron are

sought after as such a source usually ensures good

quality design and manufacture, as well as having

a signature and normally a unique number. This

emphasis on signed pieces is a reaction to the large

quantity of unsigned and recently made pieces on

the market imitating vintage European pieces.

Pearls have increased in value more than any other

gemstones. Historically, the world’s best pearls

were collected along the Persian Gulf especially

around what is now Bahrain by breath-hold divers

until oil exploration in the 1930s disrupted the

oyster beds. The fact that no more natural pearls

are being harvested, combined with strong interest

from the Gulf States, which value the acquisition

of heritage objects, has forced pearl jewelry prices

up to unprecedented levels – increasing by 405%

in the last ten years. With world records being

set every year, the finest jewels and gemstones

continue to be objects of desire, having the advantages

of displaying wealth, wearability, portability

and scarcity value.


AMRD Pearl Jewelry Index vs AMRD General

Jewelry Index on a 14MMA basis over ten years.

The index was rebalanced to 1000 in 2003.






01.04 01.06 01.08 01.10 01.12 01.14

Jewelry (general)



European securitization

From illiquid assets to

profitable investments

To foster economic growth, the European Central Bank needs to revive the securitization market.

This market is currently down to 25% of precrisis volumes or only 14% of US issuance in 2013.

Improved transparency, the clearing of bank balance sheets and improved regulatory rules are expected

to provide a catalyst for the securitization market going into the second half of 2015, offering

attractive yield opportunities for investors.

Illustrations: Frida Bünzli


In the aftermath of the financial crisis, the European securitization

market collapsed. New issuance in European securitization decreased

by more than 75% compared to volumes in 2008 and has

not recovered since then. Primary market activity in 2013 was below

EUR 200 billion, corresponding to only 14% of US issuance over

the same time period (see Figure 1). The lack of a functioning securitization

market is a major disadvantage for European banks, the

economy and investors. Regulatory-forced deleveraging and its negative

impact on lending and economic growth could have been better

mitigated, in our view.

For the European Central Bank (ECB) to be successful in fostering

economic growth, the current pool of assets for Quantitative Easing

(QE) might prove to be too narrow, so that the issuance of securitized

investment products based on high-quality assets – so-called Qualifying

Securitization (QS) – needs to pick up in order to broaden the

ECB’s investment base. As the ECB is pressuring interest rates and

yields into negative territory, banks are in need of margin expansion.

If structured correctly, this can be achieved by QS and align the banks’

need to earn profits with the ECB’s need for economic growth and

the investors’ need for attractive yield opportunities.

To make the securitization market grow in Europe, it must become

economically attractive for banks. So far, the maths have not quite

worked out, mainly due to regulatory rules with respect to securitization

that result in a lack of “capital relief” for the banks (see box on the

risk capital treatment of different loans and securitizations on p. 61).

Given their need to remain exposed to the part of the securitized assets

with the highest risk, to which a risk weight of 1,250% is applied, the

transaction simply lacks economic appeal for the banks.

ECB as an asset-backed securities buyer

In 2014, the ECB released details of its asset-backed securities (ABS)

purchase program, which was followed by the release of a legal act

enabling implementation of the purchase program with actual purchases

having started. The ECB has appointed four executing asset

managers for the purchase program. The asset managers will conduct

the purchases on behalf of the Eurosystem and undertake price checks

and due diligence prior to approving the transactions. The program

will involve the purchase of senior tranches and guaranteed mezzanine

tranches of loans originated in the euro area. Greek and Cypriot ABS

will also be included in the purchase, albeit with tighter provisions.

The combined size of the ABS purchase program and covered bond

purchase program will reach EUR 1 trillion.

Several other measures have also been taken in the meantime

to facilitate the development of the securitization market in Europe.

Among them, we would highlight the changes to Solvency II >

Turning an illiquid asset into an investment opportunity takes time

The ECB is in the middle of a multiyear process to regain investors’

and market trust, as well as to foster economic growth. In our view,

the basis for regaining investor trust – including the ECB as an investor

– was provided by the comprehensive asset quality review (AQR)

and the stress test carried out by the ECB and the European Banking

Authority (EBA).

In October 2014, following a yearlong analysis of over a million

pieces of data, the ECB and EBA published the much-awaited results

of the AQR and stress test. The AQR exercise covered 130 banks

within the Eurozone’s 18 countries, with total assets of EUR 22.0

trillion accounting for around 82% of total banking assets under the

European Single Supervisory Mechanism (SSM). The EBA stress

tests covered 123 banks across 22 of the 28 EU countries, including

banks from the UK and the Nordic region. Overall, 25 of the 130 banks

failed, with an identified capital shortfall of EUR 24.6 billion. More

specifically, 13 banks were identified to face capital shortfalls totaling

EUR 9.5 billion.

We believe that the ECB/EBA announcement struck the right balance

between being too harsh and being too lenient, notably highlighting

areas of vulnerability for some of the examined banks. Despite not

forcing them to take immediate action, the ECB made it very clear that

the adjustments would become part of its ongoing supervision of capital

requirements as it continues to forge ahead with the agenda

of improving the quality of European banks’ balance sheets. More

importantly, we believe that the process toward a European Banking

Union has significantly contributed to increased disclosure and transparency,

which is building the basis for a greater investor attraction

toward banking assets.

01_Primary market activity of

European and US asset-backed securities

New issuance of asset-backed securities (ABS) remains subdued in

Europe compared to the US. The European market is, however, forecast

to pick up during the course of the year following the launch of the

ECB’s purchase program. Source: AFME, Credit Suisse

in EUR bn







2006 2007 2008 2009 2010 2011 2012 2013 2014

Total European ABS placed Total US ABS placed

European ABS placed in % of US ABS placed (rhs)







GLOBAL INVESTOR 1.15 — 60 The bank then bundles a number of home loans –

How does securitization work?

The following illustrations show how loans can be turned into tradable securities:


When a bank grants a mortgage to a borrower,

the bank earns an interest income.


both risky and less risky – into a pool of mortgages.


The bank places these pools of mortgages

into a trust. The trust then sells bonds, which

are secured by the mortgages.


The return and the risk of the bonds depend on the

riskiness of the mortgages which secure the bonds.

To create different risk categories of bonds, the

bank divides the mortgages into risk groups called

tranches. Rating agencies such as Standard &

Poor’s or Moody’s then often rate the tranches to

reflect the risk of default. The bank is required by

regulation to keep a tranche of the highest risk



The newly created bonds are sold to private and

institutional investors and even central banks.

Thus, the bank has earned a fee for originating

mortgages, but sold the risk and rewards of these

mortgages to investors through the process of

converting them into tradable securities (bonds).


regulatory rules for insurance companies, which made the capital

charges less onerous for high-quality securitization. Further, rules on

the Liquidity Coverage Ratio (LCR) for banks have also allowed some

high quality securitization to qualify under certain criteria. However,

there is still considerable debate on whether the existing rules on

securitization still make the capital treatment too onerous for the issuing

banks and this is an area that needs to see some change to

help revive the European securitization market.

Securitization market with significant volume

We believe that the data published by the EBA and ECB on banks’

risk exposures and risk-weighted assets should allow the market to

better understand and quantify the eligible securities. From an issuer’s

point of view, we conclude that there are currently situations where

an unsecuritized portfolio may require less capital than a securitized

portfolio (see adjacent box). As a result, the loan portfolio to be

securitized might contain a higher proportion of assets with a higher

risk weight attached to it. Thus, we believe that securitization may

take place in regard to high-quality small and medium enterprise (SME)

loans due to the higher risk weights applied. This is precisely the

area where the ECB is trying to unlock the funding gridlock.

With securitization accounting far from clear under International

Financial Reporting Standards (IFRS) and a likely piecemeal

approach to capital relief, we have tried to estimate the potential

size of qualifying securitization assets for Europe. Depending on the

range of assets taken into account, we have adjusted the data for

asset encumbrance and estimate that the market could range from

a minimum of EUR 1 trillion (including mainly SME loans) to EUR 2.4

trillion (including lower risk-weighted asset categories such as securitized

or collateralized lending). From the asset breakdown, we

predict that securitization is more likely to reopen bank funding channels

for SMEs and corporate lending as we would expect the capital

relief to transmit into lower sustainable funding costs in these sectors.

We therefore believe that securitization can play a key role in

serving the macroeconomic policy objectives of the ECB to foster

economic growth.

Given the completion of the AQR and the launch of the ABS

purchase program, we believe that these are supportive steps toward

a fully fledged securitization market throughout 2015. In turn, we

continue to believe this will provide a positive backdrop for the

Eurozone by releasing capital pressure from banks’ balance sheets,

reducing the cost of borrowing for SME clients and providing lending

to the economy. In an environment of very low yields, investors

(including the ECB) will gain access to higher-yielding assets, which

we expect to be attractively priced at the beginning to reopen the

securitization market.

Christine Schmid

Head of Global Equity & Credit Research

+41 44 334 56 43


Carla Antunes da Silva

Head of European Banks

Investment Banking Equity Research

+44 20 7883 0500


The risk capital treatment

of different forms of

loans and securitizations

In this box we compare the capital requirement for

a securitized portfolio (leaving 5% on the book as

per retention rules) with that of the underlying loan

portfolio. In the analysis, we have assumed that

the bank uses the standardized approach for the

calculation of risk-weighted assets.


Capital requirements for typical loan portfolios

We take three types of loan portfolios and apply the

risk weights under the standardized approach. We

take a secured residential mortgage, a commercial

mortgage and an unsecured corporate loan,

and present our capital charge analysis below:


CAPITAL REQUIREMENT = 0.08 × 35 = 2.4%


CAPITAL REQUIREMENT = 0.08 × 100 = 8%


CAPITAL REQUIREMENT = 0.08 × 150 = 12%


Capital requirement for a typical securitization

For a bank that keeps 5% of the portfolio on its

books, the maximum capital charge would be

as follows:

1 RISK WEIGHT = 5 × 12.5 = 62.5

2 CAPITAL REQUIREMENT = 0.08 × 62.5 = 5%

We can see that a bank does not always gain capital

relief from securitization. For residential mortgages,

for example, the capital requirement is greater for

the securitized asset than for the underlying loan

portfolio. This difference in capital treatment might

encourage securitization of high risk assets, i.e.

on a risk-based measure, a higher risk-weighted

SME asset would generate more capital relief for a

bank than a lower risk-weighted residential mortgage.

Regulators thus have to address the risk weight

applied to securitization of assets more closely

compared to the underlying risk of the assets.


Illiquidity in corporate bond markets

No exit?

The efforts of regulators to strengthen the financial system

have led to both lower and more volatile liquidity in the corporate

bond markets. As a result, investors could potentially find

themselves in a situation where no one will buy. To properly

manage expectations, and to be able to plan ahead, investors

need to understand this new landscape and what it means.

financial crisis in 2008/2009: global market

activity is concentrated more in the most

liquid securities like sovereign bonds, and less

in riskier securities such as corporate bonds.

According to the paper, this trend suggests

an increased fragility of the latter. As data

availability is limited, the International Capital

Market Association, a self-regulatory organization,

conducted a series of interviews with

market participants to analyze the topic from

a market view. The study, titled “The Current

State and Future Evolution of the European

Investment Grade Corporate Bond Secondary

Market,” finds that liquidity in secondary

European corporate bond markets has declined;

interviewees described the decline

ranging from “significantly” to “completely.”

Another survey of large banks published by

the European Central Bank (ECB) in January

2015 focused on Euro-denominated markets

and arrived at similar results. More banks reported

that their market-making activities for

credit securities had decreased during 2014

rather than increased, and a further decrease

is expected in 2015. The study also found that

participants’ confidence in their ability to act

as market makers in turbulent times had

diminished in 2014 compared to 2013.

Since the financial crisis in 2008,

regulators have tightened rules

on financial institutions to improve

the stability of the financial system.

Banks and dealers have subsequently

strengthened their financial profiles and

scaled back risky capital market activities.

This structural change is especially important

to bond markets as they depend on intermediaries

willing to warehouse risk and facilitate

trading activity. As a number of studies by

governing institutions suggest, liquidity in

bond markets has decreased since 2008:

investors now find it harder to enter and exit

positions or are incurring higher transaction

costs. This could increase the risk of more

severe price swings. In an extreme scenario,

investors might find themselves trapped as

nobody is willing to buy. Here, we take a

closer look at this structural change in bond

markets and how it interacts with current

market conditions, and analyze what investors

can expect.

Corporate bond markets

Compared to equities, the fixed income

market relies more on dealers and over-thecounter

structures, which makes it more decentralized

and dependent on functioning

intermediaries. Further, the market for corporate

debt is much more fragmented than

the market for equities as companies usually

offer very few classes of equity, but a large

number of different debt instruments. Within

the bond market, different classes of debt

exhibit different liquidity characteristics. The

market for government bonds is perceived as

more liquid compared to the market for corporate

bonds, partly due to the different structures

of securities issued. Governments issue

in larger lots, have fewer maturities and usually

do not add exotic features to their debt.

The corporate bond market is much more

fragmented and thus shallower. Moreover, in

the corporate bond market, different risk segments

exhibit different liquidity traits. Investment-grade

debt is usually more liquid, while

high-yield and emerging-market debt are

perceived as less liquid.

Declining liquidity raises awareness

A number of recent publications by regulatory

institutions and think tanks suggest

liquidity in bond markets has changed. In

November 2014, a paper published by the

Bank for International Settlements on marketmaking

activities found that liquidity in debt

markets has shown a diverging trend since the

Regulatory tightening a driver

We believe that the decline in corporate bond

market liquidity can be attributed to an increase

in regulation in the financial sector.

This matches with the ECB survey results

mentioned above, as banks most often cited

regulation and balance sheet capacity as reasons

for a decline in market-making activities.

The financial crisis in 2008 revealed a

number of shortcomings of financial regulation.

Since then, governing institutions have

been actively improving and tightening the

regulatory framework, thus leading to a reduction

of market-making and trading activities

by banks. The Basel regulations for banks

have increased the amount of equity banks

need to hold against their risky positions. This

makes market-making activities, which require

sizable balance sheet capacity, less

profitable. Additionally, the newly introduced

Liquidity Coverage Ratio and Leverage Ratio

are steering banks toward holding more

liquid securities, reducing high-volume/lowmargin

business such as trading activities,

and limiting their reliance on short-term funding.

Moreover, banks have cut proprietary

trading in view of, for example, the Volcker

Rule in the USA. Proprietary trading has

been a source of liquidity, especially during


volatile markets. As a result, banks and dealers

have reduced their fixed income trading

activities since 2008 as well as their ability to

warehouse risk and facilitate capital market


Conditions affecting structural changes

The structural change stemming from financial

regulation comes at a time of historically

low interest rates fueled by quantitative easing

programs adopted by central banks around

the globe. On the one hand, we believe that

this accommodative stance has reduced market

uncertainty and thus eased investors’

concerns about liquidity. On the other hand,

low interest rates have increased the corporate

debt markets as companies take advantage

of the lower funding costs. In Figure 1, we

show the increasing gap between primary

dealers’ inventory and the size of the US corporate

debt market. Moreover, investors’ motivation

to drop low-yielding government debt

and pile into higher risk and most often less

liquid securities has also risen due to monetary

policy, in our view. This in turn adds to liquidity

concerns again (see Figures 2 and 3).

Liquidity most relevant in times of stress

So far, the decline in bond market liquidity

has not caused much of a headache for investors

as corporate bonds are in good demand.

However, it is quite easy to imagine a scenario

of many investors exiting at the same

time with no one willing to buy or provide

market-making activities. In this case, liquidity

would evaporate quickly, leaving investors

high and dry. The modest decrease in liquidity

in the last few years might therefore not

be a good indicator of what to expect during

turbulent times or in case demand for corporate

bonds falls. This could, for example, occur

when interest rates increase from their historic

lows. We believe the asset management

industry is particularly exposed to a sudden

drop in corporate bond market liquidity. Investors’

expectations of their ability to redeem

mutual fund shares or sell ETFs (exchangetraded

funds) on a daily basis could reveal the

low liquidity of the underlying bonds bundled

into these funds. In case of a pronounced

outflow from funds, many asset managers

could be forced to sell into dry markets and

incur significant losses.

The Bank of England’s Financial Stability

Report, published in June 2014, aims at extracting

the liquidity premium inherent in bond

prices by comparing credit derivatives and

actual bond prices. The analysis found that

the liquidity premium increased in European

investment grade issues from approximately

50 basis points in 2007 to 200 basis points

the following year. For European high-yield

issues, the rise was even more extreme, from

approximately 100 basis points to almost

1,200 basis points during the same period.

This suggests that, in times of crises, investors

chase liquidity and also quality. Furthermore,

according to the study, the liquidity

premium is fairly low at the moment. To us,

this raises concerns that current market prices

influenced by low volatility and low interest

rates do not compensate investors enough

for the ongoing decline in liquidity and a potential

hike in turbulent times.

Implications for investors

We believe that investors need to recognize

the structural change toward lower liquidity

as well as the volatile nature of liquidity, especially

buyers of higher-yielding corporate

bonds. Certainly, liquidity is more relevant in

turbulent market times, but we think investors

should plan ahead and assess to what degree

they rely on markets. If holding fixed income

securities to maturity is an option, investors

can shrug off liquidity concerns. If not, investors

should analyze each case to see if they

are rewarded for the risk of not being able to

sell at their convenience.

Investors are not alone. Supervisory institutions

are increasingly aware of the structural

changes in bond markets. A policy response

to cushion abrupt movements is not

unlikely, in our view. In the long term, we

believe that the gap left behind by banks will

be filled or that banks will adjust their trading

activities to cater to their clients more specifically.

As traded corporate debt is a substantial

part of the financial system, new forms of

trading are evolving quickly. Electronic platforms

that rely on peer-to-peer trading instead

of dealers already exist and are likely to grow.

Another approach would be to standardize the

corporate bond market more to reduce complexity

and simplify trading and market making.

A combination of both seems pragmatic to us

as electronic trading requires standardized

units to flourish. In the meantime, a closer look

at how much an investor relies on liquidity

when a security is purchased will help to avoid

most of the concerns.

Jan Hannappel

Equity and Credit Research Analyst –

European and US Banks

+41 44 334 29 59


01_Corporate debt market up

A growing gap between primary dealers’ inventory

and the size of the US corporate debt market is

fueling liquidity concerns.

Source: Credit Suisse, Federal Reserve, SIFMA

Federal Reserve data










SIFMA data


2001 2004 2007 2010 2013

Outstanding corporate debt USD bn (US)

(left-hand axis) Primary dealer inventory USD bn

(US) (right-hand axis)




02_Turnover ratio down

The turnover ratio of corporate debt is much lower

than the ratio of Treasuries and the total debt

market. The turnover ratio of the US debt market

has decreased on average by more than 30%

since 2007. Source: Credit Suisse, SIFMA

in %









2007 2009 2011 2013

US Treasuries US total debt

US corporate debt

03_Outstanding US bond

market debt

US debt markets have increased 14-fold from

1980 to 2013. Source: Credit Suisse, SIFMA

USD bn











1980 1990 2000 2013

Municipal Treasury Mortgage-related

Corporate debt Federal Agency securities

Money markets Asset-backed




Oliver Adler

Head of Economic Research.........................................


+41 44 333 09 61.......................................................

Oliver Adler is Head of Economic Research at Credit

Suisse Private Banking and Wealth Management.

He has a Bachelor’s degree from the London School of

Economics and an MA in International Affairs and a PhD

in Economics from Columbia University in New York.

> Pages 10–12, 14, 26–29

Carla Antunes da Silva

Head of European Banks, Equity Research....................


+44 20 7883 0500.....................................................

Carla Antunes da Silva is Head of the European Banks

at Credit Suisse Investment Banking and has covered the

European banking sector for 15 years. Previously, she

was Associate Director of Research and lead analyst on

UK banks at JPM. She started at Deutsche Bank in 1996,

covering Iberian banks. She was consistently ranked a

top analyst in the space. She has an MA in PPE from the

University of Oxford and an MSc in Management from

the LSE. > Pages 58–61

José Antonio Blanco

Head of Global Multi Asset Class Solutions...................

+41 44 332 59 66.......................................................


José Antonio Blanco is Head of the Global Multi-Asset

Class Solutions unit and a voting member of the

Investment Committee. He holds a degree in economics

and a PhD in applied econometrics from the University

of Zurich. Mr. Blanco is a member of the Executive

Committee of the Swiss Financial Analysts Association

(SFAA) and the Swiss Society for Financial Market

Research. > Pages 10–12, 14, 26–29

Gregory Fleming

Senior Analyst.............................................................


+41 44 334 78 93.......................................................

Gregory Fleming joined Credit Suisse in 2006 as a senior

analyst for the Investment Decision Cockpit and Investment

Committee. Previously, he worked in portfolio strategy

for Westpac and Grosvenor Financial Services Group,

and for the International Textile Manufacturers Federation

as a global economist. He holds an MA with Distinction

in Economic History from the University of Canterbury,

New Zealand. > Pages 13, 38–39, 42–43

Nikhil Gupta

Fundamental Micro Themes Research...........................


+91 22 6607 3707......................................................

Nikhil Gupta joined Credit Suisse Private Banking and

Wealth Management in 2011, and is currently part of the

Fundamental Micro Research team. Before joining

Credit Suisse, he worked for a management consulting

firm for four years. He has an MBA from the Indian

School of Business, Hyderabad. > Page 15

Jan Hannappel

Equity and Credit Research Analyst – European

and US banks..............................................................


+41 44 334 29 59.......................................................

Jan Hannappel is a Research Analyst in Global Equity and

Credit Research at Credit Suisse, focusing on European

and US banks. Before joining Credit Suisse in 2014,

he was a corporate finance analyst. Jan Hannappel holds

an MA in Accounting and Finance from the University of

St. Gallen. > Pages 62–63

Lars Kalbreier

Head of Mutual Funds & ETFs.......................................


+41 44 333 23 94.......................................................

Lars Kalbreier, CFA, is a Managing Director and global Head

of Mutual Funds & ETFs. In this role he is responsible for

the fund selection and advisory process. Before taking the

current role, Lars headed Global Equities & Alterna tives

Research and was a member of the bank’s Investment

Committee. He is a member of the investment committee

of Corpus Christi College, Cambridge. > Pages 24–25

Philippe Kaufmann

Head of Global Real Estate Research............................


+41 44 334 32 89.......................................................

Philippe Kaufmann is Head of Global Real Estate Research

at Credit Suisse Private Banking and Wealth Manage -

ment, where he also worked for Swiss Real Estate Research

for six years. Before joining Credit Suisse in 2007,

he worked for a policy consulting firm and an economic

research company. He holds an MA in Economics from

the Univer sity of Fribourg, Switzerland. > Pages 44–47

Giles Keating

Head of Research and Deputy Global Chief

Investment Officer........................................................


+41 44 332 22 33.......................................................

Giles Keating is Global Head of Research for Private

Banking and Wealth Management, Deputy Global Chief

Investment Officer and the Investment Committee’s

Vice Chair. He joined Credit Suisse in 1986. He was a

Research Fellow at the London Business School and has

degrees from the London School of Economics and

Oxford where he is Honorary Fellow. He chairs Tech4All

and techfortrade, charities that use technology to reduce

poverty. > Pages 03, 24–25

Sven-Christian Kindt

Head of Private Equity Origination & Due Diligence.........


+41 44 334 53 88.......................................................

Sven-Christian Kindt is Head of Private Equity Origination

& Due Diligence at Credit Suisse Private Banking

and Wealth Management. Before joining Credit Suisse in

2008, he worked for Bain & Company and A.T. Kearney

in London. He holds degrees from ESCP Europe and the

University of Michigan’s Ross School of Business.

> Pages 16–17

Robert Parker

Senior Advisor Credit Suisse.........................................


+44 20 7883 9864.....................................................

Robert Parker is a Senior Advisor to Credit Suisse in

Investment Strategy & Research. He has worked in the

asset management industry for 42 years and joined

Credit Suisse in 1982 as a founder of CSFB Investment

Management. He chairs the Asset Management and

Investors Council and is a board member of the International

Capital Markets Association. He has a BA and MA

in Economics from Cambridge University. > Pages 48–51

Christine Schmid

Head of Global Equity & Credit Research........................


+41 44 334 56 43.......................................................

Christine Schmid is Head of Global Equity & Credit

Research at Credit Suisse Private Banking and Wealth

Management. She has covered financials for 15 years

and coordinates the global financial view. She holds an

MA in Economics from the University of Zurich, and is

a CFA charterholder. > Pages 58–61

Beat Schwab

Head of Real Estate Investment Management Switzerland


+41 44 333 92 42.......................................................

Beat Schwab has been Head of Real Estate Investment

Management Switzerland since November 2012. From

2006 to 2012 he was CEO of the real estate services

group Wincasa AG. During his career he held various position

in the construction industry and real estate markets.

Mr. Schwab holds a PhD in Economics from the University

of Bern and an MBA from Columbia University. > Page 47

Markus Stierli

Head of Fundamental Micro Themes Research............


+41 44 334 88 57.......................................................

Markus Stierli is Head of Fundamental Micro Themes

Research at Credit Suisse Private Banking and Wealth

Management, based in Zurich. He holds a PhD in

International Relations from the University of Zurich

and is a Chartered Alternative Investment Analyst.

> Pages 04–08, 15

Marina Stoop

Cross Asset and Alternative Investments Strategist........


+41 44 334 60 47.......................................................

Marina Stoop is the Head of Risk and Flow Analysis

within the Cross Asset Strategy and Alternative

Investments team. She is responsible for providing input

to the Investment Committee on financial market risks,

liquidity and flow. Marina Stoop joined Credit Suisse

in 2010 after graduating from ETH Zurich with an MA

in Science. > Pages 21–23

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Credit Suisse AG, Investment Strategy & Research,

P.O. Box 300, CH-8070 Zurich


Giles Keating


Oliver Adler, Markus Stierli, Gregory Fleming

Editorial deadline

30 April 2015

Production management

Markus Kleeb, Manuel Moser



Design and realization


Charis Arnold, Benno Delvai, Angélique El Morabit,

Monika Häfliger, Samira Moschettini, Nadia Bucher,

Rahel Schwarzentruber (project management)

Editorial support


Giselle Weiss, Robin Scott, Dorothée Enskog


GDZ print, Zurich

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Cover photo: Dorling Kindersley/Getty Images



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