LDI chaos likely to hurt private equity and real estate allocations

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The UK market turmoil triggered by a government securities-linked derivatives strategy is bad news for allocations to everything from private equity to property.

The volatility has left pension funds taking heavy mark-to-market losses, forcing them to offload everything from government bonds to securitized debt. This is prompting a rethink of European pension funds after amassing illiquid assets in the era of cheap money, according to PensionsEurope, an industry group whose members have combined assets of more than €7 trillion (6, $9 trillion).

This would mark a sharp reversal after spending years chasing private assets in search of returns commensurate with their long-term commitments. About a quarter of global pension fund holdings are made up of alternatives such as private credit and infrastructure, up from 7% 20 years ago, according to consultancy Willis Tower Watson.

However, the alternatives take longer to sell, which means less liquidity during turbulent times such as those triggered in recent weeks by liability-driven investment strategies. These products are used by pension companies to match their liabilities to their assets through the use of derivatives.

Illiquid assets

“What happened in the UK has prompted some pension funds in Europe to reassess their holdings of illiquid assets because in times of heightened volatility this could pose a problem,” said Matti Leppala, managing director of PensionsEurope. .

While there are no solvency issues, Leppala said, it’s a matter of “having good liquidity and risk management in place.” An increase in gilt yields “of this magnitude was unexpected” and “is a lesson learned.”

Yields on UK government bonds soared after the country’s unpriced mini-budget caused huge losses in market value for those using LDI strategies, forcing funds to sell assets to meet market pressures. margin calls. Losses may have reached £150bn since early August, leading the Bank of England to intervene to stop the contagion from spreading.

The fire sales were mostly in government bonds, Leppala said, a crucial reminder that liquidity can easily dry up during times of stress, even for assets that are otherwise the easiest to trade. As a result, pension funds are considering capping illiquid assets, he said.

Leppala is the latest figure from the financial sector to warn that the LDI saga could point to wider dislocations in markets as inflation rises and quantitative easing comes to an end.

Additional volatility

Paul Marshall, the co-founder of Marshall Wace LLP, said the crisis is “the first casualty of the era of money for nothing”. Fellow hedge fund managers Crispin Odey and Alberto Gallo also warned that greater volatility could come as central banks raise interest rates after keeping them artificially low for years.

“I wouldn’t be surprised if rates go up ‘if more forced sellers emerge’ as pressure builds in the system,” Blackstone Inc. Chairman Jonathan Gray told investors Thursday.

Regarding LDI, Leppala points out that the exposure of eurozone pension funds is relatively low. The exception are Dutch pension funds which have liabilities of around €1.4 trillion ($1.2 trillion), but generally have lower leverage than their UK counterparts.

Leppala estimates that a two percentage point increase in interest rates in the euro zone would trigger an 82 billion euro margin call on Dutch pension funds. Traders expect a move of this magnitude by March next year.

Decrease in liabilities

Leppala also points out that pension funds likely saw an even bigger drop in the value of their liabilities as rates rose, which is good for overall strength. This matches the BT Group Plc pension fund, which has seen asset values ​​fall by around £11bn in recent weeks without worsening its funding position.

“If – as seems evident so far – Europe avoids the self-reinforcing dynamics of recent gilt volatility, we believe it is likely that there will be further measures to mitigate risks. “, wrote Simon Freycenet, strategist at Goldman Sachs Group Inc. in a note to clients. “First, liquidity buffers will likely be strengthened and leveraged duration exposure will likely be reduced.”

–With help from Greg Ritchie.

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James V. Hayes