Skip to main content

How shall liquidity stress testing be performed for illiquid asset Funds?

Illiquid assets or hard to value assets such as real estate and private equity have specific characteristics which distinguish them from other asset classes. The distinct nature of Funds invested in illiquid assets is generally coupled with a lock-up period or other liquidity management tools which cater for liquidity risks arising from the characteristics of the underlying investments.

The Guidelines require for aggregation of liquidity stress testing across both the asset and liability sides of the balance sheet with the aim of understanding the overall liquidity risk of the concerned Fund. The fundamental features of illiquid asset Funds, such as their pre-emptive liquidity management tools, require for Managers to delve further into understanding the Fund’s assets and liabilities prior to conducting liquidity stress testing.

Stress testing the asset side of the balance sheet

The Guidelines highlight the importance of considering low probability high impact scenarios when stressing illiquid asset Funds. Such scenarios may consist of simulating a stressed market which may lead to possible difficulty in arriving to reliable pricing of hard to value assets held in the portfolio, impacting investors. Illiquid assets may be particularly vulnerable in times of low market liquidity, hence affecting time to liquidate, liquidation costs and also the ability of liquidating such assets at all. Even though lock-up periods protect the Fund against investor redemptions for a pre-defined period of time, investors are still exposed to substantial costs in illiquid market scenarios through lower Fund performance. In any market scenario, the ultimate aim of the Manager should always be to act in the best interest of investors.

Furthermore, illiquid asset Funds may receive cashflows from assets held such as via rent or dividends. In such case, the Manager shall consider how stressed market conditions may impact such cashflows, whether such cashflows are used to cater for any liabilities and whether liability commitments could still be met should cashflows be severely impacted by a stressed market condition.

Stress testing the liabilities side of the balance sheet

In view that illiquid asset Funds are in the majority of cases subject to a lock-up period, prior to termination of such period, the Fund is not exposed to liquidity risks arising from redemptions. Naturally, the liabilities of a Fund do not solely consist of redemptions but may

consist of other liabilities such as servicing costs, maintenance costs, legal costs, collateral requirements, margin requirements and interest payments. The Manager must understand which stressed market scenarios would inflate such liability requirements and utilise such scenarios in liability liquidity stress testing conducted. For example, for a Fund having a capital commitment, a potential stress test would be to simulate an unexpected event causing higher capital outlay.

Use of reverse stress testing

Illiquid asset Funds are exposed to low-probability high impact risks, making reverse stress testing a particularly valuable approach for assisting Managers in identifying scenarios which may lead to Fund liquidity risks. When using reverse stress testing, the Manager should assess the potential sources of liquidity risks to which a Fund may be exposed and ensure adequate liquidity to avoid such risks materialising.

Leave a Reply