4 liquidity risk management principles for endowments and foundations

Erika Murphy is a portfolio manager on a team that manages multi-asset class portfolios on behalf of institutions, including pension plans, and endowments and foundations (E&Fs). She regularly receives queries on the topic of managing liquidity. The following four points outline what she believes are key considerations for E&Fs.

1. Liquidity stress testing

Ongoing evaluation of portfolio liquidity is important to ensure nonprofit organizations are aligned with their spending requirements. Consider annually reviewing each item below and applying stress tests to formulate a rough liquidity plan. In practice, liquidity plans are unlikely to anticipate all issues, but having a sense of your source of funds in advance can help streamline decision-making in periods of stress.

• Assess your contribution and distribution assumptions for your private allocations. How much liquidity might be required to fund capital calls? 
• Which allocations are subject to lockups or could be subject to a gate? How might this impact your allocations?
• Which allocations are most critical to achieving your return objectives? For many E&Fs, public and private equity investments drive most of the risk and return in the portfolio. How can you source liquidity to keep the combined exposure close to your strategic target in periods of dislocation?

2. Assess your surroundings

When it comes to managing your liquidity, knowing your asset managers philosophy, process, and return drivers is not enough—try to understand potential outside influences, including:

• Any counterparty exposure your asset managers might have, and whether they have proper risk controls in place.
• Who is invested alongside you? And what is the size of their investment?

Many allocators collect this information when making an initial allocation, but it can become stale over time or it could vanish from an institutional knowledge base due to team turnover. To help avoid ending up in a less liquid position than you might otherwise realize, institute processes to regularly document and aggregate how much of a fund you represent, the types of investors who sit alongside you, and if there are any concentrated investors who could impact others in the fund.

3. Pace spending to mitigate transaction costs and impact on asset allocation

• If you can, raise and spend cash incrementally throughout the year. Sourcing liquidity in smaller transaction sizes helps to minimize potential distortions to your asset allocation as well as transaction cost impacts.
• When you need to raise cash, give your managers sufficient advance notice. Private fund terms often specify a required redemption notice period, but even for daily dealing strategies, asset managers appreciate advance notice. The sooner asset managers know about redemptions, the more they can communicate with underlying managers and traders and develop a plan to access liquidity in the most cost-efficient way.

4. Asset managers can help you source liquidity if you don't want to hold cash

Recently, we've received questions wondering if cash and "near cash" are the only true sources of liquidity. While private distributions in many cases have slowed, we believe public market exposures still offer ample liquidity. Despite periodic headlines regarding a lack of liquidity in bond markets, public equity and fixed income markets are very deep and extremely broad. Global equity markets were at more than $61 trillion in market cap as of November 2023,1 and global bond markets are over $130 trillion.2 Billions of dollars are traded daily on exchanges around the globe. In the context of these large markets, most E&F trades are small especially if paced throughout the year—so any liquidity needs from publicly traded assets should be easy for markets to digest. Based on our team’s trading experience, E&Fs with meaningful public market exposure should be able to raise liquidity from these assets daily. For this reason, our team's view is that cash should generally be invested in daily-liquidity public market exposures to enhance returns, rather than held for liquidity purposes.