Savvy investors know that one of the biggest draws of private markets is the illiquidity premium. But what exactly is the illiquidity premium and why do some investors embrace it? In this article, we'll uncover the secrets of the illiquidity premium and explore why investors embrace it. From understanding the concept to assessing its potential impact on your portfolio, we'll take a deep dive into the world of private markets and the illiquidity premium.
What is the illiquidity premium? Why does it exist?
The illiquidity premium is the additional potential return of illiquid assets relative to liquid assets.
The premium compensates investors for the added risk and inconvenience of not being able to easily liquidate their assets (particularly compared to listed market investments). Furthermore, illiquid assets tend to be more complex and many investors simply put it in the “too hard basket”. While some investors shy away from the challenge, for those who take the time to fully grasp the potential, the rewards can be substantial.
Illiquid vs Liquid: The Battle for Investment Returns, What Does the Research Say?
Just like past performance is not a guarantee of future performance, the outperformance of illiquid assets also cannot be guaranteed.
There has been a significant amount of research on the illiquidity premium, and the findings of this research have been somewhat mixed. Some studies have found that illiquid assets do tend to earn a higher return than liquid assets, consistent with the existence of an illiquidity premium, while other studies have found little or no evidence of an illiquidity premium.*
A reason for the mixed findings could be that the size of the illiquidity premium can vary significantly depending on the specific asset being considered and the market conditions at the time. For example, the illiquidity premium may be larger for new private market investments in times of financial market stress, when investors are more risk-averse and prefer the perceived safety of liquidity. In contrast, the illiquidity premium may be smaller for new private market investments when yields are low, pushing investors to riskier assets for the additional return potential (which ironically gets eroded as the prices of those riskier assets push higher due to the additional demand).
Why do investors invest in illiquid assets if the illiquidity premium is not guaranteed?
Like most opportunities across the investment universe there is always a trade-off between risk and return and it is no different when comparing illiquid and liquid assets.
For some investors, the potential for additional returns can be a strong enough lure despite the additional risk (note cash can be considered a risky investment for some investors if it means they will never achieve their investment goals). For others, the potential additional diversification offered by illiquid assets, such as private market investments, can also be a strong draw. While for some investors the inability to liquidate an investment ensures discipline and prevents them from selling an investment out of fear.
Of course, it is important for investors to carefully consider the potential benefits and risks of illiquid assets in the context of their personal circumstances (e.g. investment horizon, liquidity needs, investment goals etc.) before including them in their portfolio.
For investors that decide that illiquid assets are an appropriate investment, it is likely that an appropriate investment portfolio would include a mix of liquid and illiquid assets.
If you need assistance in determining what an appropriate investment portfolio could look like, we strongly recommend you seek professional financial advice. A financial adviser can assist you in understanding the risks and potential benefits of investing in illiquid assets, such as private market investments, and helping you determine how much would be appropriate.
For more information about our available private equity funds, please visit our private equity funds page.
* For those inclined: Amihud, Y., 2002, “Illiquidity and Stock Returns: Cross-Section and Time-Series Effects,” Journal of Financial Markets, 5, 31–56; Amihud, Y., and H. Mendelson, 1986, “Asset Pricing and the Bid-Ask Spread,” Journal of Financial Economics, 17, 223–249; Ben-Rephael, A., O. Kadan, and A. Wohl, 2015, “The Diminishing Liquidity Premium,” Journal of Financial and Quantitative Analysis, 50, 197–229; Jang, B.-G., H. K. Koo, H. Liu, and M. Loewenstein, 2007, “Liquidity Premia and Transaction Costs,” Journal of Finance, 62, 2330–2366; Kang, W., N. Li, and H. Zhang, 2017, “Information Uncertainty and the Pricing of Liquidity,” Working Paper, Shanghai University of Finance and Economics.
