Illiquid assets

GLOBAL INVESTOR 1.15 — 17
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 %
18
16
14
12
10
8
6
4
2
Global
government
bonds
Small equity
US fixed
income
Deposits
High yield
Real estate
Hedge funds
1 2 3 4 5
Venture capital
Private equity
Illiquidity estimates
6
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 %
40
30
20
10
Top decile
Median 2nd quartile
3rd quartile
–10 bottom decile
–20
Long-only Long-only
fixed income equity
Hedge
funds
Private
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
19.4%
Pension
28%
Endowments
2%
Individual
investor
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
companies.
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.