Holding private equity investments can allow an illiquidity premium to be harvested, potentially boosting portfolio performance. But what exactly is the illiquidity premium and how can it be exploited? We explore historical estimates for this premium, analyse its trends over time, and discuss how best investors can incorporate private equity among their holdings.
The liquidity of a financial market helps oil the pace at which deals are made, the volumes that can be digested, and the spreads that are paid. Market liquidity is not a binary distinction. While public equities are traded every second, corporate bonds may be traded only daily, municipal bonds usually twice a year, and institutional real estate around every decade.
The value of liquidity is most apparent when it comes to buying or selling an asset. For instance, in illiquid markets, a sale may incur high search costs (to find a buyer), transaction costs, and the trade itself could hit the price. A tightening of financial conditions would exacerbate all these issues and make selling illiquid assets in distressed markets a very poor choice. It is for these reasons that investors can demand an illiquidity premium for holding such assets. In other words: they get rewarded for providing liquidity to an illiquid market.
There are several ways to obtain the premium. You could invest in inherently illiquid assets, like real estate or private market funds; focus on illiquid parts of broader markets, such as less liquid bonds; act as a market maker; or simply rebalance your diversified portfolio frequently, which provides liquidity to sought-after assets and absorbs liquidity for assets that recently sold off.
In the remainder of this article we focus on the illiquidity premia harvested from private equity (PE) funds. This includes looking at how to measure such premia, analyse changes in them over time, and address volatility in conjunction with liquidity.