Research Roundtable Publication
Investment theories purport to explain market movements and investor behavior in ways that help us make better portfolio management and asset allocation decisions. Some of these theories are so ubiquitous, however, that it is easy to forget that they are theories, rather than truths.
Theories should be tested with quality data to make sure that the decisions they drive are prudent. They should hold up to questioning over time and be reliable.
We’ve written a few pieces on the importance of this and how we need to be mindful that some of the tools we use to create investment models may not be optimal.
Diving deeper into the reliability of one of the most confidently repeated investment theories, we now ask this question:
Does an Illiquidity Premium Exist?
The illiquidity premium theory is logical. It generally states that if someone is going to give up liquidity, control, and the flexibility to make changes, especially in the constantly changing investment world, they should be handsomely compensated with higher returns.
A potential problem, though, is that the theoretical illiquidity premium is often mentioned and then modeled as if it is an absolute – similar to a law of nature. As an example, quotes like this are not uncommon:
“An illiquidity premium is the additional return that is received from an illiquid asset.”
“Private investments have a very large illiquidity premium, which alone accounts for significant outperformance.”
Laws of nature are useful in models, as they can be relied upon. We can send a satellite into orbit and, relying on physics constants such as gravity, we can be confident that it will move around the earth as expected.
Investors would never spend billions of dollars on a satellite project if they were not confident that it would circle the earth in a predictable manner. Long-term commitments are made to these ventures based on the stability and reliability of key inputs that impact long-term performance over the life of the project or investment period.
When we invest in private investments, we also put large dollars into ventures that, once committed to, offer little to no optionality for change. Unlike 10-year + space projects, however, some of the key factors that drive these private investments are not based on law of nature constants, but on theories and metrics that may be unreliable or have flaws.
Problematic Return and Risk Metrics
Before we dive into what multiple studies have concluded about the reliability of the illiquidity premium theory, it is useful to understand some of the metrics used in calculating the returns and risk of illiquid investments as compared to liquid investments.
On the return side, the most common historical metric used to compare annualized private investment returns to public market returns is internal rate of return, or IRR.
As we have written about before, the problem is that comparing the annualized IRRs of private investments to the annualized returns of public investments can be like comparing apples to oranges.
Public investment returns are calculated and presented using compound annual growth rate formulas (CAGR). This is generally accepted as the best way to provide an investor with a good understanding of the average annual return that they have received over a specific time period.
The annualized returns of private investments are often presented as IRRs. While some IRRs may look attractive, they do not represent the average annual return investors have received over a specific time period. The reasons behind this are complex (more on this can be found in an article we wrote for the CFA Institute) but, as Cambridge Associates simply states in their reporting of IRRs:
“Due to the fundamental differences between [how private IRRs and public market CAGRs are calculated], direct comparison… is not recommended.”
Bottom line, as we wrote in a piece we called Baking with the Wrong Ingredients, if you see someone comparing a private investment IRR to a public investment CAGR, and touting the return difference as an example of the illiquidity premium – discard. An apple is not an orange.
On the risk side, we commonly see standard deviation comparisons that may also lead investors to the wrong conclusions.
Cliff Asness of AQR calls the underpinning of this Volatility Laundering. This label may be a little too tough for some, but we do consistently see disclosures in return comparisons similar to the following, which we detail in the Baking post we linked to above:
“Public market returns are as of the most recent quarter-end period. Private investment returns are based on a one or two quarter lag.”
Especially in down market periods, these lags can make private investments look much less risky, as the returns of public investments will reflect drops, while private investments, due to the lags mentioned above, may not.
A few newer metrics have been developed to try to solve these comparison issues, but they also have potential problems that investors should keep in mind. We wrote more on this in an article we titled, Solutions to Increase Trust. The piece highlights one of the better comparative return and risk methods we think exists, Duration Adjusted Return, but even this method requires detailed measurements that can make comparisons quite complex.
Questioning from Independent Researchers
The challenges of making good return and risk comparisons alone cast doubt on some of the bold statements we hear about the existence of an illiquidity premium.
To test these doubts and search for answers that hold up to questioning, we reviewed multiple independent academic research papers and the conclusions they reached.
Possibly the most robust research on the existence, or lack thereof, of the illiquidity premium we found is in Real Estate. The CFA Institute published a Risk and Return Assessment of Private Real Estate Categories in 2019 that offers a good example.
The article summarized a Journal of Portfolio Management peer-reviewed study of the long-term performance of more liquid Open-End Core real estate funds to more illiquid Value-Added and Opportunistic private real estate investments across multiple strategies. After analyzing 18 years of returns from datasets that represented various segments of real estate the researchers found this:
“Value-Added [private] funds have, on average, generated an [negative] alpha of –3.26%.”
“Similarly, Opportunistic [private] funds have generated an [negative] alpha of –2.85%.”
Next, when looking at data on Private Equity funds, the evidence again was inconsistent with the often categorical narratives we hear about an illiquidity premium.
The quotes below are what the authors of a 2020 peer-reviewed Journal of Alternative Investments paper, Demystifying Illiquid Assets found:
“Our analysis suggests that private equity does not seem to offer as attractive a net-of-fee return edge over public market counterparts as it did 15–20 years ago, from either a historical or forward-looking perspective.”
“Mediocre performance in the past decade [of private equity] versus corresponding public markets, and weak evidence on the existence of an illiquidity premium.”
“[Private Equity] demand may reflect a (possibly misplaced) conviction in the illiquidity premium [and] may also be due to the appeal of the smoothed returns of illiquid assets in general.”
These studies, and more articles that we have included below under Related Reading, suggest that a private investment illiquidity premium does not necessarily exist. As we discussed above, though, finding exact long-term apples to apples comparisons of public and private investment returns can be challenging.
So, to dig further, we looked for evidence of an illiquidity premium in Small Cap stocks – an area that researchers suggest is a good proxy for private investments.
What did we find looking at the much longer-term data that exists in this asset class?
Multiple studies suggested that an illiquidity premium does not exist in a robust fashion, including another peer reviewed paper, this one published in 2021 by the Journal of Banking and Finance, Liquidity and The Cross-Section of International Stock Returns.
After analyzing 30 years of data across 45 developed and emerging markets the researchers concluded this:
“Using several different liquidity measures… we demonstrate that the liquidity effect exists only among microcap stocks that are of negligible economic significance. When these firms are excluded, hardly any illiquidity premium can be detected anywhere.”
“If illiquidity is not rewarded anywhere except for an irrelevant segment of hardly tradeable stocks, then it should not be considered as a separate factor in qualitative portfolio management. Also, the use of illiquidity in a performance evaluation or a cost of capital estimation may be questionable.”
Our Questioning Conclusion
We are not saying that the illiquidity premium is not a valid idea. It is.
If you lock your money up for 10 years or more without control over the timing or implementation of your investments, you should be compensated in a premium manner.
We are, however, pointing out that investors should be mindful that the illiquidity premium is a theory – not a law of nature – and one that has consistently been shown to be quite inconsistent.
Our professionals have invested in private investments at size for many years, think that good private investment opportunities exist, and believe that investors should keep an eye out for outlier opportunities.
In addition, we have worked with researchers and many in the industry to hopefully help investors identify attractive investments by publishing lists of Private Investment Questions to Consider.
Should investors set very high bars before taking on private investment illiquidity and discount the possibility of an illiquidity premium – potentially significantly?
We think so.
Demystifying Illiquid Assets: Expected Returns for Private Equity – Journal of Alternative Investments – 2020
Private Equity Is Still Equity – Nothing Special Here – Journal of Investing – 2020
Liquidity and the Cross-Section of International Stock Returns – Journal of Banking and Finance – 2020
Another Look at Private Real Estate Returns by Strategy – Journal of Portfolio Management – 2019
Persistence That Just Ain’t So? – CFA Institute Enterprising Investor – 2019
The Lasting Value of Public Real Estate – Verdad Capital – 2018