The Illiquidity Premium and the Market for Private Assets

The Illiquidity Premium and the Market for Private Assets

The illiquidity premium is one of the most frequently discussed and hotly disputed subjects in financial economics. Speaking broadly, an investment is not a checking account. One generally cannot just “get the cash back” at a moment’s notice, by visiting some equivalent of an ATM.

How long will it take to get one’s cash back from investment X, whether it is a corporation, a futures contract, a house, or a hedge fund, is what is meant by the illiquidity of that investment. All other things being equal, liquidity is good and illiquidity is bad. Investors would like to be able to liquidate whenever they have a pressing need. Thus, we reach a non-controversial opinion: investors must be bribed to accept illiquidity. There is an illiquidity premium.

Beyond that, there is plenty of room for controversy. What factors determine how large the bribe must be, and why/how its size fluctuates over time? Are the markets segmented, so that the illiquidity premium for bonds is a different issue altogether from the illiquidity premium for real estate? And perhaps the premium for bonds of one maturity is a different matter from that of bonds of another? Or is it all one big connected higgle-haggle?

Those questions will suffice to show that there is a drive to understand the “why” of the liquidity premium in a way that goes further than the qualitative/intuitive reasoning of the first two paragraphs above.

Baz, Stracke, and Sapra

A new paper by three Pimco executives looks at this question, specifically in the context of private markets. Their paper ”Liquidity, Complexity and Scale in Private Markets” begins with a quote from Barrie/Hibbert that describes this premium as “the price discount or excess return/yield offered by the security relative to some hypothetical perfectly liquid security with otherwise equivalent characteristics.”

The authors of the Pimco paper are Jamil Baz, managing director, head of client solutions and analytics; Christian Stracke, managing director, global head of credit research; and Steve Sapra, executive vice president, client solutions and analytics.

The authors work through liquidity literature chronologically, beginning with a paper published in 1986 in the Journal of Financial Economics by Yakov Amihud and Haim Mendelson. Amihud and Mendelson treated the premium as manifesting differences between investors. Long-term investors, those with patience, have less demand for liquidity than do their more myopic counterparts, so they get to amortize their trading costs over a longer horizon.

In more quantitative terms, Amihud and Mendelson stressed that the relationship between the expected return and the holding horizon is concave: the return increases but at a diminishing rate.

Don’t Ignore the Outliers

Baz et al. observe that Amihud and Mendelson essentially show how average liquidity is priced in equilibrium. But later scholars have widened the discussion to include the variability of uncertain situations, the way returns may reflect crises in which liquidity is far from average.

As an example of this more recent work, they cite Acharya and Pedersen’s 2005 paper, also in the JFE. Acharya and Pedersen explained that investors should (in the words of Baz et al. paraphrase), “command an illiquidity premium not only for the average, or expected, level of transaction costs but also the sensitivity to market-wide liquidity.” Subsequent studies, not to mention non-academic headline-making crises, have confirmed Acharya and Pedersen’s point that liquidity can suddenly and unexpectedly disappear in a crisis. Hence the illiquidity premium for at least some investments must bribe the investors for the risk that the duration will encompass such a crisis.

The Bottom Line

This leads us back to the distinction between public and private investment. Baz et al. say that it is “highly likely” based on the Acharya-Pedersen reasoning, that “the illiquidity premium is higher in the market for private assets, because secondary markets provide very little opportunities to trade such assets.”

The bottom line of the Pimco authors is this: “Given that typical real estate, private equity and private loan investments have an average turnover of four to five years, an optimal allocation of 12% to illiquid assets sounds like a good rule of thumb.” They also acknowledge, though, that there are a lot of parameters that must be considered in the application of that rule, so that the 12% number has “to be met with healthy skepticism.”

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  1. Brad Case
    April 15, 2019 at 2:13 pm

    The article by Pimco is fatally flawed–in fact, I would say that Baz, Stracke & Sapra are blatantly pandering to potential clients and encouraging them to make poor investment decisions while pretending to help them make good ones.
    As the author notes, “liquidity is good and illiquidity is bad.” For this reason, the “illiquidity premium” is the minimum additional return that an investor MUST get in order to be no worse off for having sunk money into the illiquid asset. If the investor FAILS to get the illiquidity premium, she is worse off.
    That’s not the way Baz, Stracke & Sapra make it sound. They define both the illiquidity premium and the complexity premium in almost universally positive terms: (1) “the additional return compensation that patient investors CAN EXPECT TO EARN;” (2) “the excess return/yield OFFERED;” (3) “patience is necessary to EARN the liquidity risk premium” while “scale is necessary to EARN the complexity risk premium;” (4) “patient investors can EARN an illiquidity premium by specializing in less liquid segments of the market;” (5) “more-patient investors are able to COMMAND a liquidity risk premium relative to their less patient peers;” (6) “the longer the patient investor’s horizon, the higher the premium.” In this framework, illiquidity and complexity are not bad things at all: they’re wonderful, because they enable the investor to “earn” or “command” a higher return. In fact, there might as well be no risk at all, because the premiums will come automatically as long as the investor is patient and/or sophisticated.
    Even worse, Baz, Stracke & Sapra act as though investors don’t need any information other than a measure of illiquidity: why bother thinking about returns or other risks when you know that you’ll get a high return just because your asset is illiquid? When discussing the excellent article by Acharya & Pedersen, they simply state–as if looking at empirical evidence is simply not worth the trouble–that “it’s highly likely that the illiquidity premium is higher in the market for private assets, because secondary markets provide very limited opportunities to trade such assets.” And when they discuss the even more excellent article by Ang, Papanikolaou & Westerfield, they make the astonishing claim that “an optimal allocation of 12% to illiquid assets sounds like a good rule of thumb.” What!? (Absolute shame on the author of this summary for quoting such an irresponsible statement.)
    Empirical evidence is, indeed, available–and it should lead investors to avoid illiquid assets no matter how patient and large-scale they are. There is a multitude of studies comparing the returns of private equity with the returns of public equities that are otherwise similar: I believe it’s literally true that every single one of them has found either that private equity returns were LOWER or that they were higher but not by enough to compensate for illiquidity risk. There is also a multitude of studies comparing the returns of private real estate with the returns of otherwise similar public real estate, and here there is no such ambiguity: not a single study has ever found that private returns were even as high as public returns.
    The very worst statement in the marketing piece by Baz, Stracke & Sapra is the last one: “Fortunately, this subset of investors has the ability to extract both the illiquidity premium and the complexity premium in the market for private investments.” This is absolute pandering: they’re saying nothing more sophisticated than “if you play with private investments, that proves that you possess the necessary patience and the scale to undertake them.” How do Baz, Stracke & Sapra square their pandering language with the empirical evidence–which they could have found easily enough if they had wanted to do so–that the investors with “the necessary patience and scale” have actually made themselves WORSE off by investing in private assets?
    Shame on them.

  2. Mihail Garchev
    April 16, 2019 at 1:11 am

    To add to the previous comments – look at the pricing in the private infrastructure. If anything, there is a reverse illiquidity premium as the infrastructure projects, for example, in the UK are bought at a substantial premium to their regulatory asset base. Not vice versa. These markets are segmented and because of this the law of one price which we can observe in (most) public markets is not valid. Same for private equity, for most take private, there is actually a premium being paid and subsequently recovered via (mostly) value creation activities. Median managers do not outperfom public markets when properly adjusted.A lot of the perceived outperformance is an artifact of the available private asset databases where there is a significant survivorship bias and what manifests as “an illiquidity premium” is mostly the economic value added accrued by the “surviving” top managers. Finally, the materialize an illiquidity premium, one needs to buy cheap from somebody else. Most of the assets are acquired at a premium (20-30% to 60% in certain infrastructure cases) with only small anecdotal amounts of forced sellers (e.g. Harvard) during the crises.

  3. Bruce Brown
    April 18, 2019 at 2:59 pm

    There is reason to believe that for large pension funds overseen by panels of unsophisticated board members, institutional managers would be willing to pay a premium for illiquidity.

    Consider a situation in which expected returns and expected volatility for two assets were identical. One of the assets, however, because of “illiquidity” and less frequent pricing appears to have a lower volatility. An institutional manager would have an interest in purchasing the asset with lower apparent volatility because the fund’s overseers are unlikely to appreciate the unreported volatility.

    In the most obvious real world example, a fund’s public equity will be priced monthly so that downturns are immediately reported in financial reports and must be explained by institutional managers to public board overseers. By contrast, private equity investments, priced quarterly, reflect changes only quarterly. Therefore, if the general market drops 20% in January, but bounces back by March, a pension fund manager with public equity will be subjected to two months of unpleasant board meetings, whereas a pension fund manager with private equity may never need to explain any apparent losses. While no institutional manager would admit to paying a premium for having pricing information lagged and delayed, human nature suggests that managers reporting to unsophisticated public boards would value the apparent stability of illiquid assets.

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