Private Markets Enable Investors to Exploit Illiquidity Premiums
Feb 04, 2021
Illiquidity, the state of assets that cannot easily and readily be sold or exchanged for cash without a substantial loss in value, is a relevant consideration for most investors. Both institutional and private investors generally consider the liquidity of assets before closing investments. The illiquidity of assets can be viewed in two primary ways. One is the amount of time required to sell a position at a price that is not affected by matters of urgency; or two, the amount of lost value from closing a position with urgency due to either macroeconomic, microeconomic, or personal factors. In this blog post, we aim to provide a brief overview on illiquidity in the investment universe and explain how investors who want to increase their allocations to less liquid investments can embrace lucrative investment opportunities created by private markets.
Expected premium returns: compensation for the risk of illiquidity
Liquidity risk arises when external factors force an investor to sell an asset that is not actively traded, and only a limited number of market participants are interested in buying. This lack of ready buyers may cause a substantial price reduction to achieve a bid from other market participants. The term illiquidity premium describes the additional return received for the risk of tying up capital in a less liquid asset such as estate, debt instruments, and private equity.
It has traditionally been viewed as a non-systematic risk or a risk intrinsic to the asset itself. This concept presumes that the justification for higher long-term returns in less liquid assets is that investors are compensated for the risk of illiquidity in the form of an expected premium return. Even though historical return data confirm a premium for illiquid assets, it is not guaranteed. However, it can be difficult to quantify the illiquidity premium exactly and isolate it from other risk premia. The risk of illiquid assets is often difficult to measure and illiquidity is usually not constant over time. Investments that appear to be liquid under normal circumstances may have constrained liquidity during crises such as the COVID-19 pandemic. It is in times of crisis that liquidity is most valued.
Pre-IPO investing decreases illiquidity periods
Most industry experts agree that investments in private markets typically realize an illiquidity premium. Since the 2008 financial crisis, Venture Capital (VC) and startup funding has increased drastically. Some market observers even forecasted a “new tech bubble”. Pre-IPO deals are considered to be the most relevant among the later-stage investment opportunities. Investing in companies’ growth equity positions, which are in its very late stage of the startup cycle, can reduce some of the risks associated with venture capital investing (e.g. decreased illiquidity periods).
Among the drivers of the shift from public to private equity are investors seeking better risk-adjusted performances. In other words, they search for higher returns and lower risks. Avoiding stock market volatility can be one approach to it and can be effectively done by investing in private markets such as pre-IPO and late-stage opportunities. Depending on the company, these opportunities are generally not as strongly affected by external influences.
Furthermore, by backing innovative startups that solve real-life problems and positively impacting our society, investors contribute to a better world. Successful late-stage investments often reach the pre-IPO stage after one or two years and then go public after its final private financing round. A portfolio solution can often be beneficial in achieving a good diversification among several pre-IPO opportunities.
Less liquid assets are often undervalued
According to the Yale investment director David Swensen, less liquid investments tend to have greater degrees of inefficient pricing. Many investors overvalue liquid assets. This leaves less liquid – and thus often undervalued – assets for investors with long-term investment horizons.
Investors making commitments to long-term assets must be aware that these investments are typically held for ten years or longer. It, therefore, requires a more complex due diligence process before committing to less liquid assets. Investors can manage liquidity risks by not leaving too much of their portfolios in illiquid markets or by engaging in a secondary market community.
Liquidity management mitigates illiquidity risks for investors while allowing them to exploit illiquidity premiums. With our new liquidity desk, Stableton ensures that financial intermediaries meet cash obligations without experiencing significant losses. This reduces liquidity risk exposure and facilitates the reallocation of resources.
Private market investments enhance the performance of traditional portfolios
“Liquidity may be an appealing characteristic for an investment, but a growing base of research is finding that illiquidity maybe even more desirable. Because ironically, demand for illiquid investments is so low, that they appear to carry a persistent excess return premium”, Michael Kitces, Head of Planning Strategy at the financial planning company Buckingham Wealth Partners, wrote in a blog post.
Illiquid assets can help diversify investment portfolios and counteract market volatility. Pre-IPO and late-stage growth investments are a valid option to enhance the performance of traditional portfolios. As we explained in a previous blog post, pre-IPO investing is a lot less about hype and more about data analytics. The experienced Stableton team sources and identifies pre-IPO investment opportunities directly and across an ever-increasing network of deal-sourcing partners. Register on our marketplace today and find out more about our pre-IPO and late-stage opportunities.
Contact your Stableton representative now to learn more about illiquidity premiums in pre-IPO investing and evaluate your investment opportunities.
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