Navigating Illiquidity in Private Markets

Combining public and private assets to build a more balanced and diversified investment portfolio has been gaining momentum. Alternative assets are uncorrelated to listed markets and can provide a hedge against poor performance from traditional stocks and bonds. By ‘not putting all of your eggs in one basket,’ investors limit their exposure to any single type of asset, thereby mitigating risk, lowering portfolio volatility, and increasing the potential for greater returns.

However, managing a multi-asset approach means striking a balance between investing over the long term, where you are essentially locking in capital, and ensuring sufficient liquidity. The differences in the liquidity profiles of private vs. public assets could not be more pronounced. Investors need to be aware of the liquidity risk and manage their portfolio accordingly to limit stress during uncertain market conditions.

The Rise of Private Market Investments

As global wealth continues to grow, investors are increasingly venturing beyond traditional public markets in search of higher returns. This shift is particularly pronounced in the current low-growth economic environment, where conventional assets struggle to deliver what some investors hope to achieve.

This has resulted in a marked increase in investors allocating a portion of their portfolio to private markets, especially in private equity, where it has consistently outperformed public markets. Globally, assets under management in the private equity sector increased from around $2 trillion in 2013 to around $8 trillion in 2023 (Source: McKinsey, Preqin, and Bank of England).

Managing Investor Expectations Around Liquidity

This trend brings to the fore a critical challenge: managing investor expectations around liquidity. Investors with no prior exposure to private markets are accustomed to the ease with which they can trade stocks and bonds, giving them a sense of safety and control over their capital. However, this psychological need for liquidity can often lead to underweighting illiquid investments, thereby missing out on the diversification benefits and potential for higher returns that these assets can offer (Source: Barclays Private Bank).

The idea of committing capital over a longer period can be daunting and requires a fundamental shift in mindset. Given the longer-term, illiquid nature of private equity investments, investors must approach alternative asset investment with a different mindset and, most importantly, discipline in their cash management to ensure they have sufficient liquidity should they need to redeem assets to meet their cash flow requirements.

Understanding Private Equity's Unique Characteristics

Private equity has its own unique risk/reward characteristics. The timing and profile of private company investments differ from other investments such as public equities. The so-called ‘J curve’, which resembles the letter “J” when plotted graphically, describes the typical pattern of returns for a private equity fund over time. It illustrates the initial investment dip followed by a gradual and then sharper rise in the value of the fund as assets grow in value and are realised.

*The diagram above is a conceptual J-Curve graph illustrating the potential return on cash over time.

Successful private equity firms excel in executing operational value creation strategies to build scale and accelerate growth through to a potential exit. This can include ensuring that the right senior management team is in place with the optimal combination of skills and experience to deliver on the plan, improving internal processes, and building organisational capabilities. Despite being adept at this, value creation takes time. A specific and prioritised set of key actions need to be worked through to realise the asset’s full potential. It is this management-intensive process by private equity firms which often deliver optimal returns but requires a patient approach for that to be achieved. Therefore, private equity is not a suitable asset class for an investor with a short-term investment horizon.

The Benefits of Consistent Investment and Compounding Returns

Investor exposure to alternatives, such as private equity, benefits from consistent investment over a period of time to leverage varying market conditions and secular trends. Additionally, it enables investors to profit from compounding returns as, when early investments start to mature, that capital can be reinvested, creating a self-funding portfolio.

*Graph above illustrates a 5% return per annum on a £1,000 investment over a 30 year period.

The Illiquidity Premium and Its Advantages

Illiquidity is not necessarily a problem, certainly for investors not overexposed to one particular asset class and who have a balanced, well-diversified portfolio. It is also a feature that can drive higher returns – a phenomenon known as the illiquidity premium. The illiquidity premium is the higher return potential that investors could earn by committing their capital to less liquid assets. This premium compensates investors for the risk and inconvenience of not being able to readily access their funds. Research shows that private equity investments typically command an illiquidity premium of 3-5% over public equities (Source: Harvard Business School).

Exposure to illiquidity can also be a source of stability. Private equity, for instance, is not directly linked to public market performance and therefore has the potential to offer less volatile returns even in turbulent times. Private equity-backed companies benefit from patient capital and can focus on long-term strategies without the pressure of short-term market expectations.

Innovations to Address Illiquidity Concerns

To address concerns about illiquidity, some private equity funds are developing structured liquidity solutions. These might include periodic opportunities for investors to sell their holdings or the creation of secondary markets where interests in private equity funds can be traded. Such innovations can provide a measure of liquidity while preserving the benefits of long-term, illiquid investments.

New investment structures such as FCA-authorised Long-Term Asset Funds (LTAFs), which have been designed to enable a broader set of investors to access private markets, also attempt to tackle the liquidity conundrum by being open-ended and allowing redemptions within a suitable timeframe.

The Future of Alternative Investments

The growth in wealth and the quest for higher returns are undeniably driving demand for alternatives. Private equity will continue to play a significant role in this landscape due to its impressive historical track record, and new innovative fund structures like LTAFs are opening the door to the wider retail investor. However, education and transparency are paramount. With no formal exchanges or secondary markets, alternative assets have their own unique characteristics, with liquidity often being the starkest.
While the illiquidity of alternative assets presents challenges, it also offers opportunities for those willing to navigate this complex landscape. By understanding the nuances and having a clear investment objective, investors can harness the potential of private markets to achieve their long-term financial goals.

Alternative investments are typically only suitable for experienced investors who are able to evaluate and understand the risks and merits of such investment. They are also only suitable for investors who have the resources to bear any loss that may result from such investments.