Why should investors investing in securities with low liquidity be compensated with higher returns or liquidity premiums? Is this actually the case – and if so, how high is the premium?
Thanks to the structure of their liabilities, many pension funds are in a position to invest some of their capital in illiquid investments. In return for assuming the risk associated with securities that are not readily tradeable, investors expect additional long-term returns compared to equivalent liquid investments.
Generally, liquidity refers to the ease with which securities can be traded. Most asset classes are of a more illiquid nature, and only listed equities and bonds are considered truly liquid.
What constitutes liquidity?
The liquidity of specific assets is determined by various factors. Transaction costs, including fixed costs incurred for transaction processing, represent the primary source of illiquidity. For institutional investors trading in listed equities, these costs are low since transactions on strictly regulated markets are processed electronically. However, with brokers and lawyers involved in the transaction process, investments in certain alternative asset classes may be associated with substantial costs. Higher costs make trading more expensive and reduce tradability.
Further sources of illiquidity consist of demand pressure and inventory risks. In many markets, sales are processed via so-called market makers who demand compensation for the costs and risks they incur as a result of the storage of assets (for instance commodities).
Private information and search friction, which arise in the absence of centralised markets, represent another cause of illiquidity. Compensation for this risk may create substantial deviations between the offered buying and selling prices. In regulated markets, this is referred to as bid-ask spreads, which may be very pronounced and may restrict trade.
No fixed constant
Similar to all other risk premiums, liquidity premiums1 are not constant and may fluctuate substantially over time. In times when available funding for illiquid projects is limited, the premium is likely to be high, and vice versa. The onset of the financial crisis in the wake of the Lehman Brothers collapse led to a significant increase in liquidity premiums in the last quarter of 2008. Even liquid securities suffered in some cases considerable curtailment of their tradability, while illiquid investments were frequently traded at a significant discount or not traded at all.
For this reason alone, it is virtually impossible to come up with a general figure for the liquidity premium of a specific asset class. On top of this, illiquid asset classes are also affected by other factors, such as lower data quality or the impact of portfolio managers on the return. Hence, all data on historical or future liquidity premiums should be interpreted with a degree of caution.
The studies generally corroborate the existence of a premium covering the risk of illiquidity.
A number of research studies have analysed empirical data in order to confirm or disprove the existence of liquidity premiums and to quantify their amount. Although results vary substantially in the empirical literature, the studies generally corroborate the existence of a premium covering the risk of illiquidity.
Estimates of the liquidity premium for illiquid investments can be well above 3 percent per annum, depending on the asset class, time period, data source and methodology. The estimated liquidity premium that can be generated for private equity and direct real estate investments on a long-term average is approximately 3 percent p.a. The liquidity premium for private debt is probably in the range of 2 to 3 percent p.a.2
Lower liquidity, higher premium
Generally speaking, the higher the liquidity risk, the higher the expected liquidity premium. However, this principle does not guarantee that returns rise in line with increasing illiquidity per se. Aside from the liquidity risk and the market risk (beta), the measurable investment return is substantially affected by another key element, namely the knowledge and skill of the portfolio manager (alpha).
Managerial skills primarily affect the return on illiquid investments through strategic and/or operational improvements at the level of the portfolio companies. For instance, restructuring measures can lead to lower operating costs, or plant utilisation can be optimised. Hence, the earnings potential of illiquid investments is not only determined by the illiquidity profile of a particular investment category but also to a large extent by the selection of the portfolio manager.
Typically, the more illiquid an investment, the bigger the spread over the best and worst managers. On top of this, the performance of portfolio managers tends to be more sustainable in illiquid investments than in liquid traditional portfolios.
Diversification and patience are key factors
Academic studies support the existence of a liquidity premium. However, it is not easy to separate the premium from other factors that affect the return on illiquid investments. Exact quantification at any given time is difficult. Nevertheless, long-term investors probably expect an average premium on illiquid investments of approx. 3 percent per annum.
Depending on the level of the liquidity premium and the type of investment, the return potential of illiquid investments will fluctuate substantially over time. As in all asset classes, it will be difficult to find the perfect entry point for illiquid investment strategies. Investors aiming to systematically skim off liquidity premiums should therefore establish a portfolio of illiquid investments that is broadly diversified across asset classes, strategies, managers and maturities.
Moreover, due to the capital call structure, it usually takes several years to establish such a portfolio, which in turn dilutes the effects of choosing the right time to invest.
1) The liquidity premium is also referred to as illiquidity premium.
2) Robert S. Harris, Tim Jenkinson and Steven N. Kaplan: “Private Equity Performance: What Do We Know?”, SSRN, April 2013; IPF Research Programme 2011-2015, Summary: “Liquidity in Commercial Property Markets”, January 2015; Willis Towers Watson, Asset Research Team: “Understanding and measuring the illiquidity risk premium”, March 2016; Mercer Health Wealth Career: “Seeking Returns in Private Markets”, February 2017; Thijs Markwat and Roderick Molenaar: “The Ins and Outs of Investing in Illiquid Assets”; Franzoni F., Nowak E. and Phalippou L.: “Private Equity Performance and Liquidity Risk”, The Journal of Finance, Volume 67, Issue 6 (2012), pp. 2341-2373.