Key points
• Private markets (private equity, private credit and real estate) have historically delivered an “illiquidity premium.”
• Institutions and family offices have recognized this illiquidity premium and have historically allocated significant capital to capture it.
• Advisors should consider developing an “illiquidity bucket.”
• Allocating a portion of a client’s portfolio to illiquid investments helps in maintaining a long-term approach.
Legendary investor David Swensen famously stated that the “intelligent acceptance of illiquidity, and a value orientation, constitutes a sensible, conservative approach to portfolio management.” What Swensen and so many other sophisticated investors recognized is the illiquidity premium available by allocating capital to illiquid investments like private equity, private credit, and private real estate.
In fact, throughout Swensen’s tenure as the chief investment officer of the Yale endowment, he often allocated between 70%–80% of his portfolio to alternative investments broadly, with illiquidity budgets of up to 50% of the total allocation. The illiquidity bucket is a technique institutions use to identify the amount of capital that they are willing to tie up for an extended period of time (7–10 years). As of the end of fiscal year 2023, Yale had roughly US$41 billion in assets under management, with a 50% illiquidity bucket.
Of course, endowments are very different than individual investors, and Yale has certain built-in advantages, including unique access to private markets, dedicated resources to evaluate opportunities, and long-time horizon. If Yale needs capital, it has the ability to reach out to well-heeled alumni and donors for additional capital.
Most high-net-worth (HNW) investors would be uncomfortable locking up so much
capital—but the concept of an illiquidity bucket would certainly apply. While high
net-worth-investors may not have donors to call upon, they often do share something with Yale—a long time horizon for some of their goals.
What does the data show?
Academic research has shown the historic persistence of an illiquidity premium—the excess return received for tying up capital for an extended period of time. This makes intuitive sense because the private fund manager has ample time to source opportunities and unlock value. The fund manager isn’t beholden to investors and shareholders, like their public market equivalents, who are viewing results over shorter intervals. While the magnitude of the illiquidity premium will vary over time, depending upon the market environment and the fund, the data show that private equity, private credit and private real estate have historically delivered a substantial illiquidity premium relative to their public market equivalents.
Institutions and family offices have long recognized this illiquidity premium and consequently have historically allocated significant capital to private markets. In fact, according to the UBS Global Family Office Report, Family Offices have allocated roughly 45% of their portfolios to alternative investments, with private equity and real estate representing the largest allocations at 19% and 13%, respectively.
The report notes that such families are comfortable allocating capital for the long-run in order to capture the illiquidity premium. The average illiquidity bucket for this cohort is approximately 36% (private equity, real estate, private credit (debt) and art). The report also notes that many of these global family offices are looking to increase their allocations to the private markets, notably private equity, real estate, and private credit.
How much should advisors allocate to illiquid investments?
The amount of capital to allocate to illiquid investments varies by investor and their
underlying liquidity profile. Many investors believe that they should be 100% liquid, but there is an opportunity cost, especially in today’s market environment. Traditional liquid market investments may continue to deliver returns below their historical averages, and advisors may need to consider private markets to help investors achieve their goals.
One way of determining the appropriate percentage to allocate to private markets is to develop an illiquidity bucket. Similar to the Yale example covered earlier, the illiquidity bucket should represent the amount of capital that an investor is willing and able to tie up for 7–10 years. It can be determined via the discovery process and advisors should designate these investments as long-term in nature.
As the advisor is determining the family’s needs and requirements, they should inquire about their short- and long-term liquidity needs. Do they have significant capital expenditures in the next couple of years (college funding, purchasing a second home, boats, etc.)? How much of their portfolio needs to be short-term in nature to meet these needs? What portion are they comfortable putting aside for the next 7–10 years?
For many HNW investors, a 10%–20% illiquidity bucket may be appropriate given their wealth, income and cash flow needs. Once the advisor has determined the illiquidity bucket, they can then define which asset classes are appropriate to achieve their client’s goals.
Allocating to Private Markets
Once the illiquidity bucket for long-held assets has been established for a particular client, an advisor can then determine the appropriate allocation to private markets. There are several factors to consider before allocating.
Note, with the lower minimums of registered funds, advisors may be able to allocate across private markets (private equity, private credit, and private real estate). For larger families with large liquidity buckets, you can diversify your private exposures.
As with any investment, an advisor must understand and evaluate the many dimensions of a fund before recommending (structure and strategy). Because of the specialized nature of conducting due diligence on private markets, advisors may rely on due diligence conducted by their firm or third-party provider.
The Behavioral Benefits of Illiquidity
While many consider the Altair 8800 the first personal computer (1974), the original
personal computer was the human brain. The brain is capable of complex computations, processing information rapidly, and it has extended storage capacity. The human brain processes information in seconds and is capable of learning history, math, science, literature, philosophy, and the arts.
However, unlike the personal computers that we use today, the human brain also responds to all sorts of emotional stimuli, including fear, greed, euphoria, grief, pain and pleasure. While the modern-day PC processes information in nanoseconds, in a logical and rational fashion, the human brain often responds to emotional stimuli in an irrational manner.
Daniel Kahneman was awarded the Nobel Prize for his research of behavioral finance, how the brain responds to certain stimuli, and the biases that we all exhibit. One of the behavioral biases that Kahneman studied was “loss aversion.” In his book, Thinking, Fast and Slow, Kahneman suggested that investors will go to great lengths to avoid losses.
In fact, his research concluded that for the average investor, the ratio of avoiding losses to seeking gains is roughly 2:1. Consequently, investors may fall short of their goals by being too conservative or leaving the market in times of volatility. While loss aversion is well known, and advisors often coach investors to refrain from these irrational responses, it is still very challenging to act rationally in volatile times; of course, there is a built-in benefit of allocating a portion of a client’s portfolio to illiquid investments—it removes the emotional impulse to sell at the wrong time or switch strategies midstream. By utilizing an illiquidity bucket for a portion of a client’s portfolio, an advisor can instill discipline in their investment approach.
For this portion of their portfolio, investors can’t sell at the first signs of volatility or the temptation to chase returns elsewhere. These assets are truly long-term in nature and will require patience to reap the full potential benefit. With that said, registered funds (interval and tender offer funds) do offer more flexible liquidity features, which may provide some level of comfort that investors can redeem if necessary.
Conclusion
The bottom line is there is a potential illiquidity premium for allocating capital to private markets. The illiquidity premium is the reward for giving the fund manager ample time to execute their strategy and unlock value. There is an opportunity cost for being too liquid, especially in today’s market environment.
Advisors should help investors determine their illiquidity bucket. The illiquidity bucket should be determined based on each investor’s ability to allocate capital for an extended period of time (7–10 years). An illiquidity bucket can help instill a long-term disciplined approach that can remove the impulses to respond to emotional stimuli.