What Advisors Should Know About Illiquidity
Relatively few investment advisors are making private equity available to their high-net-worth clients, according to new research from iCapital Network. In the same study, advisors cited nine obstacles to offering the asset class that include a range of issues related to the characteristics and mechanics of private equity as well as the advisors’ own proficiency with the investment category (Figure 1).
(Source: iCapital Network)
Practically speaking, the large majority of concerns named by advisors are easily surmounted with new trading platforms and educational tools that are available free-of-charge online.
The single biggest obstacle, as cited by 85% of advisors, is the lock-up period associated with an investment in private equity – something that will not change unless the fundamental nature of private equity changes. Private equity funds put money into private companies and instruments for which there is no public market, meaning that fractional interests cannot easily be priced or traded and are, in effect, illiquid until the entire fund has been monetized. The lock-up of capital during a private equity fund’s investment period is actually one of the ways managers attempt to generate returns, enabling managers to implement longer term value creation strategies that are not possible in a public market context.
First and foremost, the lock-up period means that private equity is not an appropriate investment for everyone. That said, there are a number of other factors that should be considered before eliminating illiquid investments as a potential component of a portfolio.
What should an advisor know about illiquidity?
- Liquidity is an important characteristic of investments and especially important for people who have cash flow needs. But for those who are not cash constrained, an allocation to an illiquid investment may provide certain benefits, such as diversification and enhanced return potential, to a portfolio above and beyond what is typically associated with more readily tradable assets. For most qualified purchasers (typically, individuals with over $5 million in investments), 100% liquidity is not required at all times. For reasons we describe in this article, investors who can “afford” illiquidity should consider investing in it.
- There is a well-documented return premium associated with illiquid investments1 based on historical data, meaning that an allocation to private equity has the potential to boost overall portfolio results. As of March 31, 2016, the Cambridge Associates US Private Equity index outperformed the S&P 500 and the Russell 2000 indices by 300-600 basis points over 10, 15 and 20 year periods.2 When making this comparison, it is also important to note that while investments in private equity funds provide potential for attractive returns, they also present significant risks in addition to illiquidity not typically present in public equity markets, including, but not limited to long term horizons, loss of capital and significant execution and operating risks