Decomposing the illiquidity premium
For a generation or so academics have recognised the existence of the illiquidity premium, i.e. investors who are prepared to forego liquidity to receive a higher return. A recent EPFIF private markets investment forum made me think the picture is more complex than that simple model. For example, long term infrastructure debt can trade at a zero or even negative premium to much shorter term corporate debt, simply because long duration is valuable to pension funds trying to match their liabilities. I hasten to add that what follows draws on perspectives from a number of consultants and asset managers, and does not all originate from Linchpin.
I would argue that investors in illiquid corporate debt, which I use as an example because it a more homogenous asset class than other illiquids, can benefit from the following premia: credit for taking credit risk; illiquidity for committing for a long period of time; complexity (usually accessed through illiquidity); and an LDI premium, representing the value which predictable returns over a long period can add to solvency calculations.
The credit premium can be quantified, but illiquidity and complexity are not easily separated. I would suggest that illiquidity is the opportunity cost foregone by investing in a long term asset, in other words the opposite of the reinvestment premium. Some investors, such as pension funds, will place a higher value on predictability and therefore a lower value on this premium, which is one reason why infrastructure debt may trade at a lower yield. Complexity is probably best thought of as the risk that an investor may not have fully understood a strategy, and should be reflected in a lower entry price.
Quantifying these different premia is difficult, partly because of the lack of homogeneity. At the EPFIF seminar, I believe the general view was that the illiquidity/complexity premium ranged from around 75bps for relatively short term illiquidity to around 200bps for a 20 year lock-up. The LDI premium was around -155bps for a 20 year relative to a 10 year lock-up.
We will be developing this theme over the next twelve months, and I would welcome any thoughts or insights from readers. Please contact me on firstname.lastname@example.org.