Liquidity, the ease with which an asset can be converted into cash without impacting its market price, is often considered by investors to be a crucial factor when making investment decisions. It provides flexibility and security, allowing investors to quickly access funds when needed. However, when we refer to private markets, their perceived illiquidity is often seen as a drawback.

But is this actually the case? Should liquidity be a major consideration for those with sufficient sources of income? In public markets, could investors be unnecessarily missing out on the higher returns that private markets can offer? In this article, we aim to answer these crucial questions and decipher whether liquidity is overrated.

Why Do Investors Need Liquidity?

Investors typically believe they need liquidity for several reasons including:

1. Funds accessibility: Ability to liquidate to meet imminent financial needs and to quickly rebalance or adjust investment strategies.
2.  Price discovery: Understanding an investment’s value is more straightforward, as it’s usually quoted on an exchange.
3.  Bankability: Easier to be pledged in the case of taking a financing facility.
4.  Tax benefits: For individuals, liquid investments are easier to be part of tax-advantaged pension accounts.

As a result, most investors feel a need to consistently invest in liquid assets. Private markets, on the other hand, are often deemed illiquid because investments in private equity, private debt, or real estate cannot be readily sold or exchanged and can be totally inaccessible for certain periods.

To compensate for this, investors earn a ‘liquidity premium’, which is an expected additional return for accepting the longer-term nature of these investments.

Is Liquidity Really Needed by the Majority of Investors?

Different investors have varied financial situations and goals and invest depending on their risk-reward profile. Long-term investors with stable income sources may not need high levels of liquidity, as their immediate expenses are likely already covered. Indeed, we would argue that investors with long-term goals can afford to sacrifice a certain amount of liquidity.

In addition, being fully invested in liquid markets can sometimes lead to rash decisions, with investors often being tempted to sell off assets during downturns or volatile market movements, potentially locking in losses. Liquid markets do not mean lower risk. Illiquid investments encourage a long-term perspective, reducing the temptation to exit during market lows.

This is why investors are increasingly looking to change from a traditional portfolio allocation of 60% in public equities and 40% in fixed income to one including private markets.

What Do Investors Forego by Not Investing in Private Markets?

Diversification: Investors tend to identify suitable investments based on their risk tolerance. The benefit of private markets is their potential to decrease a portfolio’s risk by giving access to a wider spectrum of assets, industries, and markets that otherwise would not have been possible if only investing in liquid markets.

Indeed, private markets offer access to high-growth sectors and innovative companies not typically available in public markets. In addition, the increased correlation between public equity and fixed-income markets has reduced diversification opportunities within these traditional asset classes.

Superior returns: By avoiding private markets, investors miss out on the liquidity premium. The liquidity premium is the expectation of excess returns. Private markets have historically proven to generate higher returns than public markets, thus employing an inherent liquidity premium.

Over a 20-year period, private markets have generated a 12.2% annualised return, compared to public markets at 5.2%.

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Long-term value: It is certainly true that investors with less tolerance for illiquidity and high exposure to liquid markets have a tendency to sell too quickly. Investors largely sell because the market is up, and some gains have been made, or it’s down and there’s a fear of losses compounding. Choices are made due to ‘loss aversion’ rather than ‘risk aversion’. In other words, investors in liquid markets are more likely to act upon their feelings and the potential for regret. Investors should consider selling if there is a change in the fundamental outlook of the investment, but it often doesn’t come into play.

Accordingly, investors in liquid markets miss out on the greater growth and subsequent value that their investments could achieve by selling too early – a factor that is much less prevalent for private market investments.

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Considerations for Investing in Private Markets

Private markets are indeed more illiquid than public markets, and as discussed, the liquidity premium is a consequential benefit of that. However, private market investment types vary quite significantly in length, with not all being very long-term (10+ years).

Private equity buyouts and private credit tend to have an investment horizon of 4 to 7 years, growth equity 5 to 8 years and venture capital and real estate 5 to 10 years.

But secondaries, which incorporate much more mature assets, have a relatively low investment horizon of 2 to 5 years. Furthermore, certain private credit funds can provide periodic liquidity.

When considering diversifying beyond traditional portfolio allocations, private markets are often a natural first step. But how much should investors allocate to private markets?

Individual liquidity needs and time horizon considerations of course come into play here, but those with longer time horizons and less requirement for liquidity can allocate more to illiquid assets.

Investors tend to trim public equity for private equity and substitute fixed income for private debt. Institutional investors, like university endowments who are very long-term minded, on average allocate 23% to private equity and venture capital, rising to 30% or higher for leading university endowments.

Grasp the Opportunity and Capitalize on the Liquidity Premium

While liquidity needs vary among investors, the belief that all investments must be highly liquid is often overstated. By avoiding private markets, investors may miss out on significantly higher returns and diversification benefits. Those with an appropriate risk profile and a long-term investment horizon can capitalize on the liquidity premium by investing in top-tier private market funds. For many, adopting a longer-term mindset could lead to more substantial financial gains and enhanced portfolio performance.

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Author

Saad Adada, CFA

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